As an early stage startup looking for investment, you can expect talking to as many as 50+ investors before you see a first sign of success. That sign of success usually comes in a form of a term sheet.
A term sheet is a non-binding document that lays out the proposed terms and conditions under which the VC or angel investor will make an investment in your startup. In general, it’s about a one to five page long document used as a framework for further negotiations. It can be prepared by either investor or a startup, but in many first-time entrepreneur cases, the startup founders are happy to accept whatever they get. In such cases, it’s important you understand what’s in the term sheet and, if the deal gets closed, what can be the impact in the long term. Here are key terms to look out for:
1. Common vs. Preferred Stock
When you take an investor on board, new shares will be issued. There are different classes of shares; in general, they can be divided in two categories: common and preferred. Usually, a share in a company gives you a right to profits and to vote members of the board (people who among other things have a right to fire the CEO). While both represent equity, preferred shares may include additional rights such as guaranteed dividends, cumulative dividends, liquidation, conversion, upgrades, redemption, participation, and voting rights, among others.
2. Pro-Rata Rights
Pro-rata rights obligate the company to allow investors participate in subsequent funding rounds. The reason for this clause is to allow investors to prevent dilution. One thing to look out for are “super pro rata rights”. These allow investors to increase their stake in subsequent rounds and gain more control over the company. In practice, an investor may own 10% in your company after the first round of financing, but demand up to 33% or 50% in the next one. To learn more about pro-rata, I recommend this post written by Mark Suster.
3. Liquidation Preferences
In case of your startup going bust, this clause determines who gets paid, and who gets when during these events.
4. Participating vs. Non-Participating Preferred Stock
Participating preferred stock allows investors to essentially double dip in the company’s gains, as they get to exercise both their liquidation preference and enjoy a pro-rata share of common stock gains simultaneously. Let’s say an investor holds $1 million in participating stock, representing 10% of the company. In case of the company going to liquidation with e.g. $2 million of assets left, the investors are entitled to get $1 million of it. In case the company is acquired for e.g. $20 million, the investor gets $1 million plus 10% of remaining $19 million. That makes $2.9 million instead of the $2 million they would normally get if they owned 10% in the common stock.
In contrast, non-participating preferred stock only entitles the holder to the preferential liquidation payment.
5. Drag Along Clause
A drag along clause is designed to protect the majority shareholder. It enables a majority shareholder to force a minority shareholder to join in the sale of a company. For example, let’s say you own 70% in the company, your VC holds 25%, and there is someone else with 5% stake (employee, co-founder etc.). Now imagine you get an acquisition offer from Google for a sum big enough to make you and your VC accept it. Without a drag along clause, the minority shareholders can refuse to sell their stock, which could make the deal fail. With a drag along clause, they are forced to to sell their shares alongside with you for the same price that you get.
This can also backfire – if you are faced with a drag along, your ownership position will determine whether or not this is a relevant issue for you.
6. Option Pool
Option pool is a term used to refer to a chunk of equity reserved for future hires. The size of your option pool, as determined during a round of funding, has a direct impact on your company’s valuation and, hence, your ownership. When dealing with an option pool, make sure with multiple scenarios of future financing. You can model your dilution using ownyourventure.
Anti dilution results in additional “bonus” shares being issued to VCs where there is a down-round, i.e. a subsequent financing at a lower price per share. It’s designed to protect investors from losing ownership in a company. Be on the lookout for a version of anti-dilution whereby the number of shares issued to the investor is FULLY readjusted if subsequent financings are down-rounds – read this post by Fred Destin for details.
8. No-Shop Agreement
No shop agreement means you’re not allowed to talk to other investors after you sign a term sheet. In all cases, you should bound to the no shop by a time period – usually 45 to 60 days is more than enough to bind an investor to get the deal done.
PS: You can find a decent, founder-friendly term sheet from Sam Altman here.
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