Receiving a term sheet from an investor can be an exciting time for you as a founder. But you shouldn’t let that excitement keep you from understanding and thinking critically about that term sheet. The better your grasp the terms presented, the more chance you’ll have of effectively starting your long-term investor relationship on the right foot and maximizing the probability of mutually successful outcomes.
Every founder and every deal is different, which means certain terms in a term sheet might have more or less significance depending on the context, but there are three in particular that universally matter.
Valuation is the financial worth assigned to a business. Unsurprisingly, it’s also typically the most talked about term on a term sheet because its a key driver in how much money everyone gets when the company exits and how much weight they have in making decisions.
When you’re looking at valuation, think about how to develop a fair calculation by factoring in your company’s current progress in acquiring customers, developing a product, and building a strong team. You also need to assess broader market conditions for how your company compares to others in your industry (known as “market comps”).
Coming up with a fair valuation will also help ensure your next round is not at a lower valuation than your current one (known as a “down round”). Ultimately, applying strong logic to your calculation will provide you a defensible range for your company’s valuation.
Just because valuation is the most talked about term doesn’t mean it’s the only economic one to understand, which is what brings us to liquidation preference.
2) Liquidation Preference
Liquidation preference determines in what order funds are returned to different stakeholders based on the particular class of stock they own.Basically, it means that when your company is sold or dissolved, some stakeholders will get their money (if there’s any to be had) ahead of others.
A typical structure for early stage investments is a 1x liquidation preference that is non-participating preferred. What this means is that at the point of exit, an investor is looking to at least return their investment amount (this is the reason why it is referred to as “1x”). If the exit is greater than the amount invested, then funds are returned to all classes of stock based on their percentage ownership (investor is only participating in the exit once which is why it is called “non-participating”).
3) Board Composition
Your Board of Directors is a group of either elected or appointed members who work together to oversee duties outlined in your company’s charter. Your board members make critical decisions about your company.
The term sheet will usually define who chooses the board members and how many people will participate on the board. Some board members will represent the common shareholders (e.g., founder/CEO) and some board members will represent the preferred shareholders (e.g., investor). In some instances, there also may be a board member that is chosen by both the common and preferred shareholders (known as the “Independent”). For early-stage companies there are typically two scenarios where there are either 3 or 5 board members which can be broken down in the way seen below.
The other element to understand is what percentage of the board needs to vote (e.g., majority, super majority) in order to approve certain critical decisions. It is important to ensure you have a voice on the board when it comes to critical decisions.
This post is part of the Hyde Park Angels Entrepreneurial Education Series, which brings together successful, influential entrepreneurs and investors to teach entrepreneurs everything they need to know about early-stage investment through events, articles, videos, and more. If you are interested in learning more about similar topics, register for “Connecting Corporations and Startups” on September 24.