I. Introduction
As a founder of a high-growth startup, it is entirely your responsibility to understand the importance of a term sheet. In this blog post, using real-life examples, we will provide insights on how different term sheets have impacted the success of startups in the past. Keep reading to learn about the key terms to look for in a term sheet, other important considerations, and negotiation tips for founders to help you achieve the best outcome possible.
II. Key Terms to Look for in a Term Sheet
Here are some key terms to look for and understand:
A) Valuation
Valuation is the process of determining the value of your company. It plays a really significant role in the amount of funding a startup can raise in any particular funding round. Most founders think that they should want to achieve the highest valuation possible at each round.
The more valuable the company is, the less equity you have to sell in exchange for the capital you are trying to raise. For example, if your startup has a £10 million valuation and an investor wants to own 20% of the company, they will need to invest £2 million to purchase this equity. However, if your valuation is double this at £20 million, the investor would now require £4 million to own the same 20% of your company.
Rather counterintuitively, a higher valuation can actually help you attract better venture capital investors, as it acts as a positive market signal. Other investors get curious as to why this particular company is being valued so highly by other investors.
In 2014, Uber raised $1.2 billion in a Series D funding round, which valued the company at $17 billion. This valuation was significantly higher than all of Ubers’ rivals, and it created a lot of attention from investors who were looking for high-growth companies to invest in.
However, prospective founders be warned. A high valuation leads to high expectations. In Uber’s case, the founders were under tremendous pressure to not only grow into the valuation they achieved at their Series D, but to significantly outgrow it and create attractive returns for their investors.
Something first time founders might not necessarily expect is that generally the best venture funds in the world don’t offer you the highest valuation. They often bring more to a deal than just money. They can leverage their extensive network of contacts, provide strategic guidance, and provide their portfolio companies with access to resources they might not otherwise have, such as legal and accounting services, marketing expertise, and more. While partnering with a reputable VC may come at a higher cost, the added value they provide can pay off handsomely.
B. Liquidation Preferences
Liquidation preferences refer to the different classes of stock in a company. In this particular case the main difference occurs in the event of a sale or liquidation of the company. Venture capitalists negotiate for a liquidation preference to minimise their downside in the event that their investment performs poorly or even fails entirely.
Liquidation preferences come in many forms, but they all result in the owner of the right receiving the capital they invested initially (plus any multiplier applied to that sum) before other classes of stock i.e. common stock. For example, a venture capitalist may negotiate for a 2x liquidation preference, which means that they will receive twice their initial investment back before any other classes of stock receive any proceeds from the sale or liquidation of the company.
The preference given to different classes of stock in a liquidation event can significantly impact the returns both you and your other investors receive. For example, if a company is sold for £30 million and has a liquidation preference in place, the owner of the right (usually the venture capitalist) will receive their initial investment back first, and any remaining proceeds will be distributed among other classes of stock based on their ownership percentage.
This means that if the venture capitalist purchased 20% of your company at a £20m valuation and had negotiated a 2x liquidation preference, they would receive the first £8million (2x their initial investment of £4 million), and 20% of the remaining £22 million i.e. £4.4 million.
Without a 2x liquidation preference the VC would have only taken £6 million (20% of the £30m). However, in this scenario, they have taken £12.4 million. The people that pay for this are you and other shareholders of common stock, as you effectively end up selling your company for £22 million, not £30 million.
C. Anti-Dilution Protection
Anti-dilution protection is a term that protects investors from dilution of their ownership in your company if/when the company issues additional shares of stock, which you have to do in future fundraising rounds.
This term can become very painful for founders if you have to raise your next fundraise at a lower valuation than before i.e. a down round. As you are likely to be one of the shareholders that doesn’t have anti-dilution protection, your equity will be disproportionately diluted.
If the anti-dilution protection is significant, it can also impact the company’s ability to attract new investors in the future, as potential investors may be hesitant to invest in a company that has a high number of outstanding shares and a complex ownership structure.
Furthermore, a down round can be a signal to the market that the company is not performing as well as expected, which can harm its reputation and make it more challenging to raise future funding rounds. This can be particularly painful for startup founders who have invested significant time and resources into building their company and may have to make difficult decisions to cut costs or pivot their business strategy in response to the down round.
For example, say you own 20% of your startup and you are able to raise a post-money Series A valuation of £15 million. This means that the investors in the Series A funding round own 33% of the company, and your other shareholders own the remaining 47% of common equity.
However, the market has now crashed and it has become impossible to fundraise, so in your Series B funding round, the company can only raise £3 million at a post-money valuation of £11 million. The new investors in this Series B round have purchased 27% of your company.
Now, if your Series A investors have anti-dilution protection, they are entitled to receive additional shares of stock to maintain the ownership percentage in your company that they had before this Series B round.
Now there are different types of anti-dilution clauses, so for illustrative purposes I will use one of the harshest. This is called a full ratchet anti-dilution protection. It entitles your Series A investors to receive additional shares of stock at the Series B price to maintain their original 33% ownership percentage in your company.
This means that your personal equity in the company is diluted to make room for the new Series B investor. Your 20% ownership and the other equity owned by common equity shareholders (worth 47%) who also don’t have anti-dilution rights now have to accommodate the new Series B investor who purchases 27% of the total equity.
Remember the Series A investor maintains their 33% ownership even after the Series B has occurred. This means that your 20% of equity and the other 47% owned by other shareholders becomes only 12%. You and the other common equity shareholders have to make room for the new investor to buy 27% of the company.
D. Board Composition and Control
The composition of a startup’s board has a significant impact on the company’s decision-making process. You can own more than 50% of your company but have no decision making power if you don’t control the majority of board seats.
The board of directors is responsible for overseeing the management of the company and making strategic decisions that can impact the company’s future success. Board control refers to the degree of influence that each member of the board has over the company’s decision-making process.
In general, the more control that your investors have over the board, the more able they are to prioritize their own interests over the interests of you the founder. One would hope that any good investor would help you create a board of directors composed of experienced individuals with diverse backgrounds, that are likely to make decisions that benefit the company, but that isn’t always the case.
Real-life examples of board composition and control in successful and unsuccessful startups
Square is an example of a startup with a great Board. Square is a financial technology company that offers payment and point-of-sale solutions, and its highest valuation was approximately $100 billion in May 2021. Their board has included the former CFO and COO of Goldman Sachs, the former US Treasury Secretary and world class venture capital investors.
This board was able to provide guidance and mentorship to Jack Dorsey (also the co-founder of Twitter).
However, experience isn’t everything, as the board of directors at Theranos was quite impressive, and comprised of:
- George P. Shultz (Former U.S. Secretary of State and Secretary of the Treasury)
- Henry Kissinger (Former U.S. Secretary of State)
- William Foege (Former Director of the Centers for Disease Control and Prevention)
- Richard Kovacevich (former CEO of Wells Fargo)
Theranos was a blood testing company founded by Elizabeth Holmes that promised to revolutionize the medical industry, but it collapsed in 2018 amid revelations of fraud and deception. The company raised approximately $700 million in funding before being forced to shut down.
*Note, Elizabeth retained 99.7% of the voting rights at Theranos and could fire her board directors if she so wished. This scale of power imbalance is highly unusual and if sophisticated venture capital investors had committed capital to her company, this would almost definitely not have remained the case.
E. Voting rights
Voting rights can have a significant impact on a startup’s decision-making process, as shareholders with more voting power can exert greater influence over the company’s strategic direction. This can be beneficial if the shareholders are aligned with the company’s long-term goals, but can be detrimental if the shareholders prioritize their own interests over the interests of the company and its stakeholders.
Real-life examples of voting rights in successful and unsuccessful startups
One example of a successful startup with a fair voting structure is Spotify. Spotify has a dual-class share structure, which gives its founders and early investors more voting power than ordinary shareholders. However, the company has also implemented a sunset provision, which will reduce the voting power of these shareholders over time, ensuring that control of the company gradually shifts to the broader shareholder base.
In contrast, WeWork’s voting structure gave its founder and CEO, Adam Neumann, outsized control over the company. Neumann held shares with 20 votes per share, compared to the one vote per share held by other shareholders. This gave Neumann significant influence over the company’s decision-making process, which ultimately contributed to the company’s downfall.
F. Information Rights
Information rights refer to the ability of shareholders to access information about the company, such as financial statements, operational reports, and other relevant data. This information can be crucial for investors to make informed decisions about their investments and to hold the company accountable for its performance.
Information rights can have a significant impact on a startup’s transparency and accountability. Companies that are more transparent and open about their operations and performance are generally viewed more favorably by investors and stakeholders, and are more likely to attract investment and build long-term relationships
IV. Negotiation Tips for Founders
A. Importance of understanding term sheet terms before negotiation
Before entering into negotiations with investors, it is so important that you the founder understand key terms in a term sheet. This knowledge should enable you to identify potential contract issues ahead of time and negotiate favourable terms that align with your personal goals and interests. That said, startup founders should always consult with a startup contract lawyer to ensure you fully understand the implications of each term and can negotiate from a position of knowledge and confidence.
B. How to negotiate favourable terms for founders
Negotiating a term sheet can be a challenging and complex process, but there are a few key strategies that can help you achieve the best outcome possible:
- Focus on the big picture: While it’s important to pay attention to the details, it’s equally important to keep the big picture in mind. Focus on negotiating terms that will help your startup achieve its long-term goals and build a sustainable business.
- Build relationships: Developing a strong relationship with your investors can help you negotiate better terms. By building trust and demonstrating your commitment to your business, you can create a more favourable negotiating environment.
- Understand your leverage: Understanding your leverage can help you negotiate more effectively. If you have multiple term sheet offers, for example, you may have more negotiating power than if you only have one offer. This is why FindVC is the perfect tool for startup founders. Use the site to get several term sheets and generate more leverage.
C. Some real-life examples of successful negotiation tactics for founders
Facebook: In 2005, Facebook founder Mark Zuckerberg negotiated a term sheet with Peter Thiel that included a $500,000 investment and a board seat for Thiel. Zuckerberg was able to negotiate favourable terms, including the ability for him to maintain control of the board and the right to buy back Thiel’s shares if he left the board.
Slack: In Slack’s Series A funding round, the company negotiated a unique equity structure that allowed the founders to maintain control of the company even as new investors came on board. The structure was a single-class of equity, where each share had 10 votes, which was designed to give the founders more voting power and control over the company. The structure also helped the company to avoid anti-dilution provisions that would have negatively impacted other investors. This unique equity structure helped Slack to attract top-tier investors, including Accel Partners, Andreessen Horowitz, and Social Capital.
Gusto: When raising their Series A round, the founding team opened talks with multiple investors simultaneously, which created a sense of competition. By leveraging this competition, Gusto was able to negotiate a favourable deal with their preferred investor and raise $20 million in their Series A round.
V. Conclusion
A. Recap of key points
In conclusion, understanding the key terms of a term sheet is essential for founders looking to raise a Series A round of funding. Some of the key terms to look out for include valuation, liquidation preferences, anti-dilution protection, board composition and control, voting rights, and information rights.
Term sheets play a critical role in Series A funding rounds, as they outline the terms and conditions under which investors will invest in your startup. Understanding these terms and negotiating favourable terms can have a significant impact on the success of your startup.
It is essential for you to seek legal advice and educate yourself on the terms and conditions of a term sheet before entering into any negotiation. By doing so, you can negotiate more effectively and achieve the best outcome possible for your startup.
