The time and energy spent by entrepreneurs in pitching to potential investors, if successful, culminates in the angel investors issuing what is known as a ‘term sheet’. A term sheet is a non-binding document that contains the terms and conditions for the investment to be made. Based on this, the negotiations happen between the parties and the final contract is drawn up. For the entrepreneurs, it lays down their contribution and sacrifices for receiving the funding. For investors, it defines their share in equity and the kind of power they will get in return for their funding and engagement.
Term sheets often contain legal terms and conditions and jargon that can be intimidating and confusing for first-time entrepreneurs. Knowing what constitutes term sheets and potential points of contention is crucial for entrepreneurs to negotiate effectively and structure it the right way. Structuring the term sheet the right way will ensure that it is a win-win for both parties, rather than one party getting a bad deal. Here are some key points to guide you in structuring the term sheet the right way:
Valuation (price per share)
The valuation of the startup refers to its net economic worth and is done before every funding round. While most entrepreneurs spend large amounts of time and energy in negotiating higher prices per share, it may not always be advisable to do so. Accepting lower prices may be better in some cases as it could mean more flexibility.
Entrepreneurs must consider a few other things while negotiating valuation, not just the price per share. One such consideration is how the current valuation will affect your ability to raise capital through future funding rounds. If the valuation is extraordinarily high, there is a possibility that future investors would want to reset the valuation to a lower level, affecting the entrepreneurs severely. Another consideration is if the stock pool option is included in pre- or post-money valuation since it has a bearing on whether investors share in dilutive costs or if the burden is fully shouldered by the entrepreneur.
This defines how the proceeds of the dilution of the firm will be divided among shareholders. This provides a safety net for preferred stockholders in the case of the startup failing, by assuring they get their investment before the common stockholders. It is ideal to maintain 1x liquidation preference so that the amount to be repaid does not compound with further funding rounds and entrepreneurs are assured of getting some share in the sales proceeds. The second consideration is whether investors get participating or non-participating preferred stocks. Since participation provides higher returns to investors, they prefer to include it in the term sheet.
In such a case, a cap should be considered to protect the interest of entrepreneurs. Say a cap of 3x is fixed. So, the investor will have to convert their preferred to common stock after the cap is reached.
Typically, a founder vesting period of 3-4 years is suggested to ensure the co-founders are aligned, that no founder walks away in the nascent stages, and the investment is protected. In the initial period, founders are seen as important elements in business success and founder vesting gives a sense of trust and commitment to angel investors.
Board structure and composition
Board structure and composition impacts the level of control and ownership of the founders in the startup. It is, therefore, important to consider the size and composition of the board and the management so that there is shared vision, balance, and alignment towards common goals.
Provisions to avoid in term sheets
Full ratchet anti-dilution provisions and cumulative dividends must ring alarm bells for founders since they have severe negative implications for them. It is also advisable to avoid milestone-based financing since it could dilute the level of control of founders while giving the right to investors to change the terms of the deal if milestones are not reached. Also, avoid redemption rights to ensure the investors do not pull out when the startup is going through a rough patch. It is best to avoid multiple boards per investor and unnecessary fees.
Investors have years of experience in the field and term sheets, and the negotiations are bound to be favourable to them. It is important that you are aware of your priorities and goals during negotiations so that your energy is focused on the right things. Be confident and command equal treatment on the negotiating table.
Prashant Pansare is Co-founder of Eagle10 Ventures, an angel investment platform enabling early-stage investments.
(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)