So… You Want to Understand Term Sheets?

As an entrepreneur, one of the most exciting moments you’ll have is being offered a term sheet. It can also be one of the most daunting if you aren’t sure what to look for. In this position, it is important to not only know what the terms mean, but also to understand how they work and which of them are most negotiable. Here’s a breakdown of some of the most critical parts of a term sheet.

Price 

Let’s go straight to the elephant in the room. People seem to get hung up talking about price and valuation, but make sure to look at the entire package of a term sheet in order to really understand the affect of each piece. There are many more aspects at play than just pre-money valuation. That said, you should still know the way to talk about price. Valuation is broken up into two categories: pre-money valuation and post-money valuation. 

Pre-money valuation is the company’s value before the money from the raise is added. Post-money valuation is the pre-money valuation plus whatever cash is added from the raise. For example, a company with a $4 million pre-money valuation that raises $2 million will end up with a $6 million post-money valuation. It is standard to discuss terms in pre-money valuation because the post-money valuation will change depending on your raise.

Liquidation Preference and Interest Rates

Liquidation preference is put in place to protect the interests of both the investors and the entrepreneurs. Though at first it may seem unfair to entrepreneurs, it is meant to ensure that deals are only made when both parties will benefit from them. There are generally two types of stock issued: common stock and preferred stock. Investors will almost always ask for preferred stock. The main difference between the two types of stock is that preferred stock holders get their money back before common stock holders upon exit. Within the term sheet, look to see if the preferred stock asks for 1x or 2x liquidation preference. This determines if the preferred stock holders have to get 1x their money back or 2x their money back before the common stock holders get any money. About 80% of deals are done with 1x liquidation preference.

There are also two kinds of preferred stock: participating preferred and convertible preferred. The main difference here is that participating preferred stock holders get their preferred return and a pro-rata portion of the common stock, whereas convertible preferred stock holders get only one or the other, but not both. Convertible preferred stock converts automatically to whichever will give the investor the highest value (preferred or common) whereas participating preferred holders get to “double-dip” into both pools.

In addition to this, it is important to understand that there will be an interest rate on your term sheets. This can also be referred to as dividend rate or coupon rate. It is typically between 6-8% of the capital investment and accrues over the time, but is not typically paid until exit.

Option Pool and Anti-Dilution

When raising a round, you’ll have to create an option pool. This is a portion of your equity that you set aside for later to incentivize future employees (in the form of stock options). Typically, an option pool will be between 12-18% of your post money valuation. You can stay on the lower end if most of your higher executives have already been hired, but you’ll need a larger option pool if you still need to hire other “chiefs”, such as a COO or CTO, since they’ll receive a larger options package. Finally, and perhaps most importantly, recognize that most term sheets require the option pool to be created before the financing event – meaning that only the founders’ equity is getting diluted…

Down the road, investors run the risk of getting diluted, as well, so, they will generally add an anti-dilution agreement in their term sheet. This means that if you sell stock in the future for less than you sold it to them, they will get issued more shares of stock for free effectively giving them the same price per share and the new investors. On the surface, this is essentially like price matching at retail stores, but deeper down, it’s quite a complicated process that you should be aware of and address when the time comes.

Vesting

Vesting, simply put, is the process by which someone earns access to their shares. This could mean that an employee gets access to their options at the end of each year, but a shorter vesting period tends to be better for managerial purposes (after the typical one-year cliff). For example, an employee with an annual vesting schedule may wait until the end of the year to get their options and then quit. Whereas if they only have to wait until the end of each month to get their options, they will quit sooner and you, the manager, will rid yourself of the unmotivated employee faster.

Even founders are given vesting schedules when taking outside investments. This implies that you are re-earning your equity over time. The date that the stock started vesting can often be negotiated to be backdated to when you started the business, instead of just when you take investment. In the case that an outside event impacts your vesting schedule, there are accelerated vesting clauses. These allow you to access your options faster under certain preset conditions, such as an acquisition that puts you out of a job or being fired without cause.

Though it can be intimidating to comprehend a term sheet, it gets significantly easier when you systematically break it down into categories, understand the key terms, and look at how they all tie together. Above all, take a moment to congratulate yourself. Receiving a term sheet is a huge milestone; it means someone believes in you and your business enough to give you money. Then, call your lawyer to make sure you didn’t mess anything up.

 

Filed under: Status Updates — Tags: , — August 3, 2012