Receiving a term sheet from a venture capital fund for your company’s first preferred stock financing round is an exciting moment for any founder, whether they are a first-timer or a serial entrepreneur. Despite the excitement, it is essential to digest, comprehend, and negotiate the key terms of the term sheet.
It very well may be overpowering to comprehend what’s key when you haven’t arranged various term sheet, however it’s indispensable to remain on track and tenacious as a significant number of these terms can lastingly affect your organization, regardless of whether the term sheet is just a page or two. Lawyers and other reputable advisors can be helpful in this situation. One of the most important business items on any term sheet is valuation and percentage ownership.
What is the pre-money valuation in relation to the size of the investment?
To put it another way, how much of a stake in the business will the investors receive?
This will not only show how much of the company you are willing to give investors, but it will also have a long-term impact on the company’s efforts to raise capital for future financing rounds, anti-dilution provisions, and option grants.
Board of Directors: It’s true that this is “your company,” but the term sheet will show how much control and power you will give the venture capital investor, both in the boardroom and through stockholder protective provisions (more on that in a moment). A three-person board consisting of two common stock representatives (typically the founder and/or founding team members) and an investor representative will typically be proposed on an investor’s term sheet.
However, there are a number of possible outcomes, such as requiring a “CEO” director at all times, using an “independent” director for one of the common stock seats, or having a larger board. To make things even more complicated, even though the default rule is that the board must act by a vote of a majority of the members, it is important to know (i) the rules for quorum and written consent, as the interaction of these rules with the composition of the board may have a bigger impact on board dynamics than you would expect, and (ii) any proposed preferred director approval rights.
Protective provisions A typical term sheet will include a list of “protective provisions” in the investor’s favor (or the holders of the majority of the preferred stock that will be issued to the investors).What does it imply?This indicates that the investor believes certain company actions cannot be taken without their consent.
Vesting In the end, an early-stage investor is investing in both the company and its founders and founding team members, sometimes more of the former and other times less of the latter.Having said that, investors place a high value on the founders and other core members of the team and will want to make sure that these key members are given incentives to stay and build the business.
Liquidation preference is a fundamental economic and legal term that you should understand and negotiate (if necessary) because it will have a long-lasting impact on subsequent fundraising efforts as well as the amount of sale proceeds that could be distributed to common stock holders in an exit.
A one-time non-participating preference is the typical construction, but other terms, such as replacing a non-participating preference with a participating preference, and references to accrued dividends (or other kinds of dividends) are also common.
Even though some of these terms and phrases may appear to be legalese, the liquidation preference is a fundamental business term that has a financial impact on the deal. As a result, it is essential to fully comprehend the terms of a term sheet pertaining to the liquidation preference.