Understanding the Term Sheet
Seeing founders rushing the negotiations and agreeing to terms without fully understanding their impact made me feel obligated to write this post.
After pitching her/his startup and receiving initial acceptance, the investors usually set another meeting to discuss the terms in the Term Sheet.
The Term Sheet is a non-binding agreement between two parties outlining the most important terms that will later bedrafted in twobinding agreementscalled the Shareholders and Subscription agreements.
The terms in the Term Sheet can be split into two main categories:
1. Economic Terms
2. Control Terms
In this post I will try to focus on the most important economic terms and leave the control terms to my next post.
Economic terms are very important to both the founders and the investors as they have a direct effect on the stake that each party will eventually have and the return they make. Economic terms include Price, Vesting, ESOP, Participation Preference and Antidilution.
Price refers to the value that both parties agree on when entering a deal. The price usually is a pre-money price (the company’s value before the investor puts in the money ). As a founder, you need to know that the price will directly impact the percentage that the investor receives. The example below explains how this percentage is calculated:
Investment Amount: USD 1M
Pre-money: USD 9M
Post-money (Pre-money + Investment Amount) = USD 10M
Round Dilution (Investment Amount / Post-money) = 10%
The vesting term is one of the terms that is usually misunderstood or perceived as aggressive by founders.It outlines the mechanism and timeline by which the founders will receive their shares after the investment. This term is important to the investors to ensure that the founders are incentivized to remain in the company for a certain period of time to see through the vision that the investors bought into. A standard (not a rule) vesting schedule commonly used in the industry is shown below:
25% of founders’ shares to vest immediately after the round closes
75% would vest quarterly/monthly over 36 months
If a founder decides to leave the company before the agreed upon period in the vesting schedule, they only receive the vested portion of their shares, and the remaining shares are usually distributed pro rata to the remaining shareholders.
Having an employee stock option plan or ESOP has become a staple in any agreement and it is one of those clauses that benefits all shareholders alike. It simply sets aside a certain percentage of the shares (usually 10% -15%) to be used to attract talent. Startups as we all know do not usually have the cash early on to onboard capable, experienced members to their team and the ESOP is a good alternative. The ESOP shares given to any employee usually follow a vesting schedule similar to that of the founders. If you agree to an ESOP with an investor, make sure you understand that the ESOP will dilute your shares as a founder and not the investors’. Although this might seem unfair, it is a standard practice as investors agree to a valuation that will give them a certain percentage after the round closes and they would not expect this percentage to change just because you agreed to an ESOP. One way to mitigate the dilutive effect of the ESOP is to factor it in at the beginning when setting the valuation with the investors.
Participation preference is a clause that is common in most term sheets. It explains how the proceeds will be distributed if there is a liquidity event (which is basically a sale of the company or most of the company). It usually indicates the amount returned to a specific class of shares ahead of the other classes. The industry standard is 1x participating preference (which is explained below) and in my opinion anything more than 1x is too aggressive.
There are three common types of participation
1. Non-participating usually means that during a liquidation event the investor receives whichever is higher; either the investment amount or her/his pro rata shares of the proceeds. This is however not a rule, and the clause could be written to specify one of the two options.
2. Full Participation (usually written as 1x participating preference) and it means that the investor will receive the investment amount first and the remaining proceeds will be distributed according to shareholding percentage. If an investor invests USD 2M at USD 8M pre-money (10% stake) and the company exits at USD20M assuming the agreed upon preference is 1x participating preference, the investor will get USD 2M first and then 10% of the remaining USD 18M.
3. Participating with a cap means that if the investor makes a certain multiple on their investment the participation does not happen. If the cap is 4x and the investor makes 4x or more on their money, they only get their share of the proceeds according to their stake in the company.
Participation preference is a very important clause that has a material effect on the proceeds a founder receives especially at low outcomes.
The antidilution clause is a protective clause for the investor in case the company goes through a down round (raises a round at a lower valuation than the investors’). There are two common variations that I will attempt to explain without getting into the calculation to make things easier.
1. Weighted Average Antidilution
This is the less aggressive approach to antidilution where the company issues just enough shares to the old investor to maintain their stake in the company. Some investors do not like this as they feel they should get the same price per share as the new investor (which will yield a higher stake) and hence the Full Ratchet Antidilution
2. Full Ratchet Antidilution
The old investors here receive a number of shares equivalent to their investment amount divided by the new (and lower) price per share. This of course is at the expense of the founders and is also a common practice that many investors insist on.
Finally, I would like to emphasize that all the terms in a term sheet are negotiable, and you could always structure a clause to mitigate some of the economic burden, however, understanding the industry’s norm and the investors perspective is also very important before negotiating any changes.