Fundraising
Term Sheet Tactics: How to Navigate Pre-Seed Startup Funding
Written by
Enrico Tan
Published on
March 21, 2024
Written by
Published on
Note: This article does not contain legal advice, and is purely informative. Please consult legal counsel when required.
A startup fundraising term sheet is an important document in the fundraising process, acting as a bridge between presenting your pitch deck to investors and signing the final investor agreement. It outlines the preliminary agreement terms, setting the stage for the detailed negotiations that lead to the final contract.
For startup founders, understanding and negotiating the term sheet is important. Created by either the founders or the investor, it typically favors the party that drafts it, thereby offering a strategic advantage in negotiations. Early-stage startups often encounter term sheets drafted by investors, who possess more experience and resources. However, taking the initiative to draft the term sheet can place startups in a stronger negotiation position, highlighting the importance of being well-prepared and informed.
A term sheet is essentially a preliminary document used during negotiations, providing a foundation for a future investor agreement but without binding the parties to it. It highlights the key aspects of the deal, such as terms of investment, and often includes confidentiality clauses, a defined negotiation period, and expectations for exclusive dealings and good faith. In contrast, a contract is a legally binding agreement between parties that solidifies the terms discussed in the term sheet, holding each party accountable to their commitments.
It's essential for startup founders to pay attention to every detail, ensuring all parties, investment size, and conditions are clearly summarized. This clarity not only facilitates the transition to a legally binding contract but also significantly reduces legal fees by streamlining the lawyer's work.
Upon receiving a term sheet, the first step for a startup founder is to thoroughly read and assess how its terms align with the startup's expectations and goals. Remember, a term sheet is not legally binding but sets the stage for negotiations. It typically includes confidentiality obligations, preventing discussions with other potential lead investors during the negotiation period, which can last from one to three months. It's crucial to respect these confidentiality terms to maintain a professional reputation. Although some investors may not strictly enforce all clauses, adhering to them demonstrates integrity and can influence the negotiation positively. The process should ideally conclude with both parties engaging in fair and sincere negotiations, aiming for a mutually beneficial agreement. The essence of the term sheet should then be translated into a formal, legally binding contract by legal professionals, ensuring all parties' intentions are clearly documented and agreed upon.
The term sheet should clearly summarize all conditions, including valuation, share classes, rights, investor protection mechanisms like anti-dilution and liquidation preference, for lawyers to draft the final contract.
Founders should approach term sheets with a critical eye, especially regarding investor protections such as liquidation preferences and clauses related to founder commitments. Recognizing and understanding standard practices in investor protections can help in identifying any red flags or terms that deviate significantly from what is considered normal in the industry.
Common conditions are the following:
It identifies all parties involved, including the startup, investors, and any other stakeholders, setting the stage for a formal investment agreement. The term sheet details the investment round, specifying the size, participants, and any angel investors, ensuring transparency and agreement on who is part of the deal.
The term sheet also specifies the duration of its validity, ranging from one to several months, during which parties agree to work towards signing a formal agreement, maintain confidentiality about their negotiations, and grant exclusive negotiation rights under certain conditions.
Legal aspects are thoroughly addressed, including the choice of governing law (German, Belgian, Dutch, etc.) for the subsequent contract, penalties for breaches of confidentiality, and the handling of intellectual property. Although a term sheet may mention intellectual property, a more detailed non-disclosure agreement (NDA) is typically necessary for comprehensive protection.
The valuation of a startup determines how much the company is worth, which directly impacts the equity percentage investors receive in exchange for their capital. An accurate valuation is crucial as it affects equity distribution, with implications for founder dilution. Higher valuations mean founders can give away less equity for the same amount of investment, preserving more control over their company. Conversely, a lower valuation might lead to giving up more equity, resulting in greater founder dilution. Valuation and equity should be mentioned in the term sheet.
➡️ Also interesting: Understanding Valuation And Validation
The investment amount a startup secures significantly influences its runway, which is the duration the company can operate before needing additional funds. It directly impacts how long the startup has to hit its strategic milestones, such as product development, market entry, user growth, or profitability. A larger investment extends the runway, giving the startup more time to refine its product, scale operations, and achieve the key objectives that make it more attractive for future funding rounds. On the other hand, a smaller investment amount may require the startup to reach its milestones more quickly to secure further investment or reach sustainability, adding pressure to deliver results in a shorter time frame.
Assigning voting rights in a term sheet delineates how decisions are made within the startup, influencing the extent of control investors have over company operations and strategic direction. Voting rights are often tied to specific types of shares, granting investors a say in major company decisions, such as approving the sale of the company, making significant financial commitments, or altering the company’s core business direction. While granting voting rights to investors can be necessary for securing funding, it can also dilute the founders' control over their company. It's a balancing act for startups to attract investment without relinquishing too much decision-making power. Founders need to carefully negotiate these terms to maintain a level of control that allows them to steer the company according to their vision while accommodating the interests and protections sought by investors.
Non-dilution provisions in term sheets protect investors from dilution of their equity stake in the event of future funding rounds at a lower valuation than what they initially invested at. These provisions adjust the price at which the investor's previous shares were purchased, effectively giving them more shares to preserve their percentage ownership in the company. There are different types of anti-dilution provisions, with the most common being "full ratchet" and "weighted average." Full ratchet anti-dilution provides the most protection for investors, allowing them to convert their investment into the number of shares that reflects the new, lower valuation as if they had originally invested at that price. The weighted average method is less protective, adjusting the conversion rate based on the weighted average of the new and old share prices, leading to a less dramatic increase in the number of shares for the investors. Both types aim to protect investors from the loss of value of their investment but need to be balanced carefully to ensure fairness for both founders and investors.
Dividends in term sheets refer to the conditions under which profits are distributed to investors, often serving as a mechanism for investors to receive a return on their investment prior to an exit event like a sale or IPO. Typically, dividends are either declared at the discretion of the company's board of directors or set as a fixed annual percentage of the investment, known as a cumulative dividend. The latter accumulates if not paid in a given year, requiring the company to pay out these dividends before any profits can be distributed to other shareholders, including founders. While dividends can make an investment more attractive by providing a potential ongoing return, startups often prefer to reinvest profits back into the company to fuel growth.
Conversion rights in term sheets define the conditions under which certain securities, like convertible notes or preferred stock, can be converted into common equity. This mechanism is pivotal for investors as it outlines how and when they can claim ownership in the company, often in anticipation of a significant event like an IPO or a new funding round. These rights allow investors to convert their initial investment into a stake in the company, potentially benefiting from an increase in the company's value. The specifics, such as the conversion rate and triggering events, are negotiated to balance the interests of both investors and founders. For investors, conversion rights offer a path to participate in the company's equity upside, while for founders, they represent a way to manage dilution and capital structure efficiently. Ensuring clear, fair conversion terms is crucial for maintaining alignment between company stakeholders as the startup grows.
In a term sheet, a non-compete clause for venture capitalists (VCs) is designed to protect the investment by preventing VCs from investing in direct competitors of the startup during a specified period. This clause aims to safeguard the startup's unique market position and intellectual property by ensuring that VCs commit to not supporting competing businesses that could undermine the startup's growth and success.
Liquidation preference significantly impacts both founders and investors, especially during a sale or liquidation of the company. It dictates the order and amount investors receive from the proceeds before other shareholders, typically ensuring that investors get their initial investment back before the founders or other equity holders see any returns. For investors, this term offers a layer of financial protection, prioritizing their returns in scenarios where the company doesn't perform as expected. For founders, while it can make the investment more attractive to potential investors by reducing their risk, it also means they might receive a smaller portion of the sale proceeds, particularly in less favorable exit scenarios.
Finally, the term sheet sets the stage for due diligence, allowing investors to thoroughly assess the startup's business, financials, and legal standings before finalizing the investment.
➡️ Also interesting: Preparing your Startup for Due Diligence: Essential Tips to Attract Investors
The role of trust and relationship building in the context of startup fundraising cannot be overstated. A term sheet is not just a precursor to a formal agreement; it's a testament to the good faith and mutual intentions between a startup and its investors. Building a strong, trusting relationship with investors is crucial for ensuring that both parties are committed to the term sheet's terms and the success of the company. Trust facilitates open communication, making it easier to negotiate terms that align with both the startup's vision and the investors' expectations. A solid relationship also paves the way for smoother negotiations and a more collaborative approach to overcoming future challenges.
➡️ Also interesting: How to Get Pre Seed Funding | The Ultimate Startup's Guide
Receiving a term sheet is a significant step in securing funding for your startup, but it's crucial to watch for red flags that may indicate potential issues. One major red flag is if the term sheet deviates significantly from what you were expecting, especially in terms of investment amount, valuation, and the structure of the deal. Any unexpected clauses or terms that weren't previously discussed can also be suspicious and warrant further clarification.
Investor protection mechanisms like liquidation preferences are standard, but their specifics can vary. A term sheet without any investor protection rights might indicate the VC is not professional or experienced. Similarly, terms like "tag-along" and "drag-along" rights are common, but their specifics need to be carefully evaluated to ensure they are fair and standard for the industry.
Founders should be cautious if the term sheet seems too harsh on them, especially regarding clauses that bind them to the company for an unusually long period without reasonable cause. Conditions related to leaving the company, such as distinctions between "good-leaving" and "bad-leaving" and associated penalties for "bad-leavers," should be clear and reasonable. VCs invest in the team as much as the idea, so terms that unduly penalize founders for leaving can be a red flag.
It's essential for founders to educate themselves on what constitutes standard and fair terms in a VC term sheet. This can be done through research online, consulting with peers, or speaking with a legal advisor. Knowing the market standard for terms and conditions can help founders negotiate a term sheet that protects their interests without compromising on fairness.
If there are terms in the term sheet that are difficult to understand, it's vital to conduct thorough research or seek legal advice before proceeding. Signing a term sheet without fully understanding its implications can lead to adverse outcomes for the founders and the startup. Remember, asking questions is a sign of due diligence, not ignorance. Ensuring that you fully comprehend your obligations and the terms of the agreement is crucial for a successful partnership with a VC.
Common mistakes in handling startup fundraising term sheets often stem from a lack of understanding and haste in moving the process forward. Founders sometimes overlook the long-term implications of certain terms, such as valuation caps, liquidation preferences, and anti-dilution protections, which can significantly affect their control and financial returns in the future. To avoid these pitfalls, it's crucial for founders to thoroughly review and understand every aspect of the term sheet. Never sign anything without a complete understanding of its contents and implications.
In the digital age, resources like Investopedia, Swifted, and Founder forms, along with AI-powered platforms like Perplexity, offer invaluable insights into interpreting term sheets. These platforms can demystify legal jargon and make the complexities of term sheets more accessible to non-legal professionals. It’s crucial for founders to engage actively in the negotiation process, fully understanding their obligations and rights under the proposed agreement.
Don’t be lazy. A lot of founders are absorbed in their jobs and don’t put sufficient time in negotiations. Sometimes they think they understand, but don’t understand some clauses fully. These documents require attention and precision. If you have a half term sheet, you will have a half agreement. You must understand everything, it’s a lot more important than you think. Agreements are for unexpected situations, otherwise we don’t need them. So prepare properly for the problems. A clear document is necessary to answer X if Y happens. What to do if Z doesn’t go to plan? Back-up scenarios are important to save you a lot of nerves, time, and stress.
When money is on the table, you want to get it ASAP. Don’t get blinded by it. It’s not the best scenario. You can be clear on the money, but not on the conditions. This will lead to trouble.
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