Learn before you sign: the 3 parts of a term sheet [Opinion]

Read In

This is an edited crosspost from Nuwait 

Perhaps the most important tool in the VC’s arsenal, especially when it comes to downside protection, is the term sheet.

A term sheet may or may not be a legally binding document, depending on each fund. It outlines the terms by which an investor will invest cash into a company in exchange for equity.

Term sheets are a high level of summary of the principal terms of investment that include funding, governance, liquidation as well as a host of other issues such as due diligence costs, lock in/lock ups, drag along/tag along, pre emption rights, ROFRs, and others. Today, we will discuss funding, governance and liquidation. 

Funding

An important distinction that entrepreneurs need to familiarize themselves with is the difference between pre-money and post-money valuation. 

Pre-money is the value of a startup before it receives investment, and post-money is the value of a startup after it receives an investment. If a company is valued at $1 million during the pre-money stage, and receives $250,000 of investment, its post-money valuation will become $1.25 million. Wamda covered the specifics of how to value your startup here, and how to use cap tables to do so here.

So before agreeing on equity, entrepreneurs must identify if the investor's desired percent of equity is based on the pre- or post-money valuation.

The table belows shows the difference of equity value in each stage.

(Table via Investopedia)

VC investors are also typically issued shares of preferred stock, not common stock, the ins and outs of which Wamda covered here. Preferred stock, as the name suggests, is preferable because it grants certain key rights to the holders – making it far more valuable than common stock. One of those rights is a liquidation preference.

Liquidation

Liquidation preferences are one of the essential components of preferred stock and are generally considered to be the second most important deal term in a VC investment term sheet (the first being the company’s valuation prior to the investment, which we now know is commonly referred to as the 'pre-money valuation' or 'pre').

This element determines who gets paid first if the company is sold or goes bankrupt. The investors with liquidation preferences are paid before other stock holders (such as employees) are paid out the amount of their investment or their ownership percentage of the sale value first.

In the worst case scenario, if the company is wound down or goes bankrupt with very little cash or assets left to sell, then anything left, after the creditors have picked the carcass (debt-holders always come first in the queue when a company goes under), would be distributed to the investors in proportion to their preference rights, as opposed to shared out equally.

Governance 

Governance is the the next major part of a term sheet, and concerns how the entrepreneur and the investors will interact together to govern the growth of the company.

Usually this is personified by the Board of Directors, which act as a regulatory oversight body compared to the execution-focused management team. In digital health startups, the board usually includes members from the founding team as well as VC general partners or maybe even an early angel investor or independent industry expert.

The idea is to provide a platform, which is accountable as much to regulators in case of wrongdoing as to shareholders, where where all opinions can be shared.

This platform must also carefully balance and protect the many interests of all the stakeholders of the corporation. Usually boards have an odd number of members so decisions aren't tied.

In the case where the number of board members is even, a single person, usually the chairman or chairwoman, is often given veto-like powers either through a casting vote, a vote that is worth two votes, or the group can agree that any major decisions require an outright or total majority.

(Featured image via Pexels)

Read In

Media categories

Countries

Share

Related Articles