While working with startup founders and small business owners for more than a decade, we have come to notice a common problem that they often fail to recognize or appreciate the value of a good term sheet startup in Series A funding.
Most startup owners have not even seen or heard of a term sheet startup before, which puts them at a significant disadvantage when looking for potential investors and venture capitalists to fund their ideas. In this article, we will cover everything you need to know about startup term sheets, and how they can prove to be instrumental in building your investments.
If you are an early-stage startup owner looking to garner more funding at any point, whether Series A, angel investors or otherwise, it is important to know what a startup term sheet is.
A startup term sheet is a document that outlines financial specifics, and terms and conditions that open up the room for negotiation between the startup founder and a prospective investor. It allows you to discuss funding and other important aspects without having signed off a legally binding document that may have otherwise lead to disputes in the future.
If a meeting was conducted alongside a startup term sheet to discuss the exact terms of an agreement, you can ‘futureproof’ yourself. It is worth noting that this is different from a letter of intent, whose sole purpose is to serve as a formal document while a term sheet is merely a checklist of proposed terms and conditions for later use.
Entrepreneurs and other investors will start the “due diligence” phase after the agreement is concluded and both parties are happy with all the conditions outlined in the startup term sheet. Both sides agree on a time limit for this phase, during which prospective investors iron out the specifics of the company’s early phases, such as its organization and financial plans.
Perhaps the most important aspect of a term sheet for startups is the details about the investment itself. This includes the exact amount of the initial investment, the percentile ownership approved by the invested funds, and the timeframe for reaping the rewards of the investment. It is helpful to include a timeline of when you would like a response to the startup term sheet to start moving forward with the process.
As a startup owner, you must outline the valuation of your startup in the term sheet. This entails mentioning both the pre-money evaluation (the worth of your startup before any investment) and the post-money evaluation (the worth of your startup after securing the aforementioned investment).
More often than not, Series A investors will have the right to convert a stock of their choice into common stock for the company at any given time. This preference is given due to the common stocks being more helpful in the case of an IPO or acquisition by another major firm.
Investors like to prepare for the worst-case scenario. Presenting the term sheet with your liquidation preferences can be very helpful when attracting investments. This will let the investors know that in case the company is sold or liquidated, the monetary assets will be divided as per the agreement amongst the investors.
This clause acts as a safety net for the stakeholders if the entire business fails and is forced to shut down. If an investor requests to be paid more than the amount they had invested initially, i.e. the share price (1x the investment is the usual return), one should steer clear of it as that is generally considered to be a red flag in the industry.
For most early-stage investors, dividends are often just icing on top of the cake as they are not expecting major annual returns just yet. This additional benefit can help attract investors through your startup’s term sheet, hence a 5-10% margin would be beneficial to include in the agreement. We should preface this by mentioning the two most common types of dividends.
Cumulative dividends accrue to the originally issued price of the stocks in a startup and favor the cumulative investors over the common stockholders, i.e. the founders. This is because the unpaid dividends are delayed to the next fiscal year and keep piling up. They are uncommon in early-stage startups and one should be wary of cumulative dividends, as the raised liquidation preference becomes a large economic hassle for the startup before it can start earning any decent profits.
The other type of dividends is called non-cumulative dividends and these are declared through the ‘right to a dividend’ by the initiated board of directors. This is more favorable to the holders of common stock than the holder of preferred stock, as both are treated equally to dividend distribution in this particular scenario.
In case the valuation of a company decreases over time as it progresses from one round to another, the investors or owners of preferred stock get dividends in the form of their anti-dilution rights. This allows them to either convert their preferred stock to common stock at a much lower price or gain additional shares within the company in case of a downturn.
Potential investors must also clearly outline their respective roles in the functioning of the company. The term sheet for startups entails their specific voter rights within the decisions of the company and how those rights will be conducted. Generally speaking, in earlier stages such as the Series A funding, the investors get the same number of votes as the number of common shares they can convert at any given time.
However, be wary that Series A investors get veto votes in funding and the sale of the company. The term sheet for startups also often includes participation rights that allow investors to take back their investment through means of receiving their share before the other contributing investors. This privilege allows them to recover their losses in case of a bad term or liquidation of the company, and continue funding in future rounds if the startup can survive the shock.
Founders should remember not to miss any key company details when drafting the term sheet as a startup, because failing to do can leave lead to confusion and conflicts in the future. They should also establish and mention the board of directors, ensuring that the business has the right structure for future growth, board votes, and distribution of funding to all the pertinent parties involved.
A model that is commonly used for this purpose is the 2:1 ratio model that allows the founders with the biggest hold over the majority stock to have two seats, and the investors, on the other hand, to have one. This ensures that the founders retain control over their company and decisions. Some companies opt for a model that has one ‘outside member’ on the board who is respected by all parties involved. Regardless of how the board of directors is arranged, it is helpful to have equal representation of founder-friendly individuals and investor-friendly individuals, for better decision making.
Investors with redemption rights have the choice of getting their money back at any they wish so. This will not be a problem if your organization succeeds or fails since the investor will get a return in the first scenario and nobody will receive anything in the latter scenario. However, redemption rights may be an issue if a business is going through a difficult patch and a wary investor requests for their money back, thereby, potentially sinking the company.
“Board fees” and “monitoring costs” are two expenses that may appear in the term sheet startup and can be open for discussion. The investor will charge you for their attendance at board meetings or the job of overseeing their investment in both instances. Do not concede to these fees since they are unwarranted, unjust, and may bother future investors.
Traditionally, all investors are only offered one board seat per round. One should be wary if an investor demands more than that as it complicates future rounds and dilutes your share in the company as a startup owner. The one-seat per-investor model allows for maximum leverage through investment.
This method of funding is rather out-of-date and is fairly uncommon to see nowadays, so feel free to steer clear if an investor is requesting it. The way it works is that you will only partially be financed (also known as a Tranched Round), and the rest of the investment will be made by the investor when you achieve certain milestones. If those milestones are not achieved, investors can change the terms of the deal. This type of investment financing can be bad for your business as often founders only receive part of it even after achieving the aforementioned milestones.
Term-sheets for startups are one of the best ways to set the groundwork for a successful negotiation between a startup founder and an investor or investors. It lays down the terms and conditions for investment so that all parties and stakeholders can work together towards finalizing and agreeing upon them. All of this depends on how explicitly well explained the terms are and whether they are summarized at the end for easier understanding. The more detail-oriented your document is, the more the investor will be confident in investing in your startup.
On the other hand, not all term sheets for startups are non-binding, and if you find wording on ‘negotiate on good faith’, then either party cannot back out. We hope this article has helped you understand the process of creating a startup term sheet, and how to best lay the foundations for an investor meeting that will continue to benefit your organization.
Are you handling too much as a startup owner? A little help will get you going and help you keep your small business on track.
Monily is your trusted partner when it comes to scalable startup accounting services, tax outsourcing services, and innovative bookkeeping. It is easier to tick things off your list when our accredited accountants and CFOs are working with you. Wherever your startup is looking for funding, make sure you have all the necessary paperwork done and out of your way first.