You’ve been pitching your startup to investors for months, and, finally, you’ve got results: a term sheet (hopefully more than one) from an investor interested in funding you.
A term sheet can take many forms (a single page or up to 7 or 8), and if you’re a first-time entrepreneur, you’ll be confronted with terms and conditions that sound like they come from an alternate universe populated by lawyers. The term sheet is an outline of the eventual terms under which the investment will be made, so my preference from an entrepreneur’s perspective is for the more comprehensive term sheet covering all of the primary points of the investment negotiation.
Frankly, I’d rather know where the points of contention will be as early in the negotiation as possible. Discovering the problems mid-way through the drafting of definitive documents (when you’ve dialed down your discussions with other investors) puts you at a distinct disadvantage.
When reading a term sheet, there is a natural tendency to 1) equate equal importance to each provision, and 2) focus disproportionately on the wrong issues. Many of the provisions included in most term sheets are close to boilerplate and will have little material impact on the matters you should care most about. You can negotiate each and every point or focus on the “big four” – issues that may dramatically affect your interests and your relationship with your investors:
1. Valuation (Price Per Share)
Valuation, or the price an investor is willing to pay for shares in your company, is obviously an important issue. This is the one where entrepreneurs tend to focus the bulk of their energy. No doubt about it, a higher price for a share of stock is better than a lower price. That said, not every offer at a $1.00 per share is equal, as I’ll explain under liquidation preferences.
There are clear cases where you’d be better off accepting a lower price in exchange for more flexible terms in some of the other areas I’ll discuss. You’ll also want to pay special attention to whether or not the Stock Option Pool for future employees is included in the “pre-money” price of your company (the value before the investor put their capital in) or is established “post-money.” Pre-money will be more dilutive to the founders (you bear 100% of the dilutive cost of the option pool), where post-money reflects a “sharing” of the dilutive cost with your new investors.
A secondary consideration around valuation is how the pricing of this round will affect your next capital raise. Remember, raising capital is a trip you are likely to make several times. A valuation that is extraordinarily high can become problematic when you raise your next round if your valuation is ahead of your business fundamentals. If this is the case, you confront the very real possibility of a “down round” as investors seek to re-set the company valuation. Earlier investors will be protected, to a certain extent by “anti-dilution” provisions, whereas you, the entrepreneur, has no such protection.
2. Liquidation Preference
Liquidation preference is one ofthe Term Sheet provisions that can have the greatest impact on an entrepreneur. Simply put, liquidation preferences define the division of proceeds between shareholders (common and preferred) in the event of a sale of the company – regardless of equity ownership. There are two provisions to watch for:
- A multiple liquidation preference (2X, 3X, etc), which entitles the shareholder with the preference to get a multiple of their capital back prior to any other investors participating in sale proceeds. The lower the liquidation preference (or “no” liquidation preference), the better for the entrepreneur.
- “Participation” versus “non-participation” – This is often used in combination with the liquidation preference. “Participation” means the investor participates in all proceeds – after the liquidation preference – based on their ownership percentage. This is called participating preferred. “Non-participation” results in investors either a) getting their liquidation preference or b) choosing to convert their preferred shares to common shares and participating pro-rata with all other investors.
Clearly, these two provisions can have a tremendous impact on participation in the proceeds of an M & A transaction. When confronting participating preferred, consider a “cap” where the provision would go away under a set of circumstances; for example, once investors are assured of a certain return on their capital (2X or 3X ) or with a new round of financing when specific conditions are met. Liquidation preferences can compound through multiple rounds of financing, placing the common shareholders further and further away from participation in the proceeds of a sale.
3. Founder Vesting
The earlier the stage of an investment, the more likely the founders will be considered “essential” to the success of a potential investment by investors. Accordingly, investors will often require that the founders re-vest (or re-earn) their equity over a period of time. For the investor, this ensures the continued focus and commitment on the part of the founding team in which they are investing. This is a valid concern and a legitimate request. With this in mind, you’ll want to get ahead of the discussion in your original stock purchase agreements: Establish founder vesting proactively in anticipation of the investor request and to ensure alignment between cofounders (what if one of you decides to leave). Other considerations:
- At the formation of the company, you may choose to establish a vesting schedule for Founders stock. Vesting monthly over four years is common. In a case where the vesting will commence sometime after the formation of the company, it may be appropriate to only subject a portion of Founder stock to vesting. For example, 50% of your stock is vested at the time of the financing, and the balances “vest” monthly over a 2-, 3-, or 4-year period.
- If you have not established a vesting schedule at the time of financing, suggest that a significant portion of your stock (25%-50%) be considered vested (in recognition of your efforts to date) and the remainder of Founders shares vest over the subsequent 2 to 4 years. Again, monthly if you can.
- Address what happens in the event a) you leave the company, b) you’re terminated (with or without cause), c) you die or are disabled, or d) the company is sold and all of your stock has not vested.
- If you leave the company prematurely, are you forced to sell your stock back to the company? At what price?
Remember, for founding entrepreneurs, the vesting focuses on stock you have purchased as part of your initial capitalization of the company, not just options you may be granted down the road. Understand the issues here and get ahead of them.
4. Board Structure and Composition
While entrepreneurs reasonably focus on ownership percentage as an indication of control, true control in a venture-backed company rests with the management team (day-to-day operational control) and the board of directors (hire and fire management – major financial and strategic decisions). As such, the structure of the board, (who is represented and how they are chosen), the list of decisions requiring board approval (budgets, financing, stock grants, M & A versus IPO), and the voting thresholds for taking action (majority, super majority) tend to have a larger impact on control of a company than share ownership alone might dictate. It is essential to think through these issues very carefully:
- In general, a smaller board is better (more efficient) than a larger board
- Who is the board member who will represent the Investor (remember, not all investors are created equal)
- Multiple investor – multiple directors: Does this add balance or complexity?
- Is there a role for an independent director? How are the chosen? (Founder proposed.)
The essential key you are looking for is balance and the ability to develop and maintain a shared vision and focus. When you bring in outside investors, you are surrendering partial control – in exchange for capital. Pay careful attention to the composition and decision making thresholds of the board. Look for alignment wherever you can, but make sure your voice will be heard when critical decisions are on the table for discussion.
Apart from these “big four” issues, don’t ignore other provisions of the term sheet. It’s always important to have your own lawyer give it a thorough reading. While uncommon, provisions calling for “cumulative dividends” or “full ratchet anti-dilution” protection should set off alarms bells.
Lastly, the term sheet is a starting point for a discussion (negotiation) with a prospective investor. By definition, it will favor the investor and is based on experience gained through thousands of investments by the investor community. While all provisions are there for a reason, some are more important than others – focus your energy there. Your investors are professionals and have the benefit of not only experience but extensive legal teams. Make sure you come to the table equally prepared.
Bob Ackerman is the Founder and Managing Director of Allegis Capital and formerly a successful serial entrepreneur. In his spare time, Bob teaches New Venture Finance at the University of California, Berkeley in the MBA program and is active in the non-profit world, focusing on education and the arts.
[Top image credit: Vlad Mereuta/Shutterstock]