4 critical things to watch on your investment term sheet by Bob Ackerman

TL;DR - When reading a term sheet, founders should especially focus on the “big four” subjects: valuation, liquidation preference, founder vesting, and board structure & composition.

Helpfulness - 5

Tags - term sheet advice, valuation, liquidation preference, founder vesting, board structure/ composition

Questions answered:

  • What is a term sheet?
  • What should founders especially focus on when reading a term sheet and why?
  • What is valuation (price per share)?
    • What are pre-money valuation and post-money valuation?
    • What are the possible consequences of an extraordinarily high valuation?
  • What is liquidation preference?
    • What is multiple liquidation preference?
    • What do “participation” and “non-participation” mean?
  • What is founder vesting?
    • What does founder vesting mean for investors?
    • What are some questions founders should address in regards to founder vesting?
  • Why are board structure and composition important?
    • What are some questions founders should address in regards to board structure and composition?
    • What should founders look for in board structure and composition?

Summary:

  • A term sheet is a document outlining the terms under which an investment will be made.
  • Founders should especially focus on terms regarding the “big four” subjects: valuation, liquidation preference, founder vesting, and board structure & composition.
  • Valuation (Price Per Share) means the price an investor is willing to pay for shares in a company.
    • A higher share price is better than a lower share price, but a lower share price sometimes means more flexible terms regarding other subjects.
    • An extraordinarily high valuation (ahead of the company’s business fundamentals) can result in a “down-round” in the next capital raise - from which founders have no protection.
  • Liquidation preferences define the division of proceeds between shareholders (common and preferred) in the event of a sale of the company, regardless of equity ownership
    • Multiple liquidation preference means the investor gets a multiple of their capital back before any common shareholders (the lower the liquidation preference, the better for the founder).
    • “Participation” means the investor participates in all proceeds, after the liquidation preference, based on their ownership percentage.
    • “Non-participation” means the investor either gets their liquidation preference or converts their preferred shares to common shares and participates pro-rata with all other investors.
  • Founder vesting is when founders vest their equity over a period of time.
  • For investors, founder vesting ensures founders’ commitment.
  • Vesting monthly over four years is common.
  • True control in a venture-backed company comes from the management team and the board of directors, rather than ownership percentage.
    • It is crucial to think through the structure of the board, the list of decisions requiring board approval, and the voting thresholds for taking action.
    • Founders should look for balance and the ability to develop and maintain a shared vision and focus in them.
  • Founders should watch out for terms calling for cumulative dividends or full ratchet anti-dilution.

Follow up links: