Series A Funding: What Is a Term Sheet and Why Is It Important?Business Advice & Research
Table of Contents
- Why Are Term Sheets Important?
- Explaining Series A Term Sheet Provisions
- How Long Does It Take To Negotiate A Term Sheet?
Receiving a Series A term sheet from a VC firm is a big deal because it’s a very strong indicator that these particular investors are interested in working with you and you’re edging closer to your goal of securing the funding you need to grow your startup and take it to the next level.
A Series A term sheet is a basic agreement that outlines all the terms and conditions of the investment. Term sheets usually focus on two key areas; control of company shares and how financials will be divided if an exit occurs.
However, it’s very important to note that the term sheet itself is not binding and can’t be used as an investment contract. It’s in no way, shape, or form a promise that the VC will invest in your company. VCs will draft an actual investment contract later which will be created based on much of the information that’s found in the term sheet.
Even though term sheets may seem a bit generic and boilerplate you should go over them carefully and thoroughly if you receive one. Specific provisions, seemingly minor or unimportant, can have as much impact on your company as the valuation itself.
The term sheet can also be useful in determining if you and the VCs offering you funding are the right fit. If they won’t budge on any terms that don’t sit well with you, or they seem unreasonable during this process, it may be better to look elsewhere.
Let’s take a deep dive into term sheets in order to understand what they entail and why they are important to any startup that is interested in raising funding.
Why Are Term Sheets Important?
Why do VCs and startups go through so much trouble drafting and agreeing on a term sheet if it’s not legally binding? From the investor’s point of view, the term sheet is a crucial tool they’ll use to evaluate the investment they’re about to make and ensure that the startup founders understand their expectations.
It also helps them gain a deeper understanding of the eventual payout they can expect and identify potential obstacles that could cut into their profits.
The term sheet can also expose early friction and disagreements between the investor and the founders and allow both sides to work these issues out before they truly become business partners. Naturally, the startup and the VC will have different objectives and will push for different terms to be included in the term sheet during negotiations.
Investors will want to maximize the potential financial return of the investment and mitigate any potential risks. They’ll also want to secure a preferred position when providing additional capital if the investment progresses well. On the other hand, the startup will want to maintain control and keep as much of its equity as possible while still receiving enough capital to develop and operate with more flexibility.
Before we get into the intricacies of the term sheet and what important information it can include, let’s see what one could actually look like.
Here’s a sample Series A terms sheet template that we’ve put together:
Explaining Series A Term Sheet Provisions
Now that you have an idea of what a typical Series A term sheet might look like, let’s take a deeper look at what the provisions and terms included in the term sheet template actually mean.
Different VCs will have different provisions included in their term sheets, which is why we’ll try to cover as many of the most common ones as possible.
The offering terms will include the following key information:
- The closing date
- Investor names
- Amount raised
- The price per share
- The company’s “pre-money valuation”
The Initial Valuation
The company’s valuation will determine what percentage of the company’s equity the investor will receive in return for their investment. VCs use two types of valuation in the term sheet: “pre-money valuation” or “post-money valuation.” As the names suggest, the pre-money valuation represents the value of the company before the investment while post-money valuation is calculated by multiplying the company’s shares after investment with the price per share at the moment the investment is made.
VCs will usually use post-money valuations. However, it’s important to clarify the type of evaluation being used with the investor to avoid any confusion.
Type Of Stock Investors Are Getting
Early-stage investors will typically look to purchase “preferred stock” when investing in startups. Preferred stock differs from common stock in that it allows the VCs to add unique terms and conditions that will not apply to holders of common stocks (typically the founders). Voting rights in the company will be unevenly distributed to favor the preferred stocks.
Additionally, they will be above common stock in the debtor hierarchy, meaning that should the company go under, the investor will get their money back before other stockholders.
Voting rights represent the rights of a shareholder to vote on matters of corporate policy. Delineating and defining these rights in the term sheet is crucial, as it will determine who controls the company.
The most important aspect of voting rights is the relation between holders of preferred stocks and common stocks. The term sheet can stipulate that specific actions (selling the company, issuing dividends, determining budgets, signing contracts, etc.) need to be approved either by a preferred or common majority. Since the founders will usually be holders of common shares and investors will hold preferred shares, this term will be crucial in deciding who has the most control in terms of determining corporate policies.
It’s essential to keep in mind that preferred stocks can also have common voting rights attached and that you’ll need to carefully balance the voting rights to ensure that control over these types of issues is as equally distributed as possible.
The Liquidation Preference
The liquidation preference is a clause in the term sheet that determines the order in which the entities that own the company will get paid in the case of a liquidation, bankruptcy, or a sale. Liquidation preferences serve to protect the VC companies from downside risks, ensuring that they get the money invested back before other shareholders are paid out.
A liquidation preference of 1x will mean that if the company is sold, the VCs will first get their investment back, and then the other shareholders will be able to divide what’s left. A liquidation preference greater than 1x (2x or, less often, 3x) will mean that the money they invested will be doubled or tripled, which can obviously lead to a very serious cut into the payout that other shareholders will receive.
The Option Pool
The Option Pool represents the amount of equity that’s left in reserve for any future hires. It’s crucial to set aside a certain amount of shares to attract and incentivize future employees with stock options and tie the success of the company to their financial success directly.
Leaving 10-15% of stocks in the option pool should be sufficient for most startups. However, if your company already has a strong management team and you’re not looking to attract many new top managerial hires, you should be able to keep the option pool smaller if necessary.
Right of First Refusal and Co-Sale Agreement
The right of first refusal (ROFR) term means that the investors will have the option to purchase shares that are being sold before any third party.
A co-sale agreement allows a group of shareholders the right to sell their shares under the same conditions if another group of shareholders decides to sell.
Series A startups will typically have a small board of directors. It will usually be a mix of founders, VCs, and outside advisors. Early-stage boards should accurately represent the equity structure of the company, meaning that both the common holders and preferred holders (investors), should be equally represented.
Here’s a simplified example of what a typical board structure might look like:
- Series A preferred holders (the VCs) will elect one member of the company’s board of directors.
- Common stockholders (usually the founders) elect one member of the board as well.
- The remaining directors are either outside experts or selected with the mutual consent of the board of directors.
However, if the venture capitalists control more than 50% of the company, they will require more representation. Keep in mind that VCs will typically consider securing a D&O policy a requirement because they are agreeing to serve on your board.
Founder Vesting Period
Founder vesting is a process during which startup founders “earn” their shares in the company over a period of time. If an employee or a founder leaves the company before the vesting period, they forgo the total amount of stock. Series A startups should consider a twelve-month cliff and a forty-eight-month founder vesting period. This would mean that if someone leaves before a year, none of their stock would be vested, and then each year, a quarter of their stock would become vested.
Founder vesting incentivizes co-founders to stay with the company and keeps the stock with the company in the case that a founder decides to leave early on in the startup’s journey.
VCs will want to have an anti-dilution provision added to the term sheet. Such provisions will protect the value of their equity should the startup raise additional funding at a lower valuation than the previous round. There are two parts to anti-dilution protection; ratchet-based anti-dilution and weighted average anti-dilution.
Ratchet-based anti-dilution or “the full ratchet,” as it’s known, means that if a company issues new shares at a lower price than what was issued in the Series A round, the Series A price is reduced or “ratcheted” to that price, giving investors more stocks for their initial investment.
Ratchet-based anti-dilution, obviously, will provide investors with more control.
Most VCs will request they be given redemption rights. This means that they will always have the option to have their outstanding shares redeemed by the company at a previously specified price. This price will typically be slightly higher than the fair market value.
These rights provide investors with protection if the company doesn’t sell or go public but is still successful enough to stay in business. However, keep in mind that for redemption rights to come into play, the redemption needs to be approved by a majority of shareholders.
A dividend is a sum of money that a company pays out in regular intervals to shareholders from its profits. Most Series A startups won’t issue massive dividends, as they’ll typically need to burn a more significant portion of their investment money quickly in order to accelerate growth.
Despite the fact that these dividends might not be huge, it’s still prudent to clearly outline when and how this compensation will be paid out to avoid future conflicts.
Pro Rata Rights
Pro rata or pre-emption rights, anti-dilution provisions, or subscription rights represent the rights of the investor to buy shares during future financing. This allows the investors the right to maintain their percentage of ownership during future financing rounds. However, it doesn’t obligate them to purchase any more equity.
The issue with granting large pro rata rights is the possibility of losing financing flexibility in later rounds. Some investors will only want to come on board to secure a sizable portion of the company. If you have large amounts of equity tied up in pro rata rights, letting new investors into the fold could prove to be impossible.
One of the easiest ways to upset a VC is to use their term sheets to try and leverage a better deal elsewhere. That’s why VCs typically require an exclusivity period during which the startup they are interested in can’t contact other investors.
Typically, a period of 30 days is required, however, some investors may ask for 60.
How Long Does It Take To Negotiate A Term Sheet?
How long negotiations take will largely depend on how much the VC is interested in investing in your startup. If they are truly excited about working with you, you’ll probably be able to work the terms out quickly. No matter how unique your company’s position, term sheets still go over relatively common terms and conditions.
This means that once you and the investor agree on the rough estimation of the company, the term sheet should materialize fairly quickly. It shouldn’t take more than a week to negotiate a term sheet once both sides are willing and dedicated to making the deal happen.
When putting together a term sheet, it’s crucial for startup founders to voice any concerns or request changes early in the process to avoid last-minute changes made in a panic and unnecessary friction during the negotiations.
It’s also important to note that your Series A term sheet will have a massive impact on future funding rounds. Investors will use your early term sheets to guide their decisions on whether you’re worth investing in and what the new term sheet should look like.