What Entrepreneurs Need to Know About Term Sheets

What Entrepreneurs Need to Know About Term Sheets

For an investment contract to be drawn up, it’s best to start by completing a simple framework directly between the investment party and entrepreneur, before any legal teams get involved. This is known as the Term Sheet. If the investment agreement components are not agreed to beforehand, then expect problems to arise during the closing process, like high legal fees or too much dilution on future rounds.

Jeff Erickson, an active, early-stage pre-seed investor, and startup advisor joined BoomStartup’s Tara Spalding to offer a deeper look into term sheets. This live webinar discussion educated founders about equity-based fundraising, and how to negotiate an agreement.

View the 1-hour webinar “OpenUp: Term Sheets and Term Types” now.

Investment terms may become established during an exciting conversation between founders and investors, however, these terms eventually become the legal road map for investment documentation, so pay attention to the details when these conversations happen. Although they are considered a letter of intent that’s non-binding, term sheets signal an investment opportunity that should be taken seriously and discussed extensively between the founder and investor before drafting up a formal agreement.

Founders can negotiate practically every aspect of the term sheet until it’s signed and there’s a purchase order or a money transfer to bind it. If you are heading a highly sought-after startup, receiving multiple term sheets will provide the opportunity to evaluate what investors think about your company’s growth plans and how investors will support your plan with capital, guidance, and more.

Term sheets include these parameters

  • Amount raised
  • Price per share
  • Pre-money valuation
  • Liquidation preference
  • Voting rights
  • Anti-dilution provisions
  • Registration rights

The type of term sheet agreement to govern the investment round depends on the business maturity and future investment round plans. When you take money from investors, it’s like getting married and there’s a ton of heartache, lost time, and money to get a divorce.

BoomStartup recommends that you learn about each type and also hire a securities attorney to help determine which is best for you. Getting proper legal advice can make sure your deal terms are not poisonous to the growth of your company.

BoomStartup also recommends that startups leverage a Pro-Forma Cap Table tool to predict how each future round will dilute the current shareholders. A Pro-forma cap table will calculate different investment scenarios based upon the amount raised and pre-money valuation.

Additionally, quick investments are very helpful to collect and close on term sheets. Leverage SPVs as a way to consolidate smaller checks from investors, and you can open and close SPVs in Tranches to pull in the cash, yet keep the investment round open. Note, only have up to 99 investors in all SPVs in your investment round.

Three common term sheet types

  1. Fixed Priced Round
  2. SAFE (Simple Agreement for Future Equity)
  3. Convertible Note

Fixed Priced Round is where the investor purchases preferred or common stock at a set price per share. Standard stock purchase documents are used, and the qualifying transaction is the payment or an SPV Purchase Order itself. The ownership is immediate and the valuation parameters are measured by pre-valuation and post-valuation demarcation.

SAFEs are considered unsecured debt until converted into preferred securities when a designated event occurs, such as the next round of meaningful equity financing or payout upon sale. There are no maturity dates, and often SAFE terms have a valuation cap and a discount percent that provides an advantage to the investor when the next funding round occurs.

SAFE agreements are available in a 6-page template and do not require a lead investor to set the terms. The ownership occurs after the next meaningful equity financing closes, so the ownership percentage will be determined at that later date.

What to watch: SAFE

  • Agreements
  • Valuation cap
  • Discount
  • Pro-rata
  • Information rights

Convertible Notes are structured more like debt that converts into equity at a specified event OR at maturity. It has similar components as SAFE agreements with the Valuation Cap and Discount, but the qualifying transaction expands with Convertible Notes.

First, Notes have a maturity date which typically is 12 – 24 months after closing.

Second, there is an interest rate amount stated, set at issuance (so it can’t adjust). The ownership takes place after a conversion occurs and that can be at the next meaningful equity financing round or if there is an operational conversion.

Convertible Notes are used not only for early-stage investment opportunities but also as a quick bridge round between series raises because of the debt and maturity trigger structure.

What to watch: Convertible Notes

  • Valuation cap
  • Discount
  • Maturity date
  • Qualified financing
  • Option to demand repayment (in case of company liquidation)
  • Interest rate
  • Liquidations preference (debt over preferred)

Convertible Notes usually give a point or two more to the investors because the interest dollar amount converts into securities. More equity is given away when founders use Convertible Notes.

Today’s market conditions favor the entrepreneurs, so SAFE are more common than Convertible Notes due to the term structure being more founder-friendly along with no forced conversion dates or interest rates.

Four Pro Tips for Entrepreneurs Negotiating Term Sheets:

  1. Work with a Securities Attorney who can dive into the nuances of the term sheet and make sure the founders do not overextend the investor’s rights
  2. Calculate the cost of equity (or ownership of your company) before signing any agreements so you are not caught off guard about how much dilution the founding team will undergo. The Pro-forma Cap Table is a fantastic solution. Gust Launch offers this in their incorporation package.
  3. Ask investors to provide their terms to you, and choose the best one after review. The lead term sheet designates your lead investor.
  4. If you need to pull in cash from a round, leverage Tranches and SPVs to collect smaller checks from more investors, without extending your cap table. BoomStartup can administer and organize an SPV for startups. Request more information.