Explore the fundamentals of deal terms in startup investing with the following 3-part video series, Conquering the Term Sheet. In watching the series, you will:
Below, find our written explanation on term sheets:
When an investor plans to make an investment in a startup, one of the things in the forefront of his or her mind is: what are the terms of the deal?
Well, luckily a document exists whose sole purpose is to delineate all the deal terms. It is agreed upon by two parties, the startup and the investor, and called, fittingly, a term sheet.
So what does a term sheet look like “in real life”?
Term sheets are basically lists—lists of terms that the investor and the startup have agreed to adhere to in this investment.
Note that the term sheet (other than the confidentiality agreement therein) is not legally binding, but under most circumstances, these same terms will make their way into legal documents relating to the deal.
The list of terms can be broken down into two categories by asking a simple question: as an investor, what matters to me? Put in VC terms: the economics of your investment and the control you have over the company.
When you invest in a startup, your money is buying into a piece of the startup itself - equity. The size of your piece is measured in terms of shares of stock. In other words, if we think of the whole startup as a pie, each share of stock is a slice. The equity you receive in return for your investment amounts to how many slices of pie you’ve obtained.
So how do you calculate that equity?
We need a few bits of information about the company, listed below:
Of course, we also need some information about the investment we’re making:
Thus, equity=$me/($me + $others + $company)
You may ask, why is my investment divided by company valuation and all the invested money? The capital invested in the company literally becomes part of the company. So the whole pie grows by the amount of investment, as if your money had magically transformed into extra pie.
The growing pie brings along quite a few problems, especially if another group of people invest after you and your co-investors. Your percentage of the pie is inevitably going to shrink, or in VC terms, you’ll be diluted.
You’ll be relieved to know that in the term sheet are two clauses that can swoop in and save you from the evils of dilution: anti-dilution and pre-emptive rights.
A “pre-emptive right” refers to your right to acquire new shares issued by a company, usually up to a proportional, or pro-rata, percentage. For example, if you owned 12.5% of the company after the first investment, in the next round, the pre-emptive right guarantees you the option to buy enough shares to still own 12.5% of the company post-dilution.
The “anti-dilution” clause protects you against severe dilution. It usually kicks in if in the next round of investment the company offers a cheaper buy-in (i.e. a lower price per share), which means the investor can buy the same chunk as you did, not only later in the game, but also at a lower price. Anti-dilution mitigates this by recalculating your equity based on how much cheaper the new price per share is.
One of the key clauses related to control is board representation. Board representation is important because it enables the investor to know what is going on in the company and have some impact on company decisions. Carrying on the pie example, you may have bought a big piece of cherry pie earlier, but since the company decided to drastically change direction, you've ended up with peach pie. How do you keep that from happening? A seat on the board.
While there are often more terms and nuances involved, investors can always use the two questions “What are the economics?” and “How do I exert control?” to wade through the terms. Of course, the term sheet for each individual company is very different. Investors on OurCrowd can refer to the Deal Terms section for each company or fund to read the specific terms for that specific investment.
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