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📢 Hidden Clauses In The Term Sheet that Every Founder Should Know
It's no secret that term sheets in the startup world can be fraught with hidden clauses and legal jargon that often go overlooked. These overlooked clauses can lead to confusion, disputes, and even chaos down the road. Most founders don't fully understand the implications of these terms until it's too late. So here we are explaining hidden term sheet clauses with real-world examples.
So grab your coffee and let’s deep dive into it.
In simple words, a term sheet is a non-binding legal agreement (non-disclosure and non-sharing) between the founders & investors that shows the investor’s interest in that startup. But signing term sheets doesn’t mean that they will go to invest in your startup.
If you are aware of the VC funding cycle - investors first sign the term sheets which contain finance and governance things then do the due diligence. During the due diligence if they find any red flags that can be resolved then only they will invest in your startup otherwise red flags in the due diligence process lead to the decline of the investment interest in the startup.
So, Understanding the term sheet can help founders get an idea about the economics, governance, and operational aspects of the term sheet and help in negotiating deals with VCs.
In this, we will solely examine the hidden economic aspects of term sheets, specifically focusing on valuation, investment amount, anti-dilution and liquidation preference. At a later time, we will delve into the governance aspects, including decision-making power, voting rights of investors and founders, and pro-rata rights. I will present the information in a way that is easy for first-time founders and aspiring VCs to understand.
Let’s understand this with a simple example -
Consider a startup that got the term sheets from two different VCs ABC & PQR included the investment aspects as follows:
On the left side, you can see terms like $ invested, Pre-money, Post-money and likewise others. I hope you are aware of these terms. But still, let’s decode the terms with explanation:
Decoding the above term sheet’s economic aspects:
ABC and PQR fund is willing to invest $2M & $4M respectively at a $8M pre-money valuation (Valuation of the company before investor invest their money).
So post-money valuation will be: For ABC Fund $10M and For PQR Fund $12M.
(Money Valuation = Pre-money valuation + Investment Amount, it is the valuation of the startup after the investor invests their money)
Equity In Company:
Equity in the company = Investment amount / Post-money Valuation
For Fund ABC, % of stake in company = $2M / $10M = 20%
For Fund PQR, % of stake in company = $4M / $12M = 33%
Option Pool:
It consists of shares of stock reserved for employees of a private company. So to attract talented people and their contribution to the startup, early-stage startups give them shares of their company. the founder has to reserve the Generally startups reserve about 15%-20% of stocks for new employees.
Here in the ABC fund - The startup is reserving 20% company’s stock as an option pool.
In the PQR fund - The startup is reserving around 15% of company stocks as an option pool.
Liquidation Preference:
It is the priority that investors have in receiving proceeds from the sale or liquidation of a company. In layman's terms, it means that the investors with a liquidation preference have the first right to get their money back before any proceeds are distributed to other shareholders.
For example, if an investor has a liquidation preference of 1x, they would get their initial investment back before any proceeds are distributed to other shareholders. If the investor has a liquidation preference of 2x, they would get twice their initial investment before any proceeds are distributed to other shareholders. Here In this term sheet, you can see both VC funds ABC & PQR have 1X liquidation preference.
There are two other terms also involved in it - participation and non-participation liquidation preference. Let’s understand both the terms, participation, and non-participation liquidation preference.
Non-Participation Liquidation Preference:
Upon liquidation, non-participating investors have the choice of receiving their funds in one of two ways: either based on a 1X preference or according to their stake in the company. Investors typically compare the potential returns from each option and select the one that would provide the most benefit for them.
Ex - Suppose for fund PQR - if in liquidation (sale) of a company valued at $10 M. let’s calculate the return for investors from both ways:
1. 1X liquidation means investors get 1X of the investment amount - so $4M OR 2. Based on the percentage of stake - 33% * $10M (Valuation) - $3.3M.
So after calculation, it’s clear that option 1 - 1X liquidation preference gives more return to the investor hence he will choose the 1X option and get a return of $4M. The rest amount of $6M ($10M - $4M) will be distributed to other shareholders.
Participation Liquidation Preference:
During the liquidation of a company, investors with a participation liquidation preference are entitled to receive their funds through both methods - a 1X preference and a percentage of their stake in the company.
Ex - Let’s take the same example as above if the fund PQR took the 1X participation liquidation preference then the calculation would be the same - but investors will get a return from both ways so 1X liquidation preference = $4M and Based on percentage stake = $3.3M. So total return for the investor = $4M + $3.3M = $7.3M and the rest amount of $2.7 ($10M - $7M) will be distributed to another stakeholder.
As a founder, if your company is liquidated and there is a participation liquidation preference in place, your returns will be minimal. Therefore, it's advantageous to have a 1X non-participation liquidation preference in the term sheet. Additionally, most venture funds typically use a 1X non-participation liquidation preference as it aligns the interests of investors and other stakeholders in the event of a company liquidation
Anti-dilution:
Antidilution rights protect venture capitalists in the event of a down round, which occurs when a company's valuation in a current funding round is lower than in a previous round. This can happen due to poor performance or other reasons. In a down round, past investors may request price adjustments to compensate for the lower valuation, allowing them to purchase shares at a lower price than in the seed round.
Investors get anti-dilution protection in two ways, BBWA (Broad-Based Weighted Average) and Full Ratchet. Let’s understand this first in layman's terms.
Let’s take an example, for fund ABC company’s value at $6M in a higher fund round but ABC valued the company at $8M -
so having BBWA antidilution protection, help to adjust the price of the company from $8M to $6M with a $2M amount of investment with a weighted average.
With the same example - If ABC fund has Full Ratchet Antidilution protection. In simple words, Full rachet means price reset. As new investors valued the company at $6M lower than the previous funding round, the previous investors also valued it at $8M, and this reset all the numbers and helped the ABC fund to get more equity in the company. And this leads to more dilution for founders and is not good for them.
So, founders need to look at Anti-dilution protection.
So, these are the important terms that are generally found in every term sheet.
But which of the one term sheet is good for you as a founder?
Ultimately, the decision is yours. Consider whether accepting a large investment now will enable you to achieve the planned growth and increase your startup's valuation in the next funding round. If the answer is yes, then go for it. If not, it might be better to accept a smaller amount and experiment to see if it works.
With this, there are other aspects in the term sheets like cap table, governance, and operational aspects. VC Opened promises you to write on that topic in the coming time.
Both founders and investors need to remember that a “term sheet does not guarantee success, only a strong business does. A term sheet is merely a tool for communicating the terms of the relationship between founders and investors.”
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📢 Featured Article: How Will a Venture Capital Recovery Feel? Observations from 2008
Recently I read an article by Tomasz on “What the Recovery of the VC Market looked like during the financial crisis time, 2008.” I found it really interesting, so sharing my key learnings and opinions.
“Reflecting on the past can often provide insights into the future. As we ponder the trajectory of a venture capital recovery, it's worth revisiting the lessons from 2008.
In the midst of the Global Financial Crisis, the venture capital market, like many others, slowed to a crawl. Yet, with the benefit of hindsight, we see that public and private markets were closely correlated, with a staggering 0.98 correlation for QQQ/Investing and 0.93 for QQQ/Exits.
However, in the moment, the markets felt sluggish. Companies were in survival mode, gritting out each quarter. It took about five quarters for the exit market to show signs of life again.
The turning point came in 2011, with successful IPOs from Cornerstone OnDemand, LinkedIn, HomeAway, and Fusion.io. These exits not only brought liquidity back into the system but also reignited belief in the potential for higher valuations and thriving businesses.
As we navigate the current landscape, we see initial signs of recovery with the Mosaic acquisition and the New Relic take-private. The IPO market, aside from SEMRush, remains quiet.
Yet, if the Nasdaq continues to strengthen, we may soon see a few of the queued IPO candidates take the leap, inviting others to join.
In the end, it's important to remember that higher funding doesn't necessarily equate to faster hiring in startups. The road to recovery may be long, but the lessons from the past remind us that resilience and patience can lead to prosperous times ahead.”
If you want to read the full article, feel free to visit the website!
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📢 Tweet: How To Convince Investors That Your Startup Can Give Maximum Return To Them?
Recently we shared a tweet on - “How can convenience investors that his/her startups can generate maximum return?” We understand that - The single biggest challenge when pitching to VCs is convincing them your startup can return their fund.
As fund return works on power law (only a few startups generate all returns to the fund) your startup should be from those few startups. And this is the key driver in decision-making. So we made it easy for you with a practical approach! Have a look - 👇
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