This is a guest post from Boast partner Renno & Co., Canada’s digital law firm specializing in blockchain, cryptocurrency & emerging technology law. If you want to learn more about the fundraising process at all stages of your business journey, download our Lifecycle of a Startup ebook.
WHAT IN THE HELL IS A TERM SHEET? AND WHY IS IT IMPORTANT?
I remember very well the first time I saw a Term Sheet for a financing round. I kept thinking to myself, “What is this? Can’t we just get to the point and sign the main agreements?” Why go through all the trouble of drafting (or worse, paying a lawyer to draft) a document which is essentially non-binding and isn’t really going to amount to much?
A couple of years and a dozen financing rounds later, I found out that a Term Sheet is one of the most important documents for founders and lawyers alike because it lays down the foundation for any financing, whether it’s through debt or equity. And much like a house or a building, a strong foundation is key, and it often determines the true strength of the structure.
Before we get started with a list of the most important items to look for in a Term Sheet, let’s quickly go over the building blocks of corporations: shares.
Shares in a corporation can be broadly categorized as common shares or preferred shares.
Common shares are usually the form of equity given to founders (and employees), and come with:
- voting rights
- dividend rights (more on this below), and
- rights to the assets of the company in case of a liquidation.
Preferred shares, on the other hand, are usually given to investors and have some or all of the following characteristics:
- liquidation preference: preferred shareholders have priority to receive funds over common shareholders in case of a liquidation of the company and
- preferred dividends: preferred shareholders are paid before common shareholders when dividends are issued. Preferred shares may or may not have voting rights attached to them.
Now that we have a basic understanding of these two classes of shares, let’s review the most important terms that are included in almost every Term Sheet, and which should be well grasped by any founder (startup or not) looking to raise capital for their companies:
Pre-Money and Post-Money Valuation
A “pre-money valuation” is the value of a company before receiving any investments. The “post-money valuation” is the value of a company after receiving an investment. Here’s an example of how a pre-money and post-money valuation may be calculated:
|Percentage Owned by investor:
|$15M + $5M = $20M
|$5M/$20M = 25%
Founders usually aim for a pre-money valuation that is neither too high nor too low. This is because if the valuation is too low, it can unnecessarily dilute the founders’ equity. On the other hand, if the valuation is too high, it can put increased pressure on the company to perform and may make subsequent funding rounds more difficult for the company. The valuation of a company is usually determined by various indicators such as growth rate, industry, traction, startup location, the strength of the team, target market, and market strength.
The “liquidation preference” provision lays out the order in which the shareholders (i.e. you and the investors) get paid and how much they get paid if the company is not successful and is liquidated and dissolved, or is acquired, goes public, etc. This is a key concept for founders to grasp as it not only impacts who gets paid first and how much in an exit, but it also has a lasting impact on subsequent fundraising rounds.
Since the primary objective of an investor is to minimize its risk while maximizing its return, liquidation preferences are usually highly negotiable points in a deal.
For starters, dividends are defined as a sum of money paid regularly (typically quarterly or annually) by a company to its shareholders out of its profits, and at the company’s discretion. There are generally two types of dividends: cumulative and non-cumulative.
The “cumulative” in cumulative dividends indicates that, if your company suspends dividend payments for any given year, the unpaid dividends owed to the shareholders entitled to such dividends (known as dividends in arrears) continue to accrue. When the company decides to restart dividend payments, it must pay all accrued cumulative dividends before making any dividend payments to common shareholders.
Non-cumulative dividends, on the other hand, would only be paid to shareholders when the company declares dividend payments (upon the discretion of the board of the directors), and such shareholders would have no right to receive payment for dividends in arrears; therefore if the company does not declare a dividend for a given year, that dividend is lapsed and never paid to those shareholders.
As you may have guessed, you should beware of giving out cumulative dividends to investors, especially in the early stages of a startup. Your company should avoid cumulative preferred dividends for the following reasons:
- The requirement to pay accumulated dividends will likely delay dividend payments to common shareholders.
- Having to pay accrued dividends means your company will have less cash available for operating expenses and investments.
Let’s go back to the basics again here as this might be a confusing concept for some:
- An option gives its holder the right (but not the obligation) to purchase shares of a given company at a later date.
- An option pool is a block of company shares you reserve, in addition to your existing number of issued shares, and set aside for future employees. For example, if a founder owns 10,000 shares (100% of the company) and creates an option pool of 1,500 shares, there are now 11,500 shares of company stock on a fully diluted basis (about 13% of which are reserved under the option pool).
Option pools are usually laid out in a document called ESOP (short for Employee Stock Option Plan), which helps companies attract top talent to a startup and incentivize these individuals to perform their duties well because if ever such companies get acquired or go public, their team members are rewarded with shares of a then highly valuable company.
In a term sheet, the option pool is specified as a percentage of the total issued and outstanding shares of a company. Typically, option pools represent about 10% to 20% of the total issued and outstanding shares of the company. If the company is sold, all the unissued and unvested options (meaning the ones that have not been exercised into shares) may then be cancelled and the investors would share the additional sale proceeds proportionally with the founders. This is one of the reasons why investors usually prefer and negotiate for a larger option pool since a portion of it will likely come back to them as proceeds. On the other hand, founders would typically prefer a smaller option pool in order to minimize their dilution.
Last but not least, a very important element included in term sheets that founders should pay attention to is investor rights. Before investors agree to invest, they typically insist on “protective provisions.” As the term suggests, these provisions protect the investors’ interests by requiring investor approval for certain types of company decisions. For example, a protective provision may require investor approval for debt that your company can take on above a certain threshold amount. Investors may also request special rights such as information rights and pro-rata rights, or the right to invest in future funding rounds an amount proportional to their current ownership percentage of the company.
The information in this blog post is provided for general information purposes only and does not, and is not intended to, constitute legal advice. This article was written by Ari Mike Varjabedian with the assistance of Pouya Makki and Robert Zalcman. Feel free to connect with the team on LinkedIn or email David at email@example.com if you have any questions.