Understanding the Term Sheet

Introduction

People often compare the founder and investor relationship to a marriage- both parties have high expectations going in and expect it to last forever (or, admittedly less romantic, at least a long-ish term). The term sheet is the prenuptial agreement in the marriage analogy- with similar benefits of setting expectations for the relationship and establishing a defined process if the parties need to part ways.  

Specifically, a term sheet is a document that provides a skeleton outline of the terms an investor and an entrepreneur’s company use to reach agreement on a financial investment in the company. Generally, the term sheet includes provisions related to funding, corporate governance, and liquidation events.  

Negotiating a term sheet is one of the most critical parts of the equity investment process; it defines the expectations between the investors and company, and can make the ensure alignment on the more difficult issues that may arise over the course of the relationship.

In this article, we’ll discuss some of the issues that commonly arise from the entrepreneur’s objectives, the investor’s objectives, and how to best ensure alignment between the competing interests. 

Valuation

Often the most negotiated provision, valuation of the company is where the parties to a term sheet negotiation usually start. It is critical to get the valuation correct from the start, as it helps determine what portion of the company the founder retains and many other terms are ultimately dependent on it. 

Valuation has many competing calculation methods that are subject to fierce debate, often depending on the stage of the company, development of any underlying technology, paying customers, users acquired, and other metrics specific to the industry and business model. 

Once a valuation is established, the respective objectives of the entrepreneur and the investor have to be considered and are discussed further in the next sections. 

Entrepreneur Goals

As a founder, your motives and goals are typically the following:

• Raise as much capital as possible to reach the key value-adding business or financial milestones for your company without giving up too much ownership prize upon your exit.
• Ensure that, in agreeing to provide downside protection to investors, you have not given up too much of the upside potential. This can be accomplished by: 
• avoiding participating in liquidation preferences that provide investors a guaranteed return of their capital plus dividends and that portion of the remaining proceeds equal to their ownership position, and 
• capping the participation so that when the investor has reached two to three times their initial investment, the participation feature disappears.
• Give up as little management control as possible over the company’s actions and general direction of strategy.
• Protect your personal position if the board decides that the founders are not performing and/or their services are no longer required to continue the business.

Investor Goals

When negotiating a term sheet as a founder, consider the investor’s motives and goals:

• Maintain participation rights to guarantee an investor the right to invest in future funding rounds. It helps investors maintain pro-rata ownership as additional investors come in and they choose to invest in any subsequent round.
• Stay informed of company details through information rights. These provisions detail what information an investor receives from the company and how often. 
• Maximize the proceeds upon the investor’s exit from the company by purchasing convertible preferred shares in exchange for their investment.
• Protect their investment if the company performs poorly through legal provisions that allow them to gain a larger percentage of exit proceeds than would be determined by looking solely at their ownership percentage.
• Retain veto rights over certain corporate actions by the company’s board or executive team that could affect their ultimate ownership position.
• Maintain the ability to force the board and management to sell the company after the investors have been involved for a long time.
• Ensure that the founders and key members of the management team are locked into staying with the company- at least as long as they are performing and adding value to the venture. This makes sense since the investors have often invested in the venture in large part because of their belief in the team.

Ensure Goal Alignment

Investors can use different methods and tools to make sure that the interests of founders and key management are aligned with the investors’ goals for the corporation:

• Reward the founder and key executives for value creation with a bigger piece of the pie upon completion of key milestones—via the founders’ shares and employee stock option plan (ESOP).
• Use key vetoes and tag-along rights to make sure that the founders and key executives do not sell the company before the investors believe that sufficient value has been created and they are ready to sell. Tag along rights prevent a founder or other voting group from selling shares to a third party without including all of the holders of the Series A shares. 
• Include a vesting schedule for the ESOP and initial founders’ shares to tie in the key people for the right amount of time.
• Include non-compete agreements and intellectual property (IP) assignment agreements to make sure that the full energy of the founders and management team is fully committed to building a successful venture.

Summary

Throughout the negotiation process, each side rarely achieves all of their objectives. If there is limited capital, then the investor will have the upper hand with the company. If there are competitive term sheets on the table, then the entrepreneur will win important negotiation points from the investors.

Hopefully, you have developed an appreciation for the competing interests and objectives of both parties to the term sheet negotiations. 

We stand ready to review your business needs and help you achieve your business objectives in consultation with your lawyer at Lloyd & Mousilli.

References 

Considering the importance of investment into the growth of your company, the following are suggested references for your review:

• Cardis, J., et al. (2001). Venture Capital: The Definitive Guide for Entrepreneurs, Investors, and Practitioners. 
• Berkery, D. (2008). Raising Venture Capital for the Serious Entrepreneur. 
• Houston, T., Johnson, A., & Smith, E. (2006, September 15). Technology Startups: A Practical Legal Guide for Founders, Executives and Investors.