If you’re a startup founder looking to raise your first round of venture capital financing, you’ll want to understand term sheets when you sit down with an interested investor. In this multi-part series, we’ll take a look at some common elements of a term sheet.
What is a Term Sheet?
When an entrepreneur begins negotiations with an investor, the term sheet is probably the first legal document he or she will sign. It outlines the provisions of the future final agreement, which the lawyers will draft later. The idea is to give all parties a (relatively) short agreement that captures their agreement on key points. Note, however, that many of the terms remain open for negotiation even after the term sheet is signed, and the term sheet is generally not binding except for a few terms such as the payment of legal fees, confidentiality during negotiation, and promises not to enter similar negotiations with a different potential investor before the closing date.1
The idea is to give all parties a (relatively) short agreement that captures their agreement on key points.
Equity vs. Debt
When a venture capital firm (“VC”) invests in a startup, the investment usually takes one of two forms: equity or debt. The most common form is an equity investment, which is paying for ownership of a part of your company, as compared to debt, which is a loan.2
An investor who holds equity has different rights to the company’s money than one who holds debt. When a company makes money to a point where it can pay back those who invested in it, debt holders have the right to get paid out first, then equity holders get what’s left over. However, the reason some people prefer equity is that in exchange for agreeing to get paid after debt holders, equity holders are entitled to theoretically unlimited upside, whereas the upside of debt holders is always capped. So for example, if a company is sold for $1 million and the debt holders are owed $1 million, then the debt holders get their $1 million and the equity holders get nothing. However, if the company is sold for $100 million, the debt holders still get only $1 million, but the equity holders split $99 million.
Preferred v. Common Stock
When an investor owns equity in a company, it comes in the form of stock, or shares of the company. This is similar to buying shares of a company on the stock market. In venture capital situations, there is usually a two-tier stock structure: preferred stock and common stock. (With multiple rounds of funding, you may see “Series A Preferred,” “Series B Preferred,” etc. depending on which round of financing it is, where A = 1st round after a seed round, B = 2nd, and so on.)
Holders of preferred stock get some extra rights that holders of common stock don’t have. For example, holders of preferred stock may get priority over common stock in getting paid out (but still lower priority than debt holders). Also important to VCs are the special voting rights that come with owning preferred stock, which allow the VC to control the company’s actions by voting for or against certain business strategies or major transactions.
A VC will require that the preferred stock be convertible into common stock, usually on a one-to-one basis. This comes into play at a liquidity event, such as when the company is being sold to or merged into another company, or an initial public offering (IPO), where the shares of the company are being placed on the open stock market, and any member of the public can buy and own stock in the company (and the company can use the money earned from the sale of stock to fund growth or whatever new strategies it wants to put into place).
Although holders of preferred stock get paid before holders of common stock, preferred stock holders may only receive a fixed amount, and the common stock holders get the leftovers. If the leftovers, divided up, amount to more than the fixed amount, it may be more desirable to convert the preferred stock into common stock.
There are a lot of moving parts in any financing deal. Most people focus on the big numbers: the dollar amount of the investment, the percentage stake in the company bought by the VC, and the resulting price of the shares. However, keep in mind the different parties’ (sometimes competing) interests. Once you close the deal, who will be affected? Although a founder is technically in charge, how many other parties will own a stake in the company?
Usually, after accepting an investment, the owners of the company will be the founder, the management team, and other early employees (who have been offered stock options), and the VC. You may have a long-term strategy for your company, including ideas like your overall mission and ideal corporate culture. This may not always align with the VC’s interests, which is ultimately to get the biggest possible return on its investment, though supporting your goals is almost always the best way to do so.
In the next post in this series, we’ll take a closer look at three areas where VCs and entrepreneurs often have competing interests – anti-dilution terms, the liquidation preference, and participation rights.
- See Daniel I. DeWolf, Venture Capital: Forms and Analysis (Securities Series) § 2.02(23)-(27) (2014). ↩
- An investor could also hold a convertible note, which begins as debt but can be converted into equity and usually comes with a lower interest rate, so it is cheaper for the company. When the holder converts the note into equity, the company is no longer required to pay back the loan. However, the debt holder then becomes an equity owner, which reduces the amount of control the previous owners had. For more information on convertible debt, see this article on Fred Wilson’s blog, AVC. ↩