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
- 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?
- 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:
- Term sheet overview and market practice, https://venturefriends.vc/what-to-expect-in-a-vc-term-sheet/
- Term sheet sample, https://www.ycombinator.com/series_a_term_sheet
- “Participation” vs “non-participation” further explanation with examples, https://www.lightercapital.com/blog/participating-or-non-participating-preferred-stock-whats-the-difference/
- Definition of a cumulative dividend, https://www.investopedia.com/terms/c/cumulativedividend.asp
- Definition of full ratchet, https://www.investopedia.com/terms/f/fullratchet.asp
- Term sheet negotiation advice, http://www.rubiconlaw.com/6-mistakes-term-sheet/, https://about.crunchbase.com/blog/how-to-negotiate-with-investors/