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Mastering your first term sheet

Receiving your first term sheet is a big milestone—and one of the final steps in the fundraising process. It serves as the outline for the conditions of the investment, making your term sheet a foundation for your future rounds of financing. It also includes a number of technicalities you want to get right.

What does the anatomy of a term sheet look like? What goes into it?

At the most basic level, the term sheet contains all of the terms that a company and an investor have negotiated on for financing. When you’re raising a Series A, you’ll have five core documents that add up to a hundred or so pages. Your term sheet, on the other hand, boils down all of the essential terms of the deal into a single document. It takes what can be easily distilled into a couple of pages and summarizes what each party has agreed to. It includes terms such as valuation, liquidation preference, board composition, and other protective provisions.

Founder tip: "Before you even receive a term sheet, become familiar with its common terms and the implications of the different protective provisions."

How do most founders learn about term sheets, and where they fit into the fundraising journey?

There’s not a lot of knowledge out there for founders about term sheets—you kind of have to figure it out as you go along. Do online research, consult with your attorneys, advisors, mentors, and experienced friends, and ask questions in community forums to learn as much as you can.

How much time should founders spend on getting their first term sheet right—are there bad decisions that are difficult to come back from later on?

It’s very exciting when you get a term sheet—especially if it’s the first term sheet you’ve ever received. But even though there may be a sense of urgency to just get it done, it’s still important to be thoughtful and strategic and not rush the process.

Before you even begin the process of fundraising, sit down and think about what your dream financing looks like. Write down all the things you definitely want and (possibly even more importantly) all of the things you definitely don’t want. That will help you know where to make concessions and where to push back.

Getting your first term sheet takes a lot of pitching and building the right relationship with your investor. If you take a round of financing, you can’t just break up with that investor—you’re in it to win it with them.

People often over-focus on the general terms, such as the valuation and the amount raised. Care more about the cleanliness of the terms, how they define the working relationship with the investor, and the rights you get to keep as the entrepreneur.

For example, think about the scenario where you’re trying to sell your company. The term sheet governs who gets which rights and governs things like liquidation preference. Depending on the rights you and the preferred owners have, they might be able to block a sale of your company.

Founder tip: "The best thing you can do is to take your time. While there may be deadlines outlined in the term sheet, investors who truly want to work with you are usually willing to lengthen that window of time—especially if it’s your first term sheet. They know you want to go through the process and do your due diligence."

Founder tip: "Remember, you need to like your investors and do your reference checks. As an entrepreneur, there’s no good reason to expose yourself to more risk than you need to. Once you’ve taken their money, you can’t really fire an investor."

What are some examples of some undesirable standards and how to spot them before they happen?

There are pretty common standards when it comes to term sheets. It makes it pretty easy to spot the red flags. Look at things like liquidation preference (1x non-participating), available option pool (8-10% post-Series A), board control (still founder-controlled post-Series A), and the absence of founder representations and warranties.

Founder tip: "The best thing you can do for yourself in the Series A process is to consult with an experienced attorney—one who has seen a lot of term sheets—and say, 'Hey, does this pass the smell test?'"

What does liquidation preference mean and why is it important?

Liquidation preference refers to the amount of money your investors get before your common shareholders (founders and employees) receive anything. 1x non-participating is pretty common in Silicon Valley and refers to how much of the investor’s original investment they get back before common stock takes anything. If it’s 1x, they get their initial investment back; if it’s 2x, they get double their investment, and so forth.

Think of a participating liquidation preference as double-dipping: The investors get their liquidation preference (say, 1x), and then share pro rata with common shareholders. Non-participating is far more standard and equates to downside protection: The investors get the greater of their liquidation preference or participate pro rata with common holders.

A good example is to think about the importance of this from both sides. Let’s say you raise a $10 million-dollar round of funding, agree to a 1x liquidation preference, and end up with a $50 million post-money valuation. If you were to turn around and then sell that company for only $30 million dollars, the investors just lost money on that deal. For them, it’s kind of like saying, “I’m going to get my $10 million dollars back as an investor and if it’s huge, we sell it for hundreds of millions.”

On the founder side, think about it this way: suppose you’re the same $50 million company and your investor has a 2x liquidation preference. The next few years didn’t work out as you hoped and you’re now only able to sell for $20 million. Well, all $20 million would go to your investor. As an entrepreneur, there would be no reason for you to sell that business, so you might as well not even try.

Founder tip: "Liquidation preferences have long-term effects for both the entrepreneur and the investor. It’s important to understand the full scope of its implications to avoid tough spots in the future."

When should entrepreneurs involve legal in the process—why does it matter if they wait until the end to consult with an attorney?

If you think about the reasons why people tend to wait, a lot of it comes down to runway. But it’s really beneficial to you and your fundraising efforts to get your attorney involved early on. First-time founders often have this feeling that they need to respond right away to the term sheet with no time to involve their lawyer. But there’s always time—and your lawyer will help you walk through the process and better strategies.

Take a holistic view of your term sheets. One term sheet might have a better valuation but provide the founders with less board control, while the other might offer more board control for the founders, but a lower valuation. You need to take the time to weigh all of the terms with regards to what is important to you. For instance, you might decide to take a lower valuation because you get to hold onto control of the company longer.

Founder tip: "At the end of the day, if a venture capital firm takes the time to send you a term sheet, they will take the time to walk through it with you. This helps you make the negotiations a better discussion around what you want your working relationship to be like with them. After all, when the negotiation is over, they become your closest business partner and you need to trust each other and get along."

Disclaimer: LTSE is neither a law firm nor provides legal advice. Before making decisions on matters covered by this post, readers should consult their legal adviser.

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