Written By: Kelly Bryant
I was recently chatting with a founder who told me he and his co-founder received a term sheet on the last day of 2021. Initially, I was thrilled for him and thought ‘what an epic way to close out the year?!’. However, after a quick conversation regarding the terms of the deal, I felt otherwise. It’s not an easy decision for a founder to turn down an offer when having cash on hand can be life or death, but it’s times like these when it’s important to remember the old saying ‘some people’s money is greener than others’.
To help set you up for success, here are some standard term sheet elements that, as a Founder, you should be familiar with:
- Non-Participating Preference: From a founder’s perspective, non-participating preferred stock is better than participating preferred stock. It is also the most common in early stage deals. Non-participating preferred stock only entitles the investor to the greater of either (1) the preferential liquidation payment and not a share in any remaining liquidation proceeds, or (2) the amount the holder would receive if they had converted to common stock. In layman’s terms, if the preferred stock is participating, the VC ‘double dips’ by getting his/her money back plus its pro rata portion of exit proceeds.
- Liquidation Preference 1x: Liquidation preference is a form of preferential treatment for preferred stockholders at exit. As a rule of thumb, any multiple above 1x is typically viewed as aggressive. A standard term sheet should have a liquidation preference at 1x. This is especially important as common shareholders will be more likely to invest in the future if preferred stock investors’ liquidation preference is set at standard.
- Weighted Average Anti-Dilution: It’s expected investors will want anti-dilution protection. They protect against a down round by adjusting the price at which the preferred stock converts into common stock. The two common types of Anti-Dilution calculations are weighted average and full-ratchet. The weighted average method strives to balance money previously raised with the amount of money raised in a down round and the share prices of each. The conversion rate is typically lower than that of a full-ratchet strategy and is more founder-friendly.
- Board Control: Control clauses state who has the right to name a board member, appoint directors, dictate compensation, etc. Essentially, who gets to make what decisions and when. Typically, for an early stage deal, the lead investor will appoint one board member while the company gets two board members (2-1).
- Short & Sweet: A term sheet should be relatively straightforward and to the point. For reference, Y Combinator has made available a standard Series A term sheet (spoiler: it’s 2 pages). Anything longer could suggest the investor is attempting to structure away perceived risk or adding in additional clauses to benefit their upside.
While there’s plenty more elements of a term sheet we could dive into, there are non-financial aspects of any deal that are just as important as what’s in black and white. For example, you should ask yourself the following questions before signing a term sheet:
- What’s your personal relationship like with the investors?
- Do they have a good reputation?
- What value can they add to your business beyond capital?
These documents serve as a foundation for your subsequent raises. Future investors will appreciate that existing terms are straightforward and it can speed up the process tremendously.
So what should you do when you receive a term sheet?
Two important actions:
- Hire good counsel. Ideally someone with lots of experience advising other venture-backed companies.
- Find more term sheets. I know, I know – easier said than done, but hear me out. This particular founder I first referenced wasn’t able to go back to the potential investor and negotiate better terms because there were no other offers on the table. The best thing you can do when fundraising is generate competition for your stock and get multiple, interested parties.
And remember – you’re playing the long game. Waiting for the right term sheet is sometimes (read always) the best choice for the outcome of your venture.
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