Term sheets

What is a term sheet? If you raise money from a venture capitalist (or an experienced angel) then the most important conditions for the investment will be summarized in a term-sheet. It sounds like this should be a simple document of a single sheet of paper, but in fact these days it is dozens of pages of legalese that is a good way towards the final legal documents. In fact, it is so complex that typically the really really important stuff will indeed be summarized in a few bullet points ln a different piece of paper (or an email).

The most important bullet point, of course, is the pre-money valuation. This is the amount that the investor values your company before putting in the money. The post-money valuation consists of this amount plus the money that they invest.

One item to make sure you understand is the employee option pool. There will be a pool of options created for future employees. The normal way is to carve this out from the previous round before the new round money goes in. This means you pay for the option pool, not the new investors. At one level this sounds unfair, but in fact it just feeds into the valuation. The pre-money valuation is thus usually the valuation of the previous round’s stock, plus the value of option pool. So the previous round’s stock is not worth as much as it sounds. Of course this can be done other ways, but that will affect the valuation differently. Make sure you understand it since not all “$8 million” pre-money valuations are created equal.

The next most important item is probably whatever is agreed about liquidation preferences. The VC will have preferred stock, and preferred means that it gets a better deal than common stock in the event of an acquisition (or wind-up) of the company. Just how much better a deal is important. At the very least, usually a VC wants to get their money back before the common stock gets any. But it can be a multiple of their money they get back, or their money plus a dividend (interest). And then they get their share of the common, which there are a number of ways to do.

Another really important area, especially when there are multiple rounds, is who has to approve change-of-control decisions (essentially acquisitions). Can the VCs over-ride the common stock? Can series B veto series A? In one acquisition I was involved with, each round of preferred stock voting had to approve the acquisition, not just the preferred stockholders voting together as a group, which is not unusual. Sounds innocuous? But one round of investment was a corporate investor (a customer) who thus had veto rights over the acquisition (that they leveraged into a very good deal for themselves since they were also a customer of the eventual acquirer).

An excellent book on term sheets is Term Sheets and Valuations which goes through the most important items on the term sheet and gives you guidance for each item as to what is middle-of-the-road, what is aggressively in favor of the venture capitalist, and what is aggressively in favor of the company (or common stockholders). I’ve purchased this book several times since my copy always goes missing when someone forgets to give it back. If you are going to raise money and have not done it dozens of times before then you should read this book.

Another really good resource is that Wilson-Sonsini, the biggest name in legal for most silicon valley stuff, has put a term sheet generator online. You fill in various pages with the data, and it spits out the legal document. If you are really raising money, you should at minimum have your lawyer go over the document, it’s still just a document generator on the web. But if you are thinking about raising money, or want to know more about term-sheets, then you can play with the tool. Even going through the experience of filling out the forms will force you to understand a whole lot of issues that you might not have come across.

There’s also lots of stuff on various venture capitalist blogs. This will often give you an insight into why a VC might care about a particular issue, when it would be important, how big a concession it would be for them to give you more favorable terms and so on.

As always, remember that the VCs have usually done this lots of times before. You, not so much. Get good advice.

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