You may have heard of a term sheet, but what is it? How do you read it? As you might expect, a term sheet lays out the terms and conditions of the contract between an entrepreneur and funder. (However, don’t be fooled by the term, “sheet”, as it is often several pages long…which makes sense, given the specificity that it entails.) Essentially, it defines what each party is both giving and getting. After all, both parties have vested interest in protecting the financial investment, so the responsibilities and expectations are clearly laid out in the term sheet.
For example, as the start-up, the term sheet may define the specifics of your business, and you are presumably giving your funders regular updates as to efforts being made, key performance indicators to show the return on investment. Additionally, you may be giving a percentage of shares in the business to your founders and possibly a certain amount of, “access” to them, allowing them to offer feedback. What are you getting?
Well, the obvious answer is that in exchange for giving reports, defending your business decisions and accepting constructive criticism, you will be receiving the funding that is needed to start and grow your business. Additionally, that constructive criticism may be highly valuable, the type of professional mentorship or guidance, from a successful businessperson, for which some people pay thousands of dollars. Interestingly enough, there is an old adage in the nonprofit fundraising world that is applicable in the realm of entrepreneurship, as well: when you ask for money, you are going to get advice, but if you ask for advice, you are going to get money.
In terms of providing information regarding company finances and operations to the investors, this is also frequently spelled out in a term sheet: the investors right to information.
Meanwhile, as the funder, what are you giving and getting? Well, you are giving the funds that the start-up needs to level. You may also be giving some professional oversight to the company, offering guidance. But, what are you getting as a funder of a start-up? Well, if the company turns out to be the next Swell or Lyft, you get a lot of bragging rights and cache as having been one of those smart, savvy investors who got in on the ground floor. Additionally, if the term sheet cites that you get shares in the company as part of your financial investment, you stand to receive quite a lot of money, should the company prove to be successful.
The definition of a term sheet is fairly straightforward. So, how do you read a term sheet? What should you be looking for?
In addition to spelling out the goals and objectives of the investment, and defining the scope of both the entrepreneur and the investor, the term sheet essentially sets the value of the company. A term sheet will typically list both the, “premoney” and, “postmoney” valuation, meaning what the company is worth prior to the investors injection and then after.
Essentially, this also calculates the percentage of the company that is then held, “postmoney” by the investors. For example, if the, “premoney” valuation is listed as $5M and the investors are making a $2M investment for a, “postmoney” valuation of $7M, then 28.4% of the company now belongs to the investors. As such, it is important for entrepreneurs to be mindful of the, “premoney” and, “postmoney” valuations that are spelled-out in the term sheet as it can potentially be a way for investors to dilute shares and take majority control of the board of directors.
The smaller the difference between, “premoney” and, “postmoney” valuation in the term sheet, the greater the control of the company that is maintained by the founder. So, while it may be tempting to accept a huge cash injection that would double the value of your start-up, it is important to read through the valuation language carefully, with an attorney.
Meanwhile, an investor will want to be prudent here, too…after all, you may not actually want a controlling interest in the start-up, which is what you could end up, if you undervalue the company on the term sheet. It is also worth noting that most term sheets are non-binding. This means that until everyone has actually signed the contract, either party can change the terms that are laid out.
In most term sheets, the number of board seats held by the investors, the founders, common shareholders, et al., are laid out, along with voting rights. For example, some investors choose to be silent partners, meaning that they provide a financial investment, own shares, but do not have a voice in business operations and do not have a vote on the board of directors.
Another issue that is frequently addressed in term sheets deals with shares. How many are there? Who gets how many? Is ownership vested?
The idea of vested ownership in the shares is sometimes confusing to entrepreneurs. After all, prior to bringing in investors, they own 100% of the shares. While it seems perfectly reasonable that an investor would have a certain percentage, based upon their investment, what is this line about vested shares in the term sheet? Essentially, it means that a founder has to earn their ownership shares, often over the span of a few years? Why do this? Investors see it as a way of ensuring that the founder will be sticking around for awhile, rather than take the money and run. Additionally, it never reflects well on a company when there is a high rate of turnover in leadership and the same is true for start-ups.
While the depth of the term sheet is often related to where the start-up is in it’s funding round (for example, a term sheet that is offered at the seed round will probably not be as lengthy and have the deep-dive as a term sheet that is proposed during a Series B or C round), there any number of other topics which you can more or less guarantee will be addressed. Some of these include:
While it may seem that term sheets are often geared to protecting the investor less than the entrepreneur, that should not be the case. The terms and conditions spelled out should provide a win-win for both parties involved.