Terms of endearment: How to know when to say ‘I do’ to a term sheet

Receiving a term sheet marks an exciting stage for any startup.

It is the external validation that someone shares the founder’s vision and confidence for their new venture.

It is not dissimilar to a marriage proposal as it signifies a desire to build a longer-term relationship between the investor and founder. Courtship has occurred, the founder has told the investor their hopes and dreams, shared their business plan and sales pipeline, and the investor has enough information to make a commitment.

In the same way that most marriage proposals follow a period of ‘getting to know each other’, the provision of a term sheet is often the formality that follows a period of preliminary due diligence between the investor and founder.

Some founders may be highly sought after and receive a number of proposals from different investors. This can result in a competitive process where the founder must select the best suitor from the investor proposals, the most compatible and attractive long-term partner.

Regardless of the situation, once a term sheet is provided by an investor and is signed by the founder, the formal (and usually confirmatory) due diligence process begins, where an investor will check the accuracy of the information that has already been provided.

In effect, the investor is saying to the founder that, subject to them not uncovering any skeletons, they are in the relationship for the long haul.

What to expect

A term sheet has a number of important components that paint the picture for the future of the relationship.

1. Valuation

The pre-money valuation or value of the business prior to investor funding as well as the post-money valuation.

2. Share type

Ordinary shares are issued to founders and staff while preference shares are often issued to investors. Preference shares will have different rights compared with ordinary shares such as how income (dividends) and capital are treated.

3. Liquidation rights

This outlines the hierarchy or order in which capital is returned to shareholders in the event a business is liquidated.

4. Future funding rights

An outline of the opportunity to participate in additional funding rounds. Many early stage investors will seek pre-emptive rights, giving them the opportunity to participate in later funding rounds.

5. ESOP

Employee share ownership plans are important to the success of a startup as they allow the founder to secure new talent by offering equity. Best practice suggests that a range of 10% to 25% be set aside depending on the stage of business.

6. Anti-dilution terms

This protects the investor’s initial investment in the event of a reduced valuation at a later funding round. The investor’s shareholding will be adjusted to reflect the price of the later valuation.

Warning bells

Ultimately there are only two binding clauses in the term sheet, confidentiality and exclusivity, both of which are fundamental to a successful long-term relationship.

It is almost always the case that investors providing a legitimate term sheet want to do the deal but there are a number of watch-outs that should ring warning bells for founders.

1. Unfair control provisions

A founder must always ensure they retain adequate control of their business. The right suitor will empower the founder to make decisions about the future strategy of their business rather than take away control.

Having a clear understanding about the role of the investor, whether they are a director or board observer, is critical. Responsible investors will desire an appropriate governance structure for the stage of the business with both flexibility and guardrails in place.

Enough freedom should be granted for founders to make critical decisions, using the investor as a sounding board.

2. Unfair anti-dilution measures

The equity of founders must be protected with anti-dilution measures for the investor being fair but not excessive. While a ‘ratchet’ clause is common it can in some circumstances increase the investor’s proportionate ownership of the startup, meaning that the value of the startup diminishes over time and the founder has a smaller ownership stake.

In extreme cases this will reduce the founder’s control of the business.

3. Timeliness and exclusivity is key

An investor who is serious about making a long-term commitment should have no trouble sealing the deal within the period of exclusivity guaranteed by a term sheet (usually 45 days).

As this process is primarily fact-checking, subject to all provided information being correct, there is no excuse for investors to drag out the process.

Any discrepancies identified in the exclusivity period may result in a renegotiation of the terms, but this shouldn’t mean the founder is held to ransom.

In sickness and in health

Through its open-source documents, the Australian Investment Council provides sample term sheets to enable founders and investors to understand what is fair and reasonable for a potential investment.

Getting the terms right sets the partnership on a good path and ensures a lasting and prosperous relationship where both parties feel that they have each other’s respect and long-term interests at heart.

NOW READ: CEA Collider accelerator publicly releases term sheet to better educate founders

NOW READ: “Never stop fundraising”: How this recruitment startup raised $4.5 million without ever talking to a VC fund