It’s an accepted fact that when it comes to investment, all founders have a need to impress those potentially willing to pump money into their startup.
However, situations often arise when the overriding need for investment masks the shortcomings of the founder(s).
Competency and knowledge are a pre-requisite, as is the delivery of results, albeit, founders can find themselves a little lost in investment jargon at times.
A Term Sheet is often quite the challenge, with terms that remain confusing.
Therefore, WGP Global wish to put your mind at rest, and provide a concise write up on the 13 key terms every founder should know in an investment term sheet.
What is a term sheet? – Definition
It’s important to remember at the outset that a term sheet remains a non-binding document.
Broadly speaking, the parameters for investment are set out within it, via agreed terms and conditions, and this allows any investors to make a considered decision when deciding on whether to place investment in a startup.
It is, essentially, a framework from which to negotiate a final agreement, but isn’t binding on the investor and therefore doesn’t compel them to complete the investment.
1) Pre-money Valuation vs. Post-money Valuation
When we speak about ‘pre-money valuation,’ it specifically relates to an agreed company value before there has been any investment made.
As and when a company is being registered shares will normally be divided up and, given that there will not be a public listing at that stage and therefore the market price for the shares cannot be ascertained, it will be the investment that establishes the value e.g. how much money is put into the company at startup is a reasonable guide as to it’s pre-money valuation.
‘Post-money valuation’ comes once there has been investment into the startup and is a mathematical value.
2) Common vs. Preferred Stock
There’s an easy differential to make between Common stock and Preferred stock.
The former, as it’s name would suggest, remains the preferred type of stock that companies will issue.
Having preferred stock means that an investor is afforded the right to additional benefits over and above those held by common shareholders.
3) Option Pool
This term specifically refers to equity that is reserved for hires further down the line.
In order to attract key employees to the business, an option pool of around 15% should be enough to target and successfully acquire those people.
It remains one of the most common startup tactics, and is wholly necessary when you consider where the company is to be positioned in the marketplace.
4) Pro-rata Rights
In any subsequent funding rounds, investors must have pro-rata rights in order to participate.
There’s no obligation to have them, however, by so doing, it allows any investor to ensure that their ownership percentage isn’t diluted.
Furthermore, it will give them the comfort of complete control over their equity stake.
5) Drag Along Clause
To avoid a scenario where a minority shareholder could cause the failure of a company sale further down the line, a ‘drag along cause’ is necesary.
The clue is in the name.
If a majority shareholder wishes to cash in his or her chips after receiving a decent enough offer for the company, he or she is able to ‘drag along’ any minority shareholders rather than have them dig their heels in and refuse to do business.
Bonus shares can be issued to those investors who’ve taken advantage of an anti-dilution protection.
Should equity be issued at a lower valuation than in previous financing rounds, as long as an investor has taken advantage of anti-dilution, there’ll be no issues for him/her whatsoever.
However, it is worth noting that founders often tie themselves in knots with anti-dilution, so it’s certainly worthwhile for them to become fully au-fait with this particularly area.
Very simply, the dividend is normally paid on a quarterly basis by the company to its shareholders, but is unlikely to affect startups too much.
Sole proprietors or more mature companies are the usual beneficiaries.
8) No-shop Agreement
Once a term sheet has been signed, the ‘no-shop agreement’ (sometimes referred to as a no-shop clause) ensures that founders are not able to speak with other potential investors.
Founders must always be aware that the no-shop agreement should be limited in terms of time.
There are no set time limits, however, 60 days should be more than enough tim to conclude any talks before opening up to other investment as required.
9) Pay to Play
Stockholders would be required to participate in future rounds of investment if pay to play has been earmarked as a provision.
Penalties, such as forced conversion to common stock, losing antii-dilution protection or losing various control rights have all been known to occur when potential investors have refused to participate further down the line.
Having a warrant ensures that the holder will have the right to buy stock at a predetermined price, as long as this purchase is made within a specified timeframe.
There is, however, no obligation on the investor to buy further stock.
11) Cost of Counsel
Reimbursing a portion of an investors legal fees is all that’s meant by cost of counsel on a term sheet.
12) Information Rights
Financials, performance metrics and more are all the types of information that would be granted to any investors that requested such information.
It’s common practice for a minimum amount of shares to be bought before an investor will receive information rights.
ROFR stands for Right of First Refusal, which gives potential investors the opportunity to accept or refuse shares before third parties are able to have access to any deal.
Essentially, those investors who have ROFR, will be able to give a yay or nay on whether they’d like to be involved in a future round before other outside investment gets the chance.