Term sheet: How to understand and review your pre seed term sheet

1. Introduction to Term Sheets

## The anatomy of a Term sheet

### 1. The Basics

At its core, a term sheet is a preliminary agreement that outlines the key terms and conditions of an investment deal. It acts as a roadmap for negotiations between startup founders and investors. Here's what you need to know:

- Parties Involved: The term sheet involves two primary parties: the startup company (with its founders) and the investor(s) (angel investors, venture capitalists, or even strategic partners).

- Investment Amount: The term sheet specifies the amount of investment the startup will receive. This can be a fixed number or a range.

- Valuation: Ah, the million-dollar question (quite literally). The valuation determines how much equity the investor gets in exchange for their investment. It's like haggling at a bazaar, but with decimal points.

### 2. Equity and Ownership

Now, let's talk equity. Brace yourself; it's about to get mathy:

- pre-Money valuation: This is the startup's valuation before the investment. Imagine your startup is a pie. The pre-money valuation is the size of the pie before anyone takes a slice.

- post-Money valuation: Post-investment, the pie grows (thanks to the investor's cash infusion). The post-money valuation includes the investment amount. The investor's slice is now part of the pie.

- Founder Equity: Founders hold equity in the startup. The term sheet outlines how much they retain after the investment. Beware: dilution (the pie shrinking) is real.

### 3. Liquidation Preferences

Investors aren't here for a casual picnic; they want their money back. Enter liquidation preferences:

- Participating Preferred: investors get their initial investment back first (like VIP tickets to the pie buffet) and then share the remaining proceeds with founders.

- Non-Participating Preferred: Investors choose either their initial investment or their share of the proceeds—whichever is higher. It's like having a "Plan A" and a "Plan B" for dessert.

### 4. Control and Governance

Investors don't just throw money; they want a say in how the startup is run:

- Board Seats: Investors often demand board seats. It's like joining the startup's inner circle. Founders, beware: decisions are now a group activity.

- Protective Provisions: These provisions protect investors from major decisions (like selling the company) without their consent. Think of it as a safety net for their pie slice.

### 5. Exit Strategies

Investors dream of the day they cash out. Term sheets cover exit scenarios:

- Exit Events: These include acquisitions, IPOs, or even a magical unicorn ride. Investors want a piece of the exit pie.

- Conversion Rights: Convertible notes or preferred stock? Investors choose wisely, like wizards picking their wands.

### Examples:

1. Alice's Startup: Alice's AI-powered cat cafe raises $1 million at a pre-money valuation of $5 million. Investors get 20% equity. Meow-tastic!

2. Bob's Biotech: Bob's gene-editing startup secures $3 million. Investors opt for participating preferred. Bob's pie just got complex.

Remember, term sheets are like love letters—sometimes sweet, sometimes nerve-wracking. Negotiate wisely, and may your startup thrive!

And there you have it, a crash course in term sheets. Now go forth, armed with knowledge, and conquer the startup galaxy!

2. Key Terms and Definitions

1. pre-seed Funding: pre-seed funding refers to the initial capital raised by a startup before it enters the formal seed funding stage. This funding is typically used to develop a minimum viable product (MVP) or conduct market research.

2. term sheet: A term sheet is a non-binding document that outlines the key terms and conditions of an investment deal. It serves as a blueprint for negotiations between the startup and potential investors.

3. Valuation: Valuation is the process of determining the worth of a startup. It is often expressed as a pre-money valuation, which is the value of the company before any investment is made, or a post-money valuation, which includes the investment amount.

4. Equity: Equity represents ownership in a company. In the context of a term sheet, equity refers to the percentage of ownership that investors will receive in exchange for their investment.

5. Dilution: Dilution occurs when additional shares are issued, resulting in a decrease in the percentage ownership of existing shareholders. It is an important consideration for both founders and investors.

6. liquidation preference: liquidation preference determines the order in which proceeds from a company's liquidation or sale are distributed to shareholders. It protects investors by ensuring they receive a certain amount of their investment back before other shareholders.

7. anti-dilution Provisions: anti-dilution provisions protect investors from dilution by adjusting the conversion price of their shares in the event of a down round, where the company raises funds at a lower valuation than the previous round.

8. Vesting: Vesting refers to the process by which founders and employees earn ownership in the company over time. It incentivizes long-term commitment and aligns the interests of stakeholders.

9. board of directors: The board of directors is a group of individuals elected by shareholders to oversee the management and strategic direction of the company. Investors often have the right to appoint board members.

10. drag-Along rights: Drag-along rights allow majority shareholders to force minority shareholders to sell their shares in the event of a sale or merger of the company. It ensures a unified decision-making process.

These are just a few key terms and definitions related to pre-seed term sheets. By understanding these concepts, you will be better equipped to navigate the complexities of investment negotiations. Remember, this is just a brief overview, and it's always recommended to consult legal and financial professionals for specific advice tailored to your situation.

3. Understanding Equity and Ownership

## The Essence of Equity

Equity represents ownership in a company. When you hold equity, you're not just a spectator; you're a stakeholder. But what does that really mean? Let's break it down from different perspectives:

1. Founder's Lens: The Birth of Equity

- Imagine you're the founder of a tech startup. You've poured your heart, soul, and countless sleepless nights into building your dream. Equity is your currency—the shares you distribute to early team members, co-founders, and investors. It's a promise of shared success.

- Example: Alice founds a health-tech startup. She allocates 40% of the equity to herself, 20% to her co-founder Bob, and reserves 10% for future employees.

2. Investor's Prism: Risk and Reward

- Investors crave equity like bees crave honey. They inject capital into your venture, hoping for exponential growth. In return, they receive equity. It's a high-stakes game—risk versus reward.

- Example: Venture Capitalist (VC) invests $1 million for 20% equity. If the startup soars, the VC's slice of the pie appreciates.

3. Employee's Kaleidoscope: Sweat Equity

- Employees aren't just cogs in the machine; they're builders. Sweat equity—earned through hard work—is their badge of honor. Stock options, restricted stock units (RSUs), and employee stock purchase plans (ESPPs) are their tools.

- Example: Charlie, a software engineer, receives 5,000 stock options. As the company grows, so does Charlie's potential windfall.

## navigating the Equity landscape

Now, let's map out the terrain with a numbered guide:

1. Common Stock vs. Preferred Stock

- Common stock: The basic flavor. Founders, employees, and early investors hold this. It's like the front-row seat at a concert—thrilling but exposed.

- Preferred stock: VIP passes. VCs and late-stage investors get these. They come with perks like liquidation preferences and anti-dilution magic. Think backstage access.

2. Vesting Periods and Cliff Dives

- Vesting is like a slow-cooked stew. Employees earn their equity over time (usually 4 years). The cliff is the initial wait—like a diving board before the plunge.

- Example: David joins a startup. His 4-year vesting schedule starts, but he must wait 1 year (the cliff) before any equity vests.

3. Dilution: The Shape-Shifter

- Imagine your pizza getting sliced into smaller pieces. That's dilution. New investors or stock grants reduce your slice. Founders beware!

- Example: The startup raises a new funding round, diluting existing shareholders' stakes.

4. Exit Scenarios: The Grand Finale

- Equity's true test lies in exits—acquisitions or IPOs. Will your shares turn into gold or fool's gold?

- Example: The startup gets acquired. Alice's 40% equity now translates into a life-changing sum.

Remember, equity isn't just numbers on paper; it's dreams, sweat, and the promise of something greater. So, whether you're a founder, investor, or employee, embrace it with wide-eyed wonder.

And there you have it—a glimpse into the labyrinth of equity and ownership. Next time you sign that term sheet, you'll know you're not just scribbling ink; you're shaping destiny.

Now, let's raise our virtual glasses to equity—the heartbeat of startups!

4. Financial Terms and Conditions

## The Financial Landscape: Perspectives and Nuances

### 1. Investor's Lens: Risk Mitigation and Upside Potential

Investors, whether angels or venture capitalists, scrutinize financial terms meticulously. Their primary goal is to maximize returns while minimizing risk. Here's what they consider:

- Valuation: The startup's worth determines the equity they'll receive. A higher valuation means dilution is less severe.

- Example: If a startup is valued at $5 million and an investor puts in $1 million, they get 20% equity.

- Liquidation Preference: Investors want protection if the startup fails. They often negotiate for a multiple (e.g., 1x or 2x) of their investment before common shareholders receive anything.

- Example: If an investor has a 2x liquidation preference and the startup sells for $4 million, they get $2 million before others.

- Anti-Dilution Provisions: These safeguard against future down rounds. full-ratchet and weighted-average are common methods.

- Example: If the startup raises funds at a lower valuation, anti-dilution adjusts the investor's equity.

- Participation Rights: Investors may choose between participating (getting both preferred return and common equity) or non-participating (choosing one).

- Example: Participating investors get their share and then participate in the common pool.

- Convertible Notes: These short-term debt instruments convert into equity during the next funding round.

- Example: An investor lends $100,000 via a convertible note, which converts into equity at a 20% discount during the Series A round.

### 2. Founder's Perspective: balancing Growth and control

Founders walk a tightrope, aiming for growth while retaining control. Financial terms impact their stake and decision-making power:

- Founder Vesting: To prevent early departures, founders vest their equity over time (usually 4 years with a 1-year cliff).

- Example: If a founder leaves after 6 months, they retain no equity.

- pre-emptive rights: Founders want the option to maintain their ownership percentage in subsequent rounds.

- Example: If new shares are issued, founders can buy more to maintain their stake.

- Drag-Along Rights: These compel minority shareholders to sell if a majority agrees.

- Example: If 75% shareholders agree to sell, the remaining 25% must follow suit.

- Tag-Along Rights: Protects minority shareholders by allowing them to sell their shares alongside a major investor.

- Example: If a founder sells, other shareholders can tag along.

- Board Composition: Founders negotiate board seats to influence strategic decisions.

- Example: A 3-person board with 2 founder seats ensures control.

### 3. Balancing Act: Harmonizing Interests

Balancing investor and founder interests is crucial for a healthy startup ecosystem. Negotiation and compromise play a pivotal role:

- Term Sheet: This initial document outlines financial terms. It's not legally binding but sets the tone.

- Example: A term sheet specifies valuation, liquidation preference, and other terms.

- Due Diligence: Both parties assess each other's financial health, legal standing, and growth potential.

- Example: Investors scrutinize financial statements, contracts, and IP ownership.

- Alignment of Incentives: Ensuring that financial terms align with long-term goals fosters trust.

- Example: Vesting schedules encourage founders to stay committed.

Remember, financial terms are like chess moves—strategic, impactful, and sometimes surprising. Whether you're a founder seeking funding or an investor seeking the next unicorn, understanding these terms is your compass in the startup wilderness.

Now, let's grab our magnifying glasses and explore the fine print!

5. Rights and Restrictions

### The Landscape of Rights and Restrictions

When negotiating a pre-seed term sheet, it's essential to recognize that rights and restrictions are the threads that weave the fabric of the startup-investor relationship. These provisions define who holds the reins, who gets a front-row seat, and who must wait in the wings. Let's dissect this from various angles:

1. Equity Ownership and Dilution:

- Founders' Equity: Startup founders often begin with a significant ownership stake. However, as funding rounds progress, new investors enter the scene, diluting the founders' ownership. Balancing growth and dilution becomes a delicate dance.

- Investors' Equity: Investors acquire equity in exchange for their capital infusion. Their rights include voting power, information rights, and sometimes board representation.

2. Voting Rights:

- Common vs. Preferred Shares: Voting rights differ between common and preferred shares. Founders typically hold common shares, while investors (especially venture capitalists) wield preferred shares with enhanced voting rights.

- Majority vs. Supermajority: Investors may seek supermajority voting rights for critical decisions (e.g., changing the company's charter, selling assets). Striking the right balance ensures efficient governance.

3. Board Representation:

- Founder Control: Founders cherish control over their vision. Investors, however, want a say in strategic decisions. Board seats become the battleground.

- Independent Directors: Independent directors (not affiliated with either party) bring objectivity. Their inclusion fosters transparency and mitigates conflicts.

4. Information Rights:

- Regular Updates: Investors crave insights into the startup's progress. Founders must provide financials, operational updates, and milestones.

- Confidentiality: striking a balance between transparency and confidentiality is crucial. Founders should disclose enough to satisfy investors without compromising trade secrets.

5. Transfer Restrictions:

- Right of First Refusal (ROFR): If a founder intends to sell shares, investors often have the first crack at buying them. ROFR prevents outsiders from swooping in.

- Lock-Up Periods: Founders may face lock-up periods during which they can't sell shares. This stabilizes the cap table post-funding.

6. Anti-Dilution Provisions:

- Full Ratchet vs. Weighted Average: Anti-dilution mechanisms protect investors from severe dilution due to down rounds. Full ratchet is harsher, while weighted average is more founder-friendly.

- Protecting Early Investors: Investors want safeguards against future funding rounds at lower valuations.

### Examples in the Wild

1. The Zuckerberg Paradox:

- Mark Zuckerberg's majority voting control over Facebook (now Meta) allowed him to steer the ship even after going public. Investors accepted this because they believed in his vision.

- However, this concentration of power sparked debates about corporate governance and shareholder rights.

2. Snap Inc.'s No-Vote Shares:

- Snap's IPO introduced non-voting shares, granting founders Evan Spiegel and Bobby Murphy immense control. Investors had no say.

- This move ignited discussions about whether such extreme restrictions are healthy for long-term shareholder value.

In summary, rights and restrictions are the warp and weft of the startup fabric. Balancing founder autonomy with investor protection is an art. As you review your pre-seed term sheet, consider these nuances—the delicate dance of power, the symphony of governance, and the interplay of trust. Remember, it's not just about the numbers; it's about building a resilient venture that thrives amidst constraints and possibilities.

Now, let's continue our journey through the term sheet landscape!

6. Exit and Liquidity Provisions

Exit and Liquidity Provisions are crucial aspects to consider when reviewing a pre-seed term sheet. This section delves into the various perspectives surrounding these provisions and provides valuable insights.

1. Exit Strategies: One important consideration is the exit strategy, which outlines how investors can realize a return on their investment. Common exit strategies include initial public offerings (IPOs), mergers and acquisitions (M&A), or strategic partnerships. Each strategy has its own advantages and considerations, and the choice depends on the specific circumstances of the startup and its investors.

2. Liquidation Preferences: Liquidation preferences determine the order in which investors receive their investment back in the event of a liquidation event, such as a sale or winding down of the company. These preferences can be structured in different ways, such as participating or non-participating preferences. Participating preferences allow investors to receive their initial investment back and then participate pro-rata in the remaining proceeds. Non-participating preferences limit investors to receiving either their initial investment or their pro-rata share, whichever is higher.

3. Anti-Dilution Protection: anti-dilution provisions protect investors from dilution of their ownership stake in the company. There are different types of anti-dilution mechanisms, such as full ratchet and weighted average. Full ratchet provides the most protection to investors by adjusting the conversion price of their preferred shares to the lowest price at which new shares are issued. Weighted average anti-dilution protection takes into account both the price and the number of shares issued in subsequent financing rounds.

4. Tag-Along and drag-Along rights: Tag-along rights allow minority shareholders to participate in a sale of the company on the same terms as the majority shareholders. This ensures that minority shareholders have the opportunity to sell their shares alongside the majority shareholders. Drag-along rights, on the other hand, enable majority shareholders to force minority shareholders to sell their shares in the event of a sale, ensuring a unified transaction.

5. Right of First Refusal: The right of first refusal gives existing investors the opportunity to invest in future financing rounds before new investors. This provision allows investors to maintain their ownership percentage and protect their investment from dilution.

6. lock-Up period: A lock-up period restricts shareholders, including founders and investors, from selling their shares for a specified period of time after an ipo or other liquidity event. This provision is designed to prevent a sudden flood of shares in the market, which could negatively impact the company's stock price.

7. Representations and Warranties

Representations and Warranties: navigating the Fine print

1. understanding Representations and warranties:

- From the Entrepreneur's Perspective:

- The Sales Pitch: Entrepreneurs are the ultimate salespeople for their startups. When negotiating with investors, they paint a rosy picture of their company's prospects. Representations are the verbal assurances made during these discussions – statements about the startup's financial health, intellectual property, customer base, and growth potential.

- The Legal Reality: Representations are legally binding statements. They form the basis of the investor's decision to invest. If any representation turns out to be false, the investor may have grounds to rescind the deal or seek damages.

- From the Investor's Perspective:

- Risk Mitigation: Investors want protection. They seek warranties – legally binding promises – that the startup's representations are accurate. These warranties act as insurance against hidden risks.

- Due Diligence: Investors conduct due diligence to verify representations. They scrutinize financial records, contracts, and other relevant documents. If discrepancies arise later, they can hold the entrepreneur accountable.

- Examples:

- Startup X claims to have secured exclusive rights to a breakthrough technology. The representation states this unequivocally. However, during due diligence, it's discovered that another company holds a similar patent. The investor now questions the startup's credibility.

- Startup Y asserts that its customer base is growing exponentially. Due diligence reveals that most customers are on free trials and haven't converted to paying users. The representation was misleading.

2. Navigating the Details:

- Specific Representations: The term sheet outlines specific areas where representations apply. These may include:

- Financial statements: Accuracy of financial data.

- Intellectual property: Validity of patents, trademarks, and copyrights.

- Litigation: Disclosure of ongoing legal disputes.

- Contracts: Honesty about existing agreements.

- material Adverse change (MAC) Clauses: These allow investors to back out if a significant negative change occurs after signing the term sheet but before closing the deal. Entrepreneurs should negotiate the scope and triggers for MAC clauses carefully.

- Indemnification: If a representation is false, the entrepreneur may need to indemnify the investor – compensate them for losses resulting from the misrepresentation.

- Survival Period: Representations typically survive beyond the closing date. Entrepreneurs remain liable for their accuracy even after the investment.

- Negotiation Points: Entrepreneurs should:

- Limit the scope of representations to avoid overcommitting.

- Be precise and avoid vague language.

- Disclose known risks upfront.

- Push for a reasonable survival period.

- Consider the investor's perspective – what risks matter most to them?

3. Conclusion:

- Representations and warranties are the contractual glue that binds entrepreneurs and investors. While they may seem like boilerplate language, their implications are far-reaching. Entrepreneurs should approach them with transparency, and investors should conduct thorough due diligence. After all, in the startup world, trust and truth matter more than anything else.

Remember, the devil is in the details – and in the world of term sheets, those details can make or break a deal.

8. Governing Law and Dispute Resolution

In the complex world of startup financing, where venture capital meets innovation, the term sheet serves as a critical document. It outlines the terms and conditions under which investors will provide funding to early-stage companies. One of the often-overlooked sections in a term sheet is the "Governing Law and Dispute Resolution" clause. While it may seem like boilerplate legalese, this section carries significant weight and deserves careful consideration.

Insights from Different Perspectives:

1. The Entrepreneur's Perspective:

- Entrepreneurs are often focused on building their product, attracting customers, and scaling their business. Legal jargon can feel like a distraction. However, understanding the governing law and dispute resolution provisions is essential.

- Entrepreneurs should consider the following:

- Choice of Law: The term sheet typically specifies the jurisdiction whose laws will govern the agreement. Entrepreneurs should ensure that the chosen jurisdiction aligns with their business operations and long-term goals.

- Forum Selection: The clause may also designate a specific court or arbitration panel for resolving disputes. Entrepreneurs should evaluate the efficiency, cost, and expertise of the chosen forum.

- Arbitration vs. Litigation: Some term sheets favor arbitration over litigation. Arbitration can be faster and more confidential, but it lacks the transparency of court proceedings.

- Exceptions: Entrepreneurs should look for exceptions to the governing law—for instance, tax-related matters or intellectual property disputes may have different rules.

2. The Investor's Perspective:

- Investors seek clarity and predictability. They want a stable legal framework that protects their investment.

- key considerations for investors:

- Risk Mitigation: Investors prefer jurisdictions with well-established legal systems and precedents. A stable legal environment reduces uncertainty.

- Enforceability: Investors want assurance that any dispute resolution mechanism will be enforceable. They may favor jurisdictions with strong enforcement mechanisms.

- Speed: Investors value efficiency. If disputes arise, they want timely resolution.

- Consistency: Investors often invest across borders. Consistent legal principles facilitate cross-border transactions.

3. Examples and Scenarios:

- Imagine a startup based in California receiving funding from a European venture capital firm. The term sheet designates California law and courts for dispute resolution. If a disagreement arises, the startup's founders and the investors would litigate in California.

- Alternatively, consider a scenario where the term sheet specifies arbitration in Singapore. In case of a dispute, an arbitration panel in Singapore would hear the case, ensuring confidentiality and potentially faster resolution.

- Now, picture a situation where the term sheet allows either party to choose between litigation in New York or arbitration in London. This flexibility accommodates both parties' preferences.

In-Depth Information:

1. Choice of Law:

- Entrepreneurs should weigh factors such as their company's location, investor preferences, and industry norms.

- Example: A biotech startup in Massachusetts may prefer Massachusetts law due to its robust life sciences ecosystem.

2. Forum Selection:

- Courts vs. Arbitration:

- Courts: Public proceedings, detailed judgments, and appeals.

- Arbitration: Private, streamlined process, but limited appeal options.

- Consider the costs and expertise associated with each forum.

- Example: A tech startup may opt for arbitration to maintain confidentiality.

3. Arbitration Clauses:

- Specify the arbitration rules (e.g., ICC, AAA).

- Address the number of arbitrators, language, and seat (where the arbitration takes place).

- Example: "Any dispute arising out of this agreement shall be resolved by arbitration under the ICC Rules in New York."

4. Exceptions and Carve-Outs:

- Some matters (e.g., IP infringement claims) may require specialized forums.

- Example: "Tax-related disputes shall be resolved in accordance with the laws of the jurisdiction where the company is incorporated."

Remember, the governing law and dispute resolution clause isn't mere boilerplate—it shapes the legal landscape for your startup's future. seek legal advice, negotiate thoughtfully, and ensure alignment with your business strategy.

I've provided an in-depth section on "Governing Law and Dispute Resolution" within the context of a pre-seed term sheet. If you need further elaboration or have specific questions, feel free to ask!

9. Negotiating and Reviewing the Term Sheet

1. Founder's Viewpoint:

- Understanding the Basics: As a founder, you must grasp the fundamental components of a term sheet. These include the valuation, investment amount, equity ownership, liquidation preferences, and anti-dilution provisions.

- Negotiation Strategy: Be prepared to negotiate. Remember that term sheets are not set in stone; they serve as a starting point. Prioritize the terms that matter most to you and your startup.

- Valuation: Valuation is often a contentious issue. Founders want a higher valuation, while investors seek a reasonable entry point. Consider the trade-offs between valuation and other terms (e.g., control, protective provisions).

- Liquidation Preferences: Understand the nuances of liquidation preferences. Participating preferred vs. Non-participating preferred can significantly impact the distribution of proceeds during an exit.

- Vesting Schedules: vesting schedules for founder equity are crucial. Ensure alignment with long-term commitment and performance.

- Anti-Dilution Provisions: These protect investors from dilution due to future down rounds. Be aware of weighted average vs. Full ratchet mechanisms.

- Board Composition: Negotiate board seats. Strive for a balanced representation that aligns with your vision and investor expertise.

2. Investor's Perspective:

- Risk Mitigation: Investors focus on minimizing risk. They assess the startup's potential, market dynamics, and team capabilities. Diligence informs their negotiation stance.

- Control and Protective Provisions: Investors seek protective provisions (e.g., blocking rights, veto power) to safeguard their investment. Balance control with founder autonomy.

- Exit Scenarios: Investors evaluate exit scenarios (acquisition, IPO) and their potential returns. Liquidation preferences and conversion rights impact these outcomes.

- Founder Commitment: Investors want committed founders. Vesting schedules and founder lock-ups demonstrate alignment.

- Alignment of Interests: Investors consider alignment with founders' goals. Milestone-based vesting can foster alignment.

- Due Diligence: Investors conduct thorough due diligence before signing a term sheet. Be transparent and responsive during this process.

3. Examples:

- Imagine a startup, XYZ Tech, receives a term sheet with a $5 million investment at a $20 million pre-money valuation. The founders negotiate for a higher valuation to retain more equity.

- Another scenario involves a participating preferred liquidation preference. If XYZ Tech gets acquired for $30 million, participating preferred investors receive their liquidation preference first and then participate in the remaining proceeds.

- Consider a founder-friendly term sheet that includes single-trigger acceleration upon acquisition. If the startup is acquired, founders immediately vest their remaining unvested shares.

In summary, negotiating and reviewing term sheets requires a delicate balance between founder aspirations and investor expectations. seek legal counsel, understand the implications, and advocate for terms that align with your startup's vision. Remember, a well-negotiated term sheet sets the stage for a successful partnership.