The Series A Term Sheet
Embarking on a Series A funding round requires intention and precision. No matter if you’re busy choosing venture capital (VC) investors or creating your perfect pitch deck, having your ducks in a row is beneficial. When it comes to the term sheet, however, your negotiating skills can either make or break you. But we can help you get it right the first time.
As the fourth blog post in our series on Series A funding, we’re honing in on the ins and outs of a term sheet. Back with insights from a seasoned VC investor—Mike Rogers, partner at Interplay Ventures–we’re delivering you an insider’s view of the VC world.
If you’re ready to learn more about the most crucial document you’ll ever encounter, let’s begin.
What is a Term Sheet?
Up till now, you’ve been working hard to strategize, educate, and make connections. The next step in this Series A round consists of a hefty amount of “street smarts,” per se. Only this isn’t the information anyone is going to hand you freely. Most VC-backed business owners pick this stuff up on their own.
Term Sheet Description
A term sheet is a blueprint for future legal documents. Although it’s not legally binding in itself, it does outline the conditions for a specific investment.
Some refer to term sheets by other names, including:
- Letter of intent
- Memorandum of understanding
- Agreement in principle
Term Sheet Purpose
It’s the first concrete step toward securing funding. Often, it’s the first piece of paper a VC will give you once they show interest in investing. Instead of a debriefing or overview, a term sheet presents the proposed investment in detail. It’s usually so precise that lawyers will typically use the term sheet as a guideline to draft transaction documents.
While the purpose of a term sheet may seem reasonably apparent, it’s a bit more complicated than merely a precursor to “stamping the deal.”
Term Sheet “Street Smarts”
Let’s face facts; VCs are in the business of making deals. They probably sign contracts in their sleep. But the VC world is small. There’s not a lot of bridge-burning happening. So, while VCs are not typically out to cheat anyone or pull the wool over your eyes, they’re approaching this thing for what it is—an investment deal.
According to Mike Rogers of Interplay Ventures, “It’s a sales process. You’re going in there, and you’re selling them on why this is an opportunity that they should be putting their capital toward. And for the VC, their capital is their business. So for them, they have to look at — every dollar that goes out is a business decision. It’s not a personal thing.”
That said, it’s up to you to use a term sheet for the betterment of your business. A VC investor isn’t going to do any hand-holding to guide you in the ways of term sheet negotiation. That’s on you (and your lawyer, of course).
Term Sheet Sections
As mentioned, a term sheet stipulates legal and financial responsibilities. In other words, it clarifies who gets what money and what either party can do legally in nearly every possible scenario.
Below includes more details on where to negotiate stipulations, but here are the three main sections of a term sheet:
- Corporate Governance
- Liquidation and Exit
Term Sheet Negotiation
Finding VC-backed success means knowing where and what to negotiate on the term sheet.
On the one hand, many entrepreneurs make the mistake of trying to control too much. Some even negotiate the life out of the deal. On the other hand, savvy entrepreneurs won’t settle for anything less than an appropriate option pool shuffle or “fair” valuation, for example. Mastering the balance between compromise and control is a feat you want in your skillset.
It’s only natural for VCs and business owners to go back and forth in negotiations during the term sheet process. However, keep in mind that not all terms are created equal. Some aspects of the deal are worth not backing down on while you can approach others more leniently.
That said, the following are the two most essential points of the term sheet (and what you’ll likely be negotiating):
- Economics—Where does the cash go upon an exit event?
- Control—Who has control of the company?
Every company is going to value slightly different aspects than the next one. So, telling you to negotiate this or that aspects of your term sheet would be a disservice to you. Instead, we’re going to share some key terms so you decide what’s vital to your business and what you can negotiate.
When it comes to negotiating during the term sheet process, the following key terms need to become like a second language. VCs will toss around this verbiage and lingo fluently. Plus, they know how to sugar coat it—though the good ones won’t—so don’t just skate over these key terms. Drill them into your mind to ensure your Series A (and future rounds) benefit your company, not only the VC investors.
Firstly, let’s look at the financial aspect of securing a VC funding round. In other words, here’s your chance to know where the cash can go upon an exit event.
Once a tough number to land on, a company’s valuation is the most vital component of the term sheet. It’s expressed in pre-money and post-money values, dictating who owns what and how the proceeds from sales will be distributed among shareholders (including if the company sells).
It’s worth noting that median see valuations have increased by compound annual growth rate (CAGR) of 11.2% compared to 16.2% and 15.0% for Series A and Series B.
The chief objective is to maximize capital investment while minimizing dilution. Keep in mind that the median pre-money valuation for seed-stage companies will eclipse $8.5 million this year. To create a win-win situation for both you and the VC, it’s crucial to negotiate a “fair” valuation—aligning your requests with the company’s industry.
A Pro Tip: Keep in mind that VCs calculate a company’s valuation differently than an entrepreneur would. As a business owner, you need to account for your option pool funding because the pool gets diluted once VCs invest their money (more on this below). VCs will assume you’ve already done this math, but it’s a step many entrepreneurs overlook.
Carefully crafted language frequently surrounds any mention of an option pool. VCs typically expect an entrepreneur to calculate this themselves rather than absorbing any part of the dilution. Hence the “prior to the closing…” verbiage.
So, when you’re planning to use the investor’s capital to hire new staff to help expand the business, make sure you calculate this into the agreement. Many entrepreneurs get overly excited at this stage, fail to read in between the lines of economics and end up getting duped in the long run.
This term is reasonably standard on a term sheet and typically settles at 1x the invested amount. VCs value their stake in your company more than the actual investment. They’re hoping for monetary profit when your company succeeds, after all.
However, if your company finds itself in a death spiral and shatters, the liquid preference will ensure an investor their money back when the company is sold—even before any other stockholders.
As mentioned, 1x liquid preference is usually the go-to number. Anything higher is a surefire sign that your company is somewhat of a trainwreck. Keep in mind that as a business owner, you don’t typically want the liquid preference to be higher than the invested amount.
This term is often found in the liquidation preferences section, and especially common when a company can’t settle on 1x liquidation preference. In this situation, an investor will attempt what is known as “double-dipping.” In plain language, it means preferred stockholders get their money back before anyone else. Plus, they get an equal portion of their ownership share.
It’s money on top of money sort of situation. Having no participation rights is ideal, but “participating with a cap” is a decent compromise, as well.
Over time, preferred stockholders can accrue an additional return, which is known as a dividend. It increases the liquidation preference, and you’ll see it expressed on the term sheet as a percentage.
It’s not uncommon for a term sheet to include mention of dividends, but you must carefully watch the language. For example, pay attention to the terms “noncumulative” and “cumulative.” The former will work in your favor while the latter ensures investors some level of return.
This particular term includes some complicated math and involves the next round of funding. Anti-dilution protects investors from massive dilution should a “down round” happen. A down round occurs when the cost per share is lower than in previous rounds.
Several forms of anti-dilution exist, including:
- Narrow-based rated average
- Broad-based rated average
Full-ratchet is often the most detrimental, especially in a down round, while broad-based is typically the most entrepreneur-friendly. Broad-based rated average encourages VCs to receive more anti-dilution benefits by investing more capital during a down round.
In tandem with the economics of the deal, control of the company is the other item for which both parties will be vying. But there’s no in-between when it comes to this aspect. Either you have control of the company, or you don’t. That said, the following elements impact most decisions and outcomes regarding the Series A round.
Board of Directors
Naturally, the board of directors is the most vital leadership body in any company. The term sheet focuses on the board of directors a lot, indicating its structure and voting abilities.
In the early stages, such as a seedling or Series A round, an entrepreneur frequently maintains control over the board of directors. That control dwindles the more rounds a company experiences.
Additionally, the board composition must be well-rounded and somewhat diverse to serve your VC-backed company best. Mainly there needs to be equal amounts of VC-friendly and entrepreneur-friendly members on the board to level the playing field.
Along with balancing tendencies on the board of directors, stockholder ownership must be well-balanced, too. Some company decisions fall outside of the board of director’s range and into the sway of stockholders.
Like the board, stockholders will either be VC-friendly or entrepreneur-friendly. Whoever controls more shares has the most say in any decision. Striving for balance is a smart move.
Before investors agree to invest, they typically require “protective provisions.” These exclusive rights allow VCs to have the final say in specific decisions or aspects of the company. For example, an investor might dictate how much debt you can have without the approval of the VC.
Most provisions are pretty standard but watch out when the list gets a little too long or too restrictive.
One final note regarding the control of the company that might influence investors is its structure. Is it a limited liability company (LLC), S-corporation, or C-corporation?
It’s worth mentioning that VCs typically prefer to invest in C-corporations as opposed to the other two options. Some firms try to pressure entrepreneurs to make the switch. The reason for the preference is mainly that LLC and S-corporate structures create complex tax implications for investors, and few VC firms want to jump through the hoops.
After all, VCs are continually looking for future gains in an exit, such as an initial public offering (IPO). But only C-corporations can IPO, so investors often avoid any other corporate structure that might limit their ROI. As a result, most startups set themselves up at a C-corporation at the outset.
Sample Term Sheet
Here is a sample Series A term sheet from Y Combinator, you can download it here.
As your company evolves and you take on new professional endeavors, you’ll face unique exposures, as well—especially during a Series A growth spurt. Founder Shield specializes in knowing the risks you face at each stage of development, and we work to make sure you have adequate protection. Feel free to reach out to us, and we’ll walk you through the process of finding the right policy for you.
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