5 Key Benefits in a Term Sheet for a Startup Founder

“Term sheets are nonbinding agreements setting forth the basic terms and conditions under which an investment will be made.”[2] Negotiating this document is one of the most critical elements in the investment process between a startup founder and an angel investor or venture capitalist as it lays the foundation for the final terms that would be included in the legal contract. It helps to draw a more detailed legal document and seals the future of both parties who are going to embark on an investment relationship for a set number of years. 

In this blog, we outline 5 key benefits in a term sheet to a startup founder as well as the ones offered to a preferred investor. 

1. Valuations

Pre-Money and Post-Money

This is one of the key steps that a startup founder needs to be clear about before the entry of an angel investor or venture capitalist. Prior to the startup being publicly listed, the value of setting up the venture is realized and the shares are established and divided amongst the founders. This is a standard means of identifying the value of a startup and is called the pre-money valuation. Once a new investor comes in, the value of the startup is derived more from the current sales figures, profits, costs, and how the new funds would be utilized. This then becomes the post-money valuation.[3] 

Note: A startup owner should know the importance of valuations and how well they could negotiate to not lose out on the new allocation of price per share to the new investor.

2. Option Pool

“An option pool consists of shares of stock reserved for employees of a private company. The option pool is a way of attracting talented employees to a startup company – if the employees help the company do well enough to go public, they will be compensated with stock.” [4]

A benefit for employees who get into the startup early is that they would receive a greater percentage of the option pool than employees who arrive later.

Note: A startup founder should be mindful that the shares for option pool are typically drawn from the investor stock of the company and NOT the shares allocated to investors.

3. Participation Rights

Participation rights help a preferred investor to redeem their investment as well as gain from a percentage of any proceeds upon an exit. Once this is done, there is less left for the other shareholders. While this is an advantage for a preferred investor, it’s quite the opposite for the founder or any other minor investor.

Note: A startup founder can push for there to be no participation rights in the term sheets. However, if the investor insists on adding participation rights then a founder can propose putting a cap on the participation. This limits how much extra an investor gets upon an exit. 

4. Liquidation Preferences

“The liquidation preference is a clause in a contract that dictates the payout order in case of a corporate liquidation. Typically, the company’s investors or preferred stockholders get their money back first, ahead of other kinds of stockholders or holders of debt, in the event that the company must be liquidated.” [6]

Note: This ‘safety net’ helps a preferred shareholder to get most, if not all, of their money back. A startup founder should not agree to more than 1X the investment for the liquidation preference as this is the standard term. [7]

5. Dividends

“A dividend is a payment made by a corporation to its shareholders, usually as a distribution of profits. When a corporation earns a profit or surplus, the corporation is able to reinvest the profit in the business and pay a proportion of the profit as a dividend to shareholders.” [8]

Startup Founders, beware of:

• Cumulative dividend – a right associated with certain preferred shares of a company. “A fixed amount or a percentage of the share’s par value must be remitted periodically to shareholders who own these shares without regard to the company’s earnings or profitability.” [9] With this dividend, it is calculated each year and if the company is unable to pay, then it is accrued and carried forward to the following year.
• Anti-dilution rights – a right that protects preferred shareholders during a down round. A down round is when a company’s valuation decreases from one round of financing to the next. This helps preferred shareholders by offering them additional shares.

Note: Non-cumulative dividend is the best bet for a founder. “Non-cumulative dividends do not have unpaid dividends carried over from previous years. If management doesn’t declare dividends for a particular year, it isn’t reported as “dividends in arrears.” This means it won’t need to be paid.” [10] This benefits a founder tremendously since if a dividend is not declared in a year, then not even the preferred stock benefit by getting it the next year.

These are 5 key benefits of a term sheet in favor of a startup founder. The blog also highlights the ones that benefit angel investors or venture capitalists. Knowledge of these terms will help a startup founder immensely when looking for angel investors and venture capitalists on Alumni Alliances, a professional networking community. Alumni Alliances gives the opportunity to find the right investors for a project or idea in the easiest way possible. Click here to know more.

If you know more points in favor of the startup founder, let us know through the comments section. And bookmark Alumni Insider for more articles like this. 

References:
1. Featured Image – Aymanejed
2. Term Sheet
3. 13 Key Terms Every Founder Should Know
4. Option Pool
5. Image – Oleg Magni
6. Liquidation Preferences
7. Term Sheets: What You Need to Know
8. Dividends
9. Cumulative Dividend
10. Non-cumulative Dividends: Everything You Need to Know