Investors, on the other hand, look at the money figure, and even the equity, as the easy part. What they worry about is a whole different set of issues, including how much control they will have over how their money is spent, what will happen when future investors jump in to dilute their position and how they will get some money back if things don’t go according to plan.
Still, no one wants the terms to be so complex that the deal never closes. The process should not be a game where investors and entrepreneurs are trying to kill each other, but one that defines a win-win arrangement: Both parties are protected and can work together with mutual respect in anticipation of a big win. Here is a summary of the key terms to expect on the term sheet, or the contract between the founder and investor:
- Consideration given for the money invested. In very early startups, which have no valuation, the term sheet may specify a convertible note. This is a loan with an option to convert to equity at a later date. For later investments, the price is equity, with a percentage of the owner stock to be assigned to the investor. Numbers in the 20 percent to 30 percent range are common.
- Type of stock assigned to the investor. Investors typically demand preferred stock, to give themselves certain voting and liquidation privileges over later shareholders. Even founder’s shares are common stock. Preferred shares are not possible with a limited liability corporation (LLC), so expect to convert to a C-corp to get an equity investment.
- Board of directors participation. Every investor would love to have a seat on the board, since that is where business control really lies. Smart entrepreneurs will limit these seats to one or two top investors, to keep the board size manageable, as well as to balance control with startup founders. A startup board of five or fewer members is optimal.
- Terms to prevent equity dilution relative to others. Investors always worry that later investors might come in at a lower valuation, effectively pushing out early investors. Accordingly, they include terms which allow early investors the right to buy shares at the new, lower price, or otherwise maintain their existing ownership share. This is normal and fair to all.
- Definition of investment delivery in "tranches." This simply means that the investor wants to deliver the cash in stages, dependent on the founder achieving specified milestones. Obviously, it reduces the investor's risk, but limits the flexibility of and increases the risk for the startup. Founders should negotiate this term away if at all possible, and get that cash now.
- Right to buy shares back from exiting investors. This “right of first refusal” allows existing owners to reclaim shares that are about to be sold to a new party, to prevent ownership fragmentation. Startup founders should insist on this option for themselves, and allow it for major investors. Venture capital investors normally insist on this option.
- Investor liquidation priority. Investors want a contract preference to get their total investment back first in any company sale, to prevent founders who are struggling from deciding to sell at a loss. If the company is sold at a profit, liquidation preference can also help them be first in line to claim their profits. Smart investors will insist on this option.
Term sheets are something you can’t avoid. Yet they need not be a mystery or a yoke around your neck. If you take the time to understand the basics, and start looking for investors before you are desperate, the whole process can be fun and exhilarating, rather than a gauntlet of fear and pain.
*** First published on Entrepreneur.com on 9/16/2015 ***
*** Spanish translation on Bbooster.org