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The Best of the Rest: More Answers to Your Term Sheet Questions

Hyde Park Angels recently hosted The Ultimate Entrepreneur’s Guide to Term Sheets, led by our Principal, Michael Sachaj. In the webinar, Michael broke down and demystified term sheets.

The full recording is now available, but we wanted to share an added bonus. During the webinar, Michael answered several questions from the audience, but missed out on some due to timing. In this special Q&A, Michael went back through unanswered questions and provided answers to them.

Read on for more information on lead investors, issuing shares, negotiating valuations, and much more!

How much information do investors typically want when making their decision? Do they ask to see financial models?

Investors ask for different types of data which varies in each stage. When you are a Seed company, investors will want to understand your value proposition and the makeup of your team. Moreover, the investors will want to understand how business model scales and that can be typically be solved with a simple financial model. At later stages of your company, investors will want to understand your traction as it may relate to users, engagement, or revenue.

A valuation cap is almost always required. How important is setting the right cap? Should I be concerned if I set the cap too high?

Typically investors would be involved with setting a fair cap. Based on general market dynamics, if the cap is set too high then investors will not be interested in investing because the risk to upside ratio is not balanced. Active investors will also typically make investment decisions based on comparing what other opportunities they can invest in. If your cap is too far above what is generally set in the “market”, investors will decide to invest in other companies.

As a startup brings on new investors and employees, I have heard that your shares become “diluted.” Can you talk about this?   

As a company takes on additional investments, there are new shares being created. From our example on the webinar, a company started with 8M shares and after the $1M investment at a $4M Pre-Money valuation the company now had 10M shares. So, those 8M shares represent 80% of the company and not 100%, but now the business is valued higher than it was before. You can have a large portion of a small pie or a small portion of a large pie.

Will all investors follow the term sheet proposed by the lead investor?

The role of a lead investor setting the terms in the term sheet is to bring other investors around the table. When a round is completed, all investors are coming in on the same financial terms.

You talked about common board seats and preferred board seats. Say in a scenario there are two founders and one investor. There are three seats: two from common and one from preferred. Is it common to have the two founders nominate themselves to the common board seats?

In order to fill the common board seats, it is determined by a vote of the “common shareholders”. Typically, when a company is first getting started the founders would represent all of the common shareholders or a majority in order to elect themselves.

What best practices are there when deciding how many shares to factor into the initial share pool?

The way to think about option pools is based on a percentage of the value of the company. At the early stages of the company, there is typically 12% to 15% of all the shares set aside in the “option pool” which would be granted to employees.

Will investors want to negotiate a low valuation? How do you avoid that?

Active investors in the market that are reasonable will be focused on providing a low valuation based on what the market bears. What helps drive up valuation is strong traction or competing term sheets.