{% include "_nav.md" %}
#Termsheets
During the process of raising funds, if you get an investor (VC/Angel) interested in investing in your startup, you will come across a document called the termsheet. This is not a legally binding document. But, it is a preliminary document that presents broad terms of the proposed investment. For understanding the details, you can avail the help of a lawyer, but as the founder, it is a good idea, to spend some time understanding yourself, the crucial aspects of a termsheet.
The entrepreneur wants the best terms favorable to him, while the investor is on the other side of the table, looking for the best terms favorable to him. Look for those investors, who are being frank and direct, rather than those who propose convoluted terms in the term sheet. They might give you a preliminary impression that their offer is the best, but a deeper look might prove to be otherwise.
Well, for any investment, the concerned parties have to agree on a valuation for the startup and decide on the quantum of investment (amount of money being invested by the investor). How you arrive at these numbers, is a separate issue. Let's assume you have agreed upon these, based on the stage of the startup, how promising the potential is, relative metrics, financial needs, competitive landscape and other reasons. Now, comes the stage, when the investor will move on to finer details and present you with a termsheet. The investors is looking at maiximizing returns from his investment, while trying to minimizing risk from the investment. To accomplish this, the investor is going to focus on 2 things in any termsheet:
- Economics (Valuation)
- Control (Decision-making power)
There will be several terms in the termsheet. Here, we will focus on some of the prominent ones. At the end, a list of resources have been provided for further details and links to sample termsheets have been provided. Some of the terms in a termsheet are:
- Pre-money/Post-money Valuation
- Option Pool
- Liquidation Preference
- Founder Vesting
- Board Structure
- Right of First Refusal (ROFR) and Co-Sale
- Drag-Along
As discussed in Raising Investment, pre-money valuation is the valuation of your startup, before you have taken any money from the investor. Let's say the pre-money valuation is INR 3 crores and you, the founding team, owns the entire company. Let's say, the investor decides to invest INR 1crore. Then the post-money valuation is INR 4 crores. So, after the dilution (by taking in money from investor, your % of ownership in the startup will decrease or get diluted), your stake gets reduced to 75% and investor gets a 25% stake.
Option Pool, is a reserve of stock, set aside for employees. It is a way of attracting talented employees to a startup and to keep them incentivised. (After a certain period, employees can exercise a stock option and convert it into common stock) In the above example, we saw that post-money, your stake gets diluted by 25% and is reduced to 75%. Investor gets the remaining 25% stake. Let us say, the investor insists on having an option pool of 15% on a post-money basis. Note that, this means, on a pre-money basis, option pool of 20% must be there (After dilution, the pre-money option pool of 20%, gets diluted by 25% to a post-money option pool of 15%). Assume that you, the founder had not kept aside any option pool, when you went to raise INR 1crore. Then, effectively, you will have to first dilute your 100% stake in the company to 80% and set aside 20% for the option pool, even before you bring in any funds. So, although your nominal pre-money valuation is INR 3crores. Your effective pre-money valuation is INR 2.4 crores (80% of INR 3crores). Post-dilution, you will have 60% stake, investor will have 25% stake and there will be an option pool of 15%. Notice that, with the addtion of an option pool clause, the effective pre-money valuation that you are getting might be very different from the nominal pre-money valuation. In a termsheet, generally, the nominal pre-money valuation will be mentioned and it is for you to calculate the other details.
The founding team owns common stock, while the investors ask for preferred stock. Basically, the investor's preferred stock will have certain preferences/additional rights. For example, during a liquidation event(like sale of the startup), liquidation preference clause kicks in. This basically defines how the proceeds from a liquidation event are divided among the stake holders (common and preferred). Liquidation preferences come in two flavors, participating and non-participating. If the investor has a participating liquidation preference, he gets his money back first and then shares in any remaining proceeds according to his equity percentage. If he has a non-participating liquidation preference, then he has to choose between getting his money back or getting a proportion of proceeds equivalent to his equity percentage. Then there can be further variants to this, which you should go through carefully. Investors add such clauses for protection from downside. Clearly, a non-participating liquidation preference, is what the entrepreneur will like. But, in the real world, the investor will want to mitigate his investments risks using such clauses.
The earlier the stage of an investment, the more likely the founders will be considered “essential” to the success of a potential investment by investors. Accordingly, investors will often require that the founders re-vest (or re-earn) their equity over a period of time, as per a pre-decided vesting schedule. For the investor, this ensures the continued focus and commitment on the part of the founding team in which he is investing.
A comapny's major decisions are made by the board, while the board itself is nominated by the shareholders of the company. The board can take drastic decisions, such as even firing the CEO. A typical board has 3-7 directors split among, founders and company executives, investors (or their designees) and often independent members affiliated to neither the founders nor the investors. An investor might ask for a board seat or a board observer position( board observers in theory don't speak in board meetings and are costless, to the company). An investor is part-owner of the company through stocks, but he exercises control over internal decision-making in the company through the board. It is prudent for the entreprenur to seek to have a small board, to avoid noise and be able to focus on his job.
If any shareholder in the company wants to sell their shares to someone else, the investor has the option to buy those shares on the same terms (ROFR) or to sell his shares, again on the same terms (Co-Sale)
If shareholders, owning more than 50% of the shares in the company want to sell their shares (typically to accept an acquisition offer) then, as long as the board and a majority of the investors approve it, all other shareholders must also sell their shares. This protects all shareholders from, say, one small, stubborn shareholder refusing to sell their shares in an acquisition offer and blocking a deal everyone else wants to see happen.
Apart from these terms/provisions, don’t ignore other provisions of the term sheet. Take legal opinion from a lawyer specializing in the space. Uncommon provisions calling for cumulative dividends or full ratchet anti-dilution protection should set off alarms bells.
The term sheet is a starting point for a discussion (negotiation) with a prospective investor. Naturally, it will favor the investor and is based on experience gained through thousands of investments by the investor community. Make sure you come to the table equally prepared. Below, are some more resources, which will give you a more extensive understanding of the various terms.
Resources:
- Termsheet explained is a document explaining provisions of a termsheet in plain English.
- Quora post on termsheet resources.
- Sample Termsheet from Passion Capital
- Another Sample Termsheet
Now, read about Graduation, and a few final parting thoughts.