So, you’ve caught the attention of an investor – congratulations! You’re now one step closer to securing the funding you need to grow your startup. But before you get too carried away celebrating, there’s a little matter to deal with: the term sheet. This document is the foundation of your agreement with the investor, and understanding it is critical if you want to protect your interests and negotiate a fair deal.

Term sheets can seem daunting at first, full of legal jargon and clauses that make your head spin. But fear not! In this guide, we’ll break down the key components of a term sheet and offer tips on how to negotiate like a boss.

What is a Term Sheet?

At its core, a term sheet is a non-binding agreement that outlines the basic terms and conditions of an investment. Think of it as a blueprint for what both you and the investor can expect from the deal. While it’s not legally binding (in most cases), it forms the basis of the final, legally binding agreements that will follow.

Key Sections of a Term Sheet

1. Valuation: This is the big one. The valuation determines how much your company is worth and, by extension, how much equity you’ll need to give up in exchange for the investment. Valuation can be pre-money (before investment) or post-money (after investment), so be sure to clarify which one the investor is using.
2. Investment Amount: How much is the investor putting into your business? This section will specify the amount of funding you’ll receive, and sometimes, it may be divided into tranches depending on certain milestones.
3. Equity: How much equity are you giving up in exchange for the investment? This section will detail the percentage of the company the investor will own after the deal is closed.
4. Liquidation Preference: This is where it gets a bit more technical. A liquidation preference outlines how proceeds are distributed if the company is sold or liquidated. Investors often negotiate for a preference to get their money back before any other shareholders (including you!) see a penny.
5. Board Composition: Investors often want a say in how the company is run. This section outlines how many seats on the board the investor will get, and whether they will have any specific control or veto rights over key decisions.
6. Voting Rights: This section determines how much say the investor will have in major company decisions, such as future funding rounds, mergers, or even your own salary.
7. Founder Vesting: Even as a founder, you’re not off the hook! Investors may want to set vesting schedules for your own shares, ensuring you stay committed to the company for a set period of time.

More Words & Phrases You Should Know…

1. Ordinary Shares: These are the basic shares most founders and employees hold. They come with voting rights, but they’re usually paid out after investors if the company is sold or liquidated.
2. Preference Shares: These are special shares investors often get. They give them priority when it comes to things like dividends or getting their money back if the company is sold.
3. Cap Table: Short for “capitalisation table,” this is a document that shows who owns what in the company – founders, investors, employees, everyone. It’s often updated after each funding round.
4. Dilution: When new shares are issued, existing shareholders own a smaller percentage of the company.
5. Founder Lock-In: This clause prevents founders from selling their shares for a certain period. It reassures investors that the founders are committed to sticking around.
6. Option Pool: This is a chunk of shares set aside for future employees. It’s usually agreed on during a funding round and is important for hiring talent later on.
7. Exclusivity Clause: This means you agree to negotiate only with one investor for a set time, so you can’t shop around for other deals while this one is being finalised.
8. Due Diligence: This is the “deep dive” investors do before committing. They’ll check your finances, legal paperwork, intellectual property, and more to make sure everything’s in order.
9. Founder Warranties: These are promises founders make about the company – for example, that there are no hidden debts. If these turn out to be false, founders could be held accountable.

How to Negotiate a Term Sheet

Negotiating a term sheet can feel intimidating, especially if you’re new to the world of venture capital. But here’s the secret: it’s a two-way street. Investors want to work with you just as much as you want to work with them. A good negotiation ensures both parties feel comfortable and confident in the partnership.

Understand Your Priorities

Before you even start negotiating, it’s important to know what matters most to you. Is it maintaining control over key decisions? Preserving equity? Or perhaps securing a high valuation? Understanding your priorities will help you focus your negotiation efforts on the terms that matter most.

Be Ready to Make Trade-offs

Negotiation is about give and take. If you’re not willing to budge on certain terms, be prepared to make compromises elsewhere. For example, if you’re determined to maintain a majority share of the company, you might have to agree to a lower valuation or a higher liquidation preference.

Valuation Isn’t Everything

It’s tempting to focus solely on valuation, but this can be a mistake. A higher valuation may sound great on paper, but it often comes with tougher terms elsewhere in the deal. Look at the bigger picture and consider the long-term impact of the entire term sheet, not just the valuation.

Liquidation Preferences Matter

Liquidation preferences are one of the most important (and sometimes most overlooked) parts of a term sheet. A 1x liquidation preference means the investor gets their money back before other shareholders see anything. A 2x liquidation preference means they get double their investment before anyone else is paid. Pay close attention to this section and negotiate for terms that feel fair.

Protect Your Control

As the founder, you’ll want to maintain control over key decisions, especially in the early stages. Negotiate for voting rights that allow you to continue steering the company in the direction you envision. Be mindful of board composition and veto rights that could limit your decision-making power.

Seek Legal and Financial Advice

Even the most seasoned founders rely on expert advice when negotiating term sheets. Make sure you have a trusted lawyer and financial advisor who can help you navigate the complexities of the document and ensure you’re getting a fair deal.

Red Flags to Watch Out For

While most investors are looking for a mutually beneficial deal, there are a few red flags to watch out for when reviewing a term sheet:

• Overly Aggressive Liquidation Preferences: Anything beyond a 1x liquidation preference could be a sign that the investor is more interested in securing their own returns than helping your business succeed.
• Excessive Control: Be wary of investors who demand too much control over your company’s decisions. Remember, you’re the one with the vision and the expertise to lead the company – don’t let anyone else take that away from you.
• Unreasonable Vesting Schedules: Founder vesting is common, but watch out for terms that make it difficult for you to earn back your shares in a reasonable timeframe.

Wrapping It Up

Term sheets can be complex, but they’re an essential part of securing investment for your startup. By understanding the key sections of the term sheet and approaching negotiations with a clear strategy, you can protect your interests and ensure a strong partnership with your investor.

Remember, this is the start of a long-term relationship, so it’s important to get it right. Take your time, seek advice, and don’t be afraid to negotiate terms that align with your goals for the company.