Startup Guide on Term Sheets and Its Significance

Term sheets are the first official, non-binding contract between the startup company and an investor. A term sheet covers all the important aspects of a deal without detailing every small uncertainty as covered in the binding contract. When startups come up with fundraising ideas, the terms and conditions of investment are outlined in a term sheet. When raising finance, the final conditions are then negotiated using the term sheet, and then the lawyer drafts a formal legal contract to formalise the agreements.

In order for everyone (and the firm) to benefit from fundraising, a proper term sheet balances the interests of the founders and investors. A poor term sheet puts entrepreneurs and investors at odds, while a well-drafted term sheet for a startup will include a bunch of elements which add to its efficiency and comprehensibility. Let us now talk about a few elements that are included in the term sheets of startup businesses:

Key Elements of a Term Sheet: All You Need To Know

If you have some fundraising ideas in mind, then here are some key elements that you must include in your business term sheets before approaching your investors: 

1. Valuation

What are the startup business‘s pre-money and post-money valuations? One should include both pre-money and post-money appraisals on a term sheet. Pre-money refers to the startup’s value prior to raising finance, whereas post-money valuation is the sum of pre-money valuation and the startup funding received.

As a founder trying to raise funds, it is important to ensure that the post-money valuation of the startup company is neither too high nor too low. If the valuation is too low, it will lead to unnecessary dilution of your stake in the organisation. However, if the valuation is too high, it will increase the performance pressure and may create difficulty in subsequent fundraising for startups.

However, determining the valuation of an early-stage startup company might be challenging; it can be done using a variety of techniques, like 

• Standard Earning Multiple Method, 
• Human Capital Plus Market Value Method, 
• Thinking About The Exit Method or 
• Discounted Cash-Flow Method.

2. Option Pools

A block of shares set aside for current or potential workers is an option pool. Option Pools, commonly called ESOPs, are a common business startup idea that companies use to attract and retain their great talents. When looking to raise funds, one may need to add the existing option pool on a term sheet. These are mentioned as a percentage of the company’s post-money valuation. Since ESOPs are generally a part of the founder’s equity, an increase in ESOPs generally means a further dilution of the founder’s capital. 

Pre-money option pools, which require that any future dilution fall on the founders, unfortunately frequently benefit the investor. Post-money calculations and the inclusion of investors in potential dilution would result in a more founder-friendly option pool. The majority of option pools, nevertheless, are determined pre-money. ESOPs are generally between 10-25%.

3. Liquidation Preference

When fundraising for startups, the liquidation preference is one of the most important elements that the investors will look out for in a term sheet. Investors who purchase preferred shares have an advantage over the other common stockholders. The holders of preferred shares have a safety net in the form of liquidation preference. Liquidation preference allows the investors to obtain at least some of their money back in the event the business fails.

When raising capital for business, 1x the investment is the accepted expression for the liquidation preference. This implies that preferred stock investors receive their investment back up to their original investment before common stockholders receive anything. (Of course, if all the money is lost, nobody wins, not even the holders of preferred shares.)

4. Board of Directors

The idea of a board of directors can sound absurd to a startup raising capital for business, but it becomes an essential component as a business expands. As a result, the Board of Directors section is present in most term sheets.

Equal representation of founder- and investor-friendly members on a board of directors is the most fair arrangement. Some businesses also like to include one “independent” member, ideally a recognised member of the business community. 

5. Investor Rights

Investor rights often refer to particular clauses that are meant to protect those who invest in startups, especially during the early stage. Investor rights are typically covered in a part of term sheets. The rights stated here might vary quite a little; therefore, it’s a good idea to speak with a lawyer to ensure that one is getting a fair bargain.

For instance: Early investors can be offered anti-dilution rights, pro-rata rights, right of first refusal (ROFR) etc.

6. Ownership Percentage of Share Classes

Even though a company’s board of directors frequently makes important decisions, some decisions will be based on shareholder voting. A section on share class ownership percentages, or the percentage of the corporation that each individual or group owns, should be included in the term sheet.

7. Participation Rights

Investors who purchase participation rights have two advantages: an early return on the money they invest in startups and a share of any leftover funds. While investors and founders must share the same viewpoints generally, there is one instance in which they can find themselves at odds. Participation rights are popular among investors because they increase their return on investment. But, the founders may favour the total absence of participatory rights.

8. Dividends

At their most basic level, dividends are just a way for a corporation to distribute its profits to its owners. Companies can either offer cash or additional shares to pay the existing shareholders. Dividends are often a percentage that grows over time, commonly between 5% and 15%.

There generally exist two types of dividends:

i) Cumulative: 

It benefits preferred stockholders (i.e., investors) at the expense of holders of common stock (i.e. founders and employees). They grow based on the initial issue cost. With cumulative dividends, the amount of the payout is determined each year. If the firm is unable to pay it, it is carried forward (accumulated) into the following year and continues to grow until it is paid in full or the right to dividends is terminated. 

ii) Non-Cumulative: 

In the case of non-cumulative dividends, the stockholders are not paid any previous unpaid or omitted dividends. These dividends are generally considered better by the startup founders as they are not obligated to make any payments to the shareholders. 

Conclusion

No matter how great your business startup idea, it’s crucial to remember that a startup’s primary objective is to create a scalable and sustainable business strategy that can attract startup funding from VC investors. Without this, fundraising becomes pointless since venture money cannot sustain a firm on its own. The founders’ objectives while raising capital should be to maintain maximum control while minimising risks.

Since their engagement with the investors continues much after the cheque is paid, picking the correct long-term investment partners may also greatly impact the business performance. When founders are well-informed, they can use term sheets to safeguard their interests when raising capital to avoid any problems.