Navigating Term Sheets: Striking the Balance Between Founders and Investors

As an entrepreneur or business owner, you've likely encountered term sheets in discussions related to financing and investment. Term sheets are crucial for start-ups seeking funding from venture capitalists (VCs) or angel investors. They outline the significant aspects of a deal without detailing every minor contingency covered by a binding contract. Term sheets help to reduce the likelihood of misunderstandings and unnecessary disputes while ensuring that expensive legal charges involved in drawing up binding agreements are not incurred prematurely.

In this blog post, we will explore the key components of a term sheet, providing examples, and identifying the best options for both founders and investors. It is essential to focus on maintaining a positive, trust-based relationship throughout the negotiation process and seeking mutually beneficial outcomes.

1.     Valuation
Valuation refers to the monetary worth of a company at a specific point in time. In the context of term sheets, valuation determines the price investors pay for their shares, as well as the ownership percentage they receive in return for their investment. There are two types of valuation: pre-money valuation and post-money valuation.

Pre-money valuation refers to the value of the company before the investment, while post-money valuation takes into account the investment itself.

Example: A start-up has a pre-money valuation of £4 million, and an investor is willing to invest £1 million. The post-money valuation would be £5 million (£4 million pre-money valuation + £1 million investment), and the investor would own 20% of the company (1/5).

Best for Founders: Regardless of whether the valuation discussed is pre-money or post-money, founders should aim for a higher valuation to minimise ownership dilution and retain a more significant stake in the company. Founders may find it more advantageous to focus on post-money valuation, as it takes into account the investor's capital injection, providing a clearer picture of the dilution and the company's value after the investment.

Best for Investors: Similar to founders, investors' preference for pre-money or post-money valuation is not binary. Investors should focus on securing a lower valuation to obtain a larger ownership percentage, increasing their potential return on investment. However, understanding the post-money valuation is essential for investors, as it reflects the company's value after their investment and the percentage of ownership they will hold.

2.     Equity Percentage

When negotiating equity percentage, a start-up must decide who will acquire the majority of shareholder control. 

Example: A start-up offers a 20% equity stake to a VC for a £1 million investment in a company valued at £4 million pre-investment.

Best for Founders: Retaining majority shareholder control to maintain decision-making authority.

Best for Investors: Acquiring a significant enough stake to have influence over company decisions.

3. Type of Stock

A start-up must agree on the nature of the security it will receive for its investment. It must consider three forms of stock for its equity share: common, convertible preferred, and redeemable preferred.

Common Stock
Common stock is a basic form of equity ownership in a company. Holders of common stock have voting rights and may receive dividends, but they rank lower in priority during liquidation events.

Best for Founders: Issuing common stock to investors may be preferable for founders, as it puts them on equal footing with investors and avoids granting liquidation or conversion preferences.

Best for Investors: Common stock may be less attractive to investors, as it doesn't offer the additional protections or preferences provided by preferred stock.

Convertible Preferred Stock
Convertible preferred stock is a hybrid form of equity that has features of both preferred stock and common stock. Convertible preferred shareholders have priority over common shareholders during liquidation events and may receive dividends, but they also have the option to convert their preferred shares into common stock at a predetermined conversion ratio.

Best for Founders: Convertible preferred stock may not be the best option for founders, as it grants investors liquidation preferences and the potential for additional ownership if the shares are converted.

Best for Investors: Convertible preferred stock can be attractive for investors, as it provides both liquidation preferences and the flexibility to convert shares into common stock, allowing them to benefit from potential upside in the company's value.

Redeemable Preferred Stock
Redeemable preferred stock is a type of preferred stock that includes a redemption feature, allowing the issuing company to buy back the shares at a predetermined price after a specific period. Like other preferred stocks, redeemable preferred shareholders have priority over common shareholders during liquidation events and may receive dividends.

Best for Founders: Redeemable preferred stock might not be the most advantageous for founders to issue, as it gives investors liquidation preferences and the potential for the company to repurchase the shares, which can impact the company's cash reserves.

Best for Investors: Redeemable preferred stock can be appealing for investors, as it offers liquidation preferences and the possibility of having the shares redeemed, providing a potential exit strategy or a return of capital in addition to any dividends received.

4. Dividends

A dividend is a payment made by a corporation to its shareholders, typically in the form of cash or additional shares of stock. Dividends are usually distributed from a company's profits or retained earnings and are a way for companies to return value to their shareholders. The board of directors decides the amount and frequency of dividend payments, which can be paid regularly (e.g., quarterly) or as a one-time special payment.

For start-ups, dividends are less common, as they usually prefer to reinvest their profits back into the business to fuel growth. However, if dividends are to be issued, the following considerations apply to founders and investors:

Best for Founders: Founders may prefer not to issue dividends or to keep dividend payouts minimal, as this allows them to retain more capital within the company for growth and expansion. If dividends are to be paid, issuing them in the form of additional shares (stock dividends), or as payment in kind (PIK) could be preferable. PIK dividends involve accruing the dividend amount until a liquidation event, and then paying it out in the form of equity. This conserves cash for business operations while still rewarding shareholders.

Best for Investors: Investors may have different preferences depending on their investment strategy and objectives. Some investors might seek regular dividend income as a source of cash flow, while others may prefer that the company reinvests its profits to maximise capital appreciation. In the context of start-ups, investors may be more focused on long-term growth and potential exit opportunities rather than immediate dividend payouts. PIK dividends can be an attractive option for investors, as they offer potential equity upside upon a liquidation event, without impacting the company's cash flow in the short term.

5. Antidilution Rights
Antidilution rights are provisions that protect investors from the dilution of their ownership percentage in a company when new shares are issued in future financing rounds at a lower valuation. Dilution occurs when a company issues additional shares, which reduces the existing shareholders' ownership stake as a percentage of the total shares outstanding.

There are two common types of antidilution rights: full ratchet and weighted average. Full ratchet antidilution adjusts the conversion price of an investor's preferred shares to the lowest price at which new shares are issued in a subsequent round. Weighted average antidilution, on the other hand, adjusts the conversion price based on the number of new shares issued and their price relative to the existing shares.

Best for Founders: Antidilution rights can be less favourable for founders, as they may reduce their ownership stake and control over the company when new shares are issued at a lower valuation. For founders, it might be better to negotiate for weighted average antidilution provisions rather than full ratchet, as the weighted average approach is generally considered less severe and more equitable.

Best for Investors: Antidilution rights are beneficial for investors, as they help protect the value of their investment by maintaining their ownership percentage in the event of future financings at lower valuations. Full ratchet antidilution rights are more advantageous for investors, as they provide the greatest level of protection against dilution. However, investors may need to consider the potential impact of aggressive antidilution provisions on founder motivation and company morale.

6. VC Appointed Board Members

The start-up is negotiating the number of directors that it may appoint to the board.

Example: The term sheet states that the investor has the right to appoint two board members out of a total of five.

Best for Founders: Maintaining control over board appointments to ensure alignment with the company's vision.

Best for Investors: Securing a sufficient number of board seats to have meaningful influence over company decisions.

7. Vesting of Founder's Shares

Vesting the founder's share of stock is a way to entice the founder to stay with the company, believing that the founder's vision and technical expertise are crucial for the success of the company.

Example: The term sheet includes a four-year vesting schedule for the founder's shares, with a one-year cliff, meaning the founder will receive 25% of their shares after the first year and the remaining shares will vest monthly over the next three years.

Best for Founders: Negotiating a reasonable vesting schedule that aligns with their commitment and contributions to the company.

Best for Investors: Ensuring a vesting schedule that incentivises the founder to remain with the company and continue driving growth and success.

8. CEO Replacement Provision

To protect investment interests and allow the founder a chance to retain the CEO title, performance benchmarks can be suggested.

Example: The term sheet includes performance benchmarks based on the founder's revenue projections presented in their first meeting. If the benchmarks are not met, discussions around replacing the CEO may be initiated.

Best for Founders: Establishing realistic and achievable performance benchmarks that take into account the inherent risks and uncertainties of a start-up.

Best for Investors: Implementing performance benchmarks that ensure the CEO is held accountable for meeting the company's growth and revenue targets.

9. No Shop Provision

A "no shop" provision would prevent the founder from shopping the deal around to other VCs in an attempt to negotiate better terms before the current agreement is signed.

Example: The term sheet includes a 60-day no shop provision, prohibiting the founder from engaging in discussions with other potential investors during this period.

Best for Founders: Negotiating a short no shop period to maintain flexibility in fundraising and potentially secure better terms.

Best for Investors: Securing a reasonable no shop period to prevent founders from using their offer as leverage to negotiate more favourable terms with other investors.

Additional Terms to Negotiate:

10.    Pre-emptive Rights

Pre-emptive rights grant investors the option to maintain their proportional ownership in future funding rounds by participating in those rounds.

Example: The term sheet includes pre-emptive rights for the investor, allowing them to purchase enough shares in future rounds to maintain their ownership percentage.

Best for Founders: Limiting the scope of pre-emptive rights, as it provides more flexibility in raising capital from new investors.

Best for Investors: Ensuring pre-emptive rights are included in the term sheet, as it allows them to maintain their ownership stake and protect their investment.

11. Drag-Along Rights

Drag-along rights allow majority shareholders to "drag" minority shareholders into the sale of a company, requiring them to sell their shares under the same terms and conditions.

Example: The term sheet includes drag-along rights, ensuring that if the majority shareholders decide to sell the company, minority shareholders must also sell their shares.

Best for Founders: Negotiating drag-along rights with thresholds that allow them to maintain some control over a potential exit.

Best for Investors: Securing drag-along rights to facilitate a smooth exit process and ensure a return on their investment.

12. Protective Provisions

Protective provisions grant investors veto rights over specific actions that could adversely affect their investment or the company.

Example: The term sheet includes protective provisions requiring investor approval for actions such as issuing new shares, changing the company's capital structure, or entering into significant debt agreements.

Best for Founders: Limiting the scope of protective provisions to retain autonomy in decision-making and prevent undue investor interference.

Best for Investors: Including comprehensive protective provisions to safeguard their investment and maintain influence over crucial company decisions.

13. Confidentiality and Non-Compete Clauses

Confidentiality clauses protect sensitive company information, while non-compete clauses prevent founders and key employees from engaging in competing businesses for a specified period after leaving the company.

Example: The term sheet includes a two-year non-compete clause and a confidentiality clause, protecting the company's trade secrets and ensuring the founder does not engage in direct competition after departing.

Best for Founders: Negotiating reasonable non-compete durations and defining clear boundaries for confidentiality agreements to avoid excessive restrictions on their professional pursuits.

Best for Investors: Ensuring robust confidentiality and non-compete clauses are in place to protect the company's intellectual property and competitive advantage. Navigating term sheets is a delicate balance between securing the best outcomes for both founders and investors.

Understanding the implications of each term and focusing on maintaining a positive, trust-based relationship throughout the negotiation process is crucial. Remember, the goal is to create a mutually beneficial agreement that serves as the foundation for a long-term, successful partnership between the parties involved. By focusing on the overall outcome and fostering a spirit of compromise, both founders and investors can pave the way for a prosperous future together.

Creo Incubator's tailored entrepreneurship courses aim to enhance the financial skills for entrepreneurs, improving both entrepreneurial and financial literacy for founders. By covering essential topics such as financial projections, cash flow management, and fundraising strategies, our Funding Readiness programme empowers you to make informed financial decisions for your start-up. With our mentoring, you'll be better equipped to navigate term sheet negotiations and communicate effectively with investors, setting the stage for a successful and sustainable future for your business.
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