So you think you’ve found an investor who’s committed to backing your company? Good for you. But before breaking out the bubbly, you need to make sure that you’ve got all the pieces in place to make this deal go through—in a way that benefits and protects you, as well as your potential investor.
The Venture Capital Term Sheet
The key to turning this potential deal into a done deal is the venture capital term sheet. As you know, a venture capital term sheet is the short, readable document that is negotiated prior to the actual contract, laying out the important terms of your deal. The term sheet itself is not necessarily legally binding, but it does offer some protection for you and your investor. And, if done well, it will lay the groundwork for the final legal terms of your agreement.
Before executing a term sheet, you need to do your due diligence on your potential investor. You’re looking for confirmation that they have a solid reputation and no history of turning tail and running from deals.
Once you know that you’re dealing with a trustworthy investor, you’re ready to check out the proposed term sheet. For your best leverage, you should try to limit the number of conditions spelled out in the term sheet. You also want to see the terms narrowly drafted.
Elements of a VC Term Sheet
In general, you’re looking for a term sheet that covers the following:
- Preferred return
- Protection of valuation and position in regards to future money
- Investment management
- Exit strategies
7 Key Terms
But while there are a number of major term sheet deal elements that bear consideration, there are 7 key items that you need to pay particular attention to:
1. Money Raised – There is usually a term around the issue of the minimum offering amount. Your investor will require that a minimum amount of money is raised before they disburse their funds. You need to carefully consider this minimum offering amount. It will be your responsibility to raise this money, so ensure it’s a realistic goal.
2. Pre-Money Valuation – You will need to work with your potential investor to negotiate a “pre-money” valuation; that is, the value of the company prior to investment. Pre-money valuation can be a bit sticky, but essentially the valuation is calculated on a “fully-diluted” basis. In other words, the value includes all issued stock and anything, such as a stock option pool, that may be converted into common stock. The venture capital fund will compute their percentage ownership of your company once their investment has been added to this value.
3. Non-Participating Liquidation Preference – There are several varieties of liquidation preferences. In all cases, the gist of this term is that investors will get their money back first, before common shareholders get their money back. One liquidation preference to look for is the 1X non-participating liquidation preference, which means that investors will get their investment back prior to common getting a distribution (whereas 2X means that the investor will get double their money back, and so on). This term also gives investors the option to participate pro rata in an exit with other shareholders. At exit, investors can choose to use the liquidation preference or just participate as shareholders. Interest accrual may be included in this preference.
4. 1:1 Conversion to Common – One actual non-negotiable in term sheets is the conversion to common. The crux of this term is that the buyer of preferred can convert to common if he decides it’s a better move to get paid on a pro rata common basis (instead of just taking the liquidation preference). Sometimes the preferred wants to be able to control a vote of the common on a particular issue – but this is a rare occurrence.
5. Anti-Dilution Provisions – These provisions call for protection, for the fund, that your company will not sell stock at a price less than they have paid for it. The basic idea is that if you have a down round, the investors will get additional stock to preserve their shares. If you don’t stick to this provision, the fund has the right to maintain their original percentage interest without additional payment.
6. The Pay-to-Play Provision – Once rare, this is a very common term in venture capital term sheets today – and something that companies and investors can usually agree upon. This term is just what it sounds like: investors must participate in future financing (i.e. pay) if they want to play (i.e. not have their preferred stock converted to common stock).
7. Board Representation – Investors want to ensure their continued involvement as your company evolves, protect their position, and play a role in the ongoing management of their investment. Towards this end, it is common for a prospective investor to request a seat on the board of directors.
Getting your first potential investor is exciting, but it can also be stressful. It’s easy to feel like the investor has all the power during this period. But, you have power too—and a great opportunity. Take this time to negotiate the terms and do your best to knock out unusual conditions. Before executing the term sheet, this is your chance to button-down key issues and position yourself as advantageously as possible for your forthcoming investment.
David Ehrenberg is the founder and CEO of Early Growth Financial Services, a financial services firm providing a complete suite of financial and accounting services to companies at every stage of the development process. He’s a financial expert and startup mentor, whose passion is helping businesses focus on what they do best. Follow David @EarlyGrowthFS.
