If you’ve made it through the pitch process and are at the point where an investor has handed you a copy of a term sheet, you have a right to feel pretty excited.
So give yourself a few minutes to celebrate — and then get down to business.
While a term sheet isn’t a legally binding document, it has the potential to shape every future round of funding you raise. It’s extremely important to read it carefully, hire a lawyer to help you understand what you just read, and make sure you’re comfortable with everything in there before signing your name.
Business Insider spoke to a series of entrepreneurship experts — including founders, investors, and lawyers — about key aspects of the term sheet and the most common pitfalls to avoid. Though everyone interviewed declined to share copies of term sheets they’d signed, citing confidentiality reasons, you can find templates on the National Venture Capital Association website.
Read on for the best advice we heard about term sheets:
Look at the big picture
It’s easy to get bogged down in all the legalese in a term sheet.
But ask Jerry Chen, a partner at the venture-capital firm Greylock Partners, and he’ll tell you the main thing to focus on is the quality of the investor and the firm they work for. If you’ve chosen someone knowledgeable and experienced, it’s unlikely they’ve included anything deceptive or unconventional in there.
The three key categories of terms to review, according to Chen, are valuation, governance, and voting rights (more on all those below). While other terms are important, they won’t have as much of an impact on your company’s future success.
Get familiar with the negotiation process
Keep in mind that you won’t be drafting a term sheet — the investor will. If you’re lucky, you’ll have multiple investors vying to be the lead, so you’ll receive competing term sheets. The terms you set with your lead investor determine the terms you’ll set with other investors participating in the round, said Bouchra Ezzahraoui, cofounder of New York City-based jewelry company AUrate, which launched in 2015 and raised $2.63 million in a seed funding round.
So, exactly how long does this whole process take? Dave Kimelberg, managing partner at Kimelberg PLLC, a New York City firm that provides legal counsel to entrepreneurs and investors, said that if your company’s in demand, it could take just a week. Otherwise, VCs won’t be incentivized to move as quickly and negotiations might take months.
Know what constitutes business standard
The term “business standard” means “how things are typically done.” If something on the term sheet isn’t business standard, be sure to ask about it and how it will benefit the company, Ezzahraoui said.
For example, Kimelberg said term sheets today are typically two pages long. If an investor sends you a 10-page term sheet, it’s on you (and your lawyer) to figure out exactly why.
Then again, you may very well want to deviate from business standard in some portion of the term sheet. Just because something is business standard “doesn’t mean it’s how it should be done,” said Nick Martell, cofounder of daily finance newsletter MarketSnacks. (Martell is now managing editor of news at Robinhood, which acquired MarketSnacks in March 2019 and renamed it Snacks.) “There’s always room for innovation in finance.”
That said, if you do want to change business-standard terms, you’ll need to back that up with supporting evidence, said Jack Kramer, cofounder of MarketSnacks (now managing editor of news at Robinhood).
Think long term
Always keep in mind that the term sheet you sign today will influence future fundraising rounds. “That document will tag around for a long time,” said Ezzahraoui.
Sacha Ross, a partner at Cooley LLP, a New York City law firm that advises high-growth companies and investors, shared an example of how myopic thinking can come back to haunt a founder. Say you agree to give the VC a 10% cumulative dividend on their investment, meaning every year they receive 10% of their investment. “A cumulative dividend of 10% for a $1 million raise may not be that impactful,” Ross wrote in an email to Business Insider. “But if that dividend is carried through to a $300 million growth round, the preference can build quickly.”
Ezzahraoui also advises founders to know where they want their company to go in two to five years, including the investors they want to target in their next fundraising round and what those investors primarily care about. She encourages founders to think about whether their current term sheet presents any obstacles to landing those future investors.
Remember this is the beginning of your relationship with investors
“There’s this tendency to think of the fundraising as the milestone moment, as the capstone,” Martell said. “The reality is that the fundraise is where the work just gets started.”
Chen said the negotiation around the term sheets give you a glimpse into what it will be like working with the VC going forward. It’s the only time when you and the investor will be on opposite sides of the table, so you’ll get to see how they conduct business.
Educate yourself and seek legal counsel
As a first-time founder, you should absolutely seek legal counsel during the fundraising process. “If you are going to spend money on legal,” said Megan O’Connor, cofounder and CEO of Clark, “this is the time to do it.” The New York City-based tutoring-software company launched in 2016 and has raised $3.5 million in angel and seed funding rounds.
Ezzahraoui added that it’s important to do your own research — reading the literature, talking to other founders — even before meeting with your lawyer, so you know which questions to ask. And of course, don’t be afraid to ask those questions. “You have to be confident enough in yourself to show when you’re not confident,” said Martell.
A word of caution: Patrick McGinnis, serial entrepreneur and managing partner at independent advisory firm Dirigo Advisors, said lawyers can miss things, too. “You must read everything extraordinarily carefully, and you must do all the math yourself and make sure all the math works out.”
Another option is to ask the investor you’re considering partnering with to give you a copy of a typical term sheet. It doesn’t have to include exact numbers, but Chen said this will give you an idea of what it looks like so you’re not caught by surprise or pressured to respond quickly. Plus, Ross wrote, “Showing that you as a founder understand what’s important to you, and want to know what’s important to your investor, establishes your credibility.”
Take the document seriously
A term sheet is not legally binding. Typically, the founders’ and investors’ lawyers will use the term sheet to draft other, legally binding documents, including stock purchase agreements and shareholders’ agreements.
But as Martell warned, don’t think you can change something when you get to the real contract. “Once you agree to the term sheet, those are the general principles you’re agreeing to, and nothing should be in conflict with what’s in the contract,” he said.
Weigh the importance of money versus control
In their 2016 book “ Venture Deals,” Brad Feld and Jason Mendelson, cofounders and managing directors at Foundry Group, which invests in early-stage technology companies, write that VCs care primarily about economics and control. Economics refers to the return they’ll get in a liquidation event (e.g., an IPO or acquisition); control refers to their ability to veto founders’ decisions and shape the fate of the business.
In fact, Feld and Mendelson write, if a VC is preoccupied with any terms beyond the scope of economics and control, that shows you how nitpicky they might be down the line.
As for prioritizing money or control, Ezzahraoui said that sometimes you’ll want to go with the investor at a lower valuation if they add more value to the business or if the term sheet positions you for a higher valuation in the future. As a founder, she said, you have a fiduciary duty to keep the best interests of the company in mind.
“Founders can get a little ‘valuation hungry,'” O’Connor said, but it’s also important to consider terms like dilution and future acquisition price. “Higher doesn’t always mean better.”
Pay attention to the liquidation preference
“Liquidation preference” outlines how the proceeds will be shared in a liquidity event. According to “Venture Deals,” it’s among the most important terms in a term sheet.
Capshare’s guide to term sheets breaks down the standard practice: When a company is sold, preferred stockholders are entitled to an amount equal to what they invested before other stockholders receive anything at all. Preferred shareholders can also convert their shares into common stock and receive cash instead.
Keep in mind the size of your option pool
Your “option pool” is the amount of equity you can grant future employees. The size of the option pool (typically between 10% and 20%) is taken into account in the company’s valuation, according to “Venture Deals” — meaning a bigger option pool isn’t necessarily advantageous.
Feld and Mendelson recommend preparing an option budget for your negotiation with an investor, listing all the hires you plan to make between now and the next round of financing and how much equity you’ll offer them.
Consider board dynamics
Kimelberg encourages early-stage founders to keep control of their board (meaning a majority of seats) and to keep it small. A three-person board is advisable, he added, typically including two representatives nominated by common shareholders and one representative for the preferred shareholders.
Whatever you do, make sure there’s an odd number of seats to avoid deadlock.
Review protective provisions
The protective provision outlines how much control VCs have over your company. For example, you might need their permission to sell the company, raise another round, issue more stock, or declare bankruptcy.
Kimelberg warned that the voting majority threshold shouldn’t be too high — in other words, “you don’t want to have to chase down 70% of all the stockholders to get approval” for a certain decision. What’s more, Kimelberg added, the protective provisions in this term sheet will set a precedent for your next round of financing.
Bring up any employment issues
“Any material employment issues, I would also throw into the term sheet, make sure they’re there, so that you’ve surfaced them,” McGinnis said. For example, if you’re the founder of another company, the term sheet might indicate that you’ll spend 10% of your time there.
If you don’t have any side projects, but that paragraph is in the term sheet anyway, it’s possible the investor suspects you’ve got something else going on, according to “Venture Deals.”