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WHAT STARTUP FOUNDERS NEED TO KNOW ABOUT TERM SHEETS FROM SOPHISTICATED ANGEL INVESTORS & VCS

WHAT STARTUP FOUNDERS NEE…

A startup’s receiving its first term sheet is generally an important early milestone. And while investor term sheets are not generic, they are designed to protect the investors’ investment – not the company. So it is not uncommon for founders and sophisticated investors to diverge on what a deal should look like.

Because term sheets are largely non-binding, the investment occurs only if and when the parties agree on definitive deal documents. Those documents are supposed to reflect with detail the term sheet’s high level expressions items– such as, “the holders of Series A stock shall receive customary restrictive covenants.” There is nothing wrong with a term sheet’s short-hand expression; this is its purpose.

But what a founder wants to avoid is agreeing unwittingly to a term sheet that bakes in a materially imbalanced right. Having already agreed in principle to the provision under the term sheet, the founder may or may not be unable to ratchet that item back after counsel retained to review the definitive documents advises of its full implications.
In our experience at DPA Law APC in San Jose, imbalanced deal terms arise most often when a first time founder negotiates the deal’s economics him-or-herself, glosses over the rest, and retains us as corporate counsel after—not before—he or she signs the investor’s term sheet.

Beyond valuation and deal economics

When considering a term sheet, valuation and deal economics are naturally at the forefront of the founder’s focus, and, consensus on pre-money valuation can be challenging to achieve. This is why very early investments often defer pre-money valuation through use of convertible promissory notes, or the West Coast startup community’s favored alternative, the so-called simple agreement for future equity (Safes).

So while pre-money valuation is important, founders—in Series A rounds in particular—can over emphasize it to the exclusion of other provisions, not always appreciating that a savvy investor may be able to “undo” through those other provisions much of what the founder thought he or she gained on the startup’s valuation.

While sophisticated investors certainly expect a valuation that secures a big enough piece of the company to justify doing the deal, they are just as keen on provisions that lock in their liquidation rights, protective provisions, and management rights. These are the provisions, often expressed in short hand, intended to get the investors paid back first in a down-side scenario, mitigate their investment’s being diluted by future investment rounds or equity grants to employees, block others from achieving liquidity ahead of them, secure a way to get their money back in as many scenarios as possible, and, importantly, ensure material participation in the startup company’s decision making process—including controlling certain founder behavior. This can include investor designees on the company’s board being given an effective veto over certain company agreements—including debt transactions, executive salaries, option awards, and others. It can also include requiring separate investor approval by super-majority vote in order for the company to buy or sell material assets or issue future rounds of stock.

Achieving a fair financing round is facilitated when one knows which, and to what extent, the investor’s proposed rights and protections are customary and the degree to which each is likely negotiable. Many of these items are best addressed, modified or eliminated at the term sheet stage at risk of losing the opportunity to do so effectively later.

Experienced founders avoid giving short shrift to any provision in an investor’s term sheet, which is why they tend to consult with corporate counsel before—not after—signing a term sheet.

 

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