A Term Sheet is a shortlist of a few of the most important deal terms (normally 10-15) that form one of the early parts of negotiating investment. Once the Term Sheet is agreed upon, the process moves forward to a long-form agreement and the final negotiations of the minor points.
For founders, negotiating a Term Sheet is vital when it comes to showing Venture Capitalists and Angel Investors your credibility, confidence, and experience.
We asked London-based Joe Knowles who is Principle Venture Capitalist at Smedbvig Capital, for some expert insight into negotiating Term Sheets. Joe actually invested in our parent company Adzuna! He advises that these initial negotiations over a Term Sheet can form the basis for the Investor and Founder working relationship moving forward. He continues, “At the beginning, it's more smiles and both sides trying to persuade each other on how well you'll be able to work together! Then there may come awkward moments where you may have differently aligned aims, so being able to have that difficult conversation early on is a good test
Joe Knowles advises that “There really isn't anything you shouldn't ask, if there is something you are worried about or thinking about, once it is signed, there is no going back. Very important you do ask whatever you're thinking.”
In terms of issues you want to raise and negotiate at this stage, Cooley Go LLP suggests a rule of three when it comes to Term Sheets. Suggesting you focus your efforts on negotiating three key areas of the Term Sheet, even if there are more or less than this.
Joe reflects, “I'd encourage people to be open and embrace the slightly awkward nature of it as a way of building the foundation of the relationship.”
Valuation: A company’s valuation is what the VCs believe your startup to be worth prior to their investment. In a Term Sheet, this is your ‘pre-money’ valuation. Your ‘post-money’ valuation is then the pre-money valuation post their investment. This establishes the percentage that the investors will own.
Valuation is not everything. If employees are offered equity for long service, the value of this will be reduced by a high valuation and cause early staff to feel disenfranchised. A high post-money valuation will also mean a significant loss of control and decision making powers for the investors.
The dilution / anti-dilution clause: An anti-dilution clause protects the VC from their ownership percentage being diluted if a company’s value falls. It’s a contingency for the investor.
This is used to protect the investor in cases of a “down round” when a company offers additional shares for sale at a lower price.
There are two main types of dilution clause, a weighted average and a full ratchet. In a full-ratchet model, if a stock is sold at a lower price than it has been sold to the VC in series A, the VC’s stock would be repriced, meaning they have more shares or invest less. When weighted average is used it takes into account the magnitude of the lower-priced issuances and not the actual valuation.
The weighted average model is substantially more founder-friendly.
Liquidation Preference: This defines the return that an investor will receive when a company is sold and can make a significant impact on what the founder receives.
Model out expected exit values so that you understand what a VC would receive based on their liquidation preference formulas.
As a note of caution, Liquidation Preference agreed in Series A carries through Series B and beyond, so that the more investors, the less the founder receives at the sale. This can be used to resist the inclusion of this clause in Series A.
The Board of Directors and company control: the board and the governance of a company are very important for the direction of a company going forward. Typically following an initial funding round a board will be made up of three. One investor, and two founders representing the common stock.
For each round, it is typical to add an investor to the board but this can quickly add up, remember the board’s job is to decide who runs the company you founded.
Ensure that the control given to investors is negotiated. It’s not worth the board and investors controlling too many small decisions that are better left to management. It wastes time, and can significantly change the direction of your company.
Founder vesting: In startups with multiple founders, especially founders who haven’t worked together before there is always a risk of founder fallout. Vesting helps reduce the impact of a co-founder leaving so that they don’t leave with a disproportionate amount of equity. If you’re 100% vested, you own 100% of the shares allocated to you. By breaking this up, typically over a 4 year period, if you leave after 2 years only 50% of those shares are allocated to you.
Most VCs will request that a co-founder vesting agreement is put in place, so it is worth considering a vesting model that will work for your business.
Veto-rights: Veto-rights or protective provisions are typical in a Term Sheet. Some of these are fairly straightforward such as a veto on a declaration of dividends. Others are worth looking out for, particularly if they impact your rights to go through further funding rounds. This will also be written as something along the lines of “no creation of a new series of stock without VC approval” or refer to amendments of the certificate of incorporation.
An exclusivity clause: This covers a period of time that you are not allowed to speak to other investors after signing a deal with your VC. This is a perfectly reasonable request, but be mindful of the length that the VC is requesting as a month or 6 weeks is more than enough time.
It can be easy for founders to get lured in by investors that are providing you with a higher valuation, it’s certainly flattering.
Being a unicorn, and having a valuation of over $1 billion USD is certainly newsworthy, but getting your company the right investor is more important.
“It can definitely make sense if you have four offers on the table and for certain reasons, you may want to choose one that hasn't given the highest offer as they could add more value due to their expertise, or your aims are more aligned and you think they will be better to work with,” advises Joe Knowles. Consider the other clauses as detailed above, the level of control, the VCs experience in growing similar companies, and whether they are the right fit.
A lesser valuation, from a better, or better fitting, venture capitalist, can be far more valuable to your business’s growth in the long run.
Remember that the investor you choose will become a significant part of your company. They might sit on the board, and they will have decision making powers to a degree. If a lower valuation is more likely to get your business over the line in the long run, than a riskier higher valuation, consider the better investment as your go-to. Joe adds, “once you've chosen who you want to work with, getting the highest value you can in a way that they are also happy with is important”. Remember the importance of negotiating.
Quite simple, no, it rarely would. Joe suggests that there “are some arguments where you are fundraising for the second time and if the valuation is too high, it may be hard to raise without a down-round and getting more dilution.”
Funding rounds can take a long time so sometimes convertible equity is used to bridge a business through the funding round. The terms of a convertible note is that they receive a discount on shares.
For example, a VC invests £100,000 into a startup at a convertible note with a discount of 10% after qualified financing reaches £1,000,000. Let’s say each share is £1. The investor can therefore buy £100,000 of shares at a 10% discount. So 90p per share. That means they can purchase approximately 111,111 shares for their convertible note.
With straight equity, £100,000 buys 100,000 shares at £1.
The advantages of convertible funding is the speed at which these agreements can be reached and therefore the speed that the company gains the money. It wouldn’t be advisable to do this later down the line but is fantastic to get money to get a business moving
If you’ve never seen a Term Sheet before, it’s worth downloading some templates online so that you know what to expect. Have a go at critiquing a standard Term Sheet so that when you’re faced with your own, you’ll know what parts of the Term Sheet are important to you.
Although a lot of Angel Investors and Venture Capitalists will have their own standard Term Sheets, others will ask you to provide one. So it’s worth considering what your ideal Term Sheet would look like.
You can download some term sheers from Seedsummit.
For companies founded outside the USA, but expanding or gaining investment from America there are some differences in the Term Sheets to be aware of.
US Term Sheets tend to have a higher focus on voting powers and control. VCs in the UK and elsewhere tend to have a less active role in company governance. Although this may seem intrusive, well networked VCs often leverage their connections to connect companies with complementary portfolios to increase the overall value of their investments, therefore increasing the overall value and growth of your business.
Vetting processes are therefore vital within the US system, as you need to understand the direction that these investors, especially those with board seats, want to take your business.
There are two key types of stock on a US Term Sheet, preferred stock (given to the investors) and common stock (held by the founders and given to employees as equity). A substantial part of the Term Sheet will relate to the voting and control rights attached to the preferred stock that is issued during the financing.
It is also not uncommon for US investors to ask companies to make substantial capitalisation changes such as making inactive founding members repurchase their shares or terminate their relationship. Vesting agreements too are more likely to be imposed with all employees subject to standard vesting terms moving forward.
And finally, one more piece of advice from Joe, “create enough opportunities where you can get the principles together in a room to unlock any deadlocks that inevitably do happen.” The value of face to face, even if via a computer screen, can be far better than emails, and messages. Approach the negotiation of a Term Sheet with confidence and professionalism.
To conclude, Term Sheets are a vital way to engage with investors early on, set the boundaries of your relationship in the long run, and understand how your business will change as it grows through different funding rounds.
