Investment plays a crucial role in backing up as well as making a business stand firmly in the beginning stage and pitching your new business or start-up is the most cynical exercise you will ever perform, if you wish to secure funding for your business. Amidst the big confusion of pitching your start-up or new business to investors for months, you will finally secure A Term Sheet from an investor interested in funding you. This guide will try to explain to you what exactly is a Term sheet and its connections on your business.
A Term Sheet is possibly one of the most significant documents a founder will ever encounter. It describes the “Terms and conditions” for an investment. These terms will define things like the agreed-upon valuation of the company, price per share for the investment, the economic rights of the new shares and so forth. In addition to these, a term sheet may specify some of the options, rights, and obligations of each party.
Usually, a term sheet itself is not binding. It acts as a blueprint for the formal legal documents that will be drafted by a lawyer. Nonetheless, you do agree to confidentiality to not to enter into negotiations with any other investors at the same time.
Important clauses in a Term Sheet
A Term Sheet can take many forms, from a single page or up to 7 or 8. And if you are 1st time entrepreneur, you may come across very confusing terms and conditions. A typical Term Sheet contains the following major clauses: –
This is the single most important term in the Term Sheet. The company’s Valuation along with the amount of money invested decides the %age of the company the new investors will own. This has direct Impact on who owns what and how much cash each shareholder shall take when the company sells.
The measurement of the company is based on pre-money and post-money valuation. A pre-money valuation stipulates the company’s estimate before the investment and post-money valuation is simply pre-money valuation plus new investment.
There is a lot of uncertainty regarding valuation. Sometimes a poor valuation can ruin the deal even if other terms were in your favor. But this is not certainly true, because a great valuation may not guarantee success if there are unfavorable terms on the term sheet.
A Term sheet may specify the creation of a reserve of stock for existing and future employees. Option pool is practiced as the way of compensating services to the company through stocks.
Multiple founders calculate the option pool stock after post-money and force the investors to share in the dilution. But the model for most term sheet should be to calculate it pre-money.
Types of Stocks
There are normally 2 types of stocks that are negotiated in the term sheet. Common stock and preferred stock. Common stocks are sustained by founders and preferred stocks are given to the investors. Preferred stocks issue with rights, preferences, and privileges, owing to the financial interest that holds this stock has in the company.
Liquidation preference clause is attached for the protection of the investors. An investor would want your business to thrive so that their stake in the company is worth more than they invested. A liquidation preference delivers them some security of not losing all money. It decides the amount of money returned to investors against the original purchase price at the time of the liquidation of the company.
The Term Sheet defines what exactly constitutes a liquidation event. Conceivably it is mergers or acquisition or selling off your company’s assets. It does not mean winding-up or closing down of the company.
Participation stipulates who gets a share of the remaining proceeds in a liquidation event. The participating right offers following privileges to the preferred stockholders:
Full Participation- This means that a preferred stockholder gets not only their share of preference but also on the leftover proceeds alongside the common stockholders.
Capped Participation- The preferred stockholders get a share of the leftovers up to a certain limit.
Non Participation- The preferred stockholders get no shares further share in the leftover proceeds after the preference is satisfied.
Dividends, displayed as %age provide a monetary amount to the shareholders by the company. All term sheet comprises a dividend clause which lays down the dividends to be paid by the company.
Anti-dilution is one of the most crucial clauses of a term sheet. It shields investors from getting totally diluted in the event of a ‘down round’ that is when numbers of shares alter or lowers the price of the share.
Pre-emptive rights are furnished to existing investors to give them preference to participate in the future round of the funding. This guarantees that investors maintain the right to maintain their ownership by buying the proportionate numbers of shares of any future issue of the shares.
Board of control
This clause specifies that a good mix of investors and promoters will form the part of the Board team. A 3rd party may also be involved to give an unbiased and fair decision. A Board observer may also be included at the insistence of the investors.
Vesting period of founders
Vesting means ownership of the shares of the company. This clause is usually included to protect the investors in the event where the founders exit. This guarantees that founders do not invest too much, too soon. The common vesting period is of four years with one-year cliff period.