You are entitled to celebrate when you receive a term sheet — a legal document that, despite its name, is usually several pages long — when you need funding. If you’ve worked hard to land a deal, you’ve probably delivered countless presentations and pitches along the way. Be cautious before signing the contract, though. A term sheet can also allow investors and venture capitalists to gain control over your board and dilute your shares.
Entrepreneurs and investors usually discuss several areas during negotiations. Consider these terms carefully during negotiations Ritual for hire An experienced securities attorney can help you avoid other pitfalls. Don’t forget that most term sheets are not binding. The terms of your investment can be changed at any time before you sign a formal agreement.
The Value of The Company
The valuation is what most entrepreneurs focus on first. There is basically an agreement between the investors and the company about how much it is worth.
There is a fundamental difference between “pre-money” and “post-money” valuation – the company’s value before and after an investment. According to this term sheet, a postmoney valuation for the company will be $8 million. These funds will consist of $3 million from investors. Consequently, the company will be valued at $5 million premoney. As a result, 37.5 percent of the company will belong to the investors.Founders keep more of their company when the premoney valuation is higher than the postmoney valuation.
Setting Aside Stock Options
Most term sheets reserve some stock for an option pool, which employees will receive as compensation. Many disagreements arise when it comes to determining the size of the pool based on premoney or postmoney valuations. Healy Jones, a former venture capitalist, and blogger at Startable.com says that founders’ shares are diluted when it comes from premoney. Taking 20 percent of the premoney valuation as the option pool, we have a 20 percent option pool.
This is a popular choice in Silicon Valley because many startups have premoney valuations in the hundreds of millions of dollars. In a post-money round, the option pool may be larger than the premoney valuation, and founders can receive less equity. For example, if the startup has $100 million in funding and the option pool is $50 million, the founders will receive 50 percent of the company (one-half of the $100 million), but the founders will own only one-fifth of the shares. In this case, the investors are receiving all of the stock.
Wow! Earning Your Shares Requires Hard Work
A vesting plan stipulates those founders and other common shareholders earn ownership stakes over a specific period, usually two to three years. According to David Freschman, managing principal of Innovation Capital Advisors, an early-stage VC firm in Wilmington, Delaware, this term is meant to ensure that the founders will stick around the company. Founders, who possess 100% of their shares before they bring in investors, find vesting schedules difficult to understand, according to Salil Deshpande, a former entrepreneur and general partner at Bay Partners, a Palo Alto venture capital firm.
Vesting schedules are important because the longer founders and common shareholders hold their shares, the more control they will have over the company. This is especially true when founders and other common shareholders own large portions of the company. In these cases, they can exercise their influence by voting out managers or board members. In contrast, investors don’t have any control over the companies in which they invest. According to the National Venture Capital Association, less than 5% of venture capital firms offer common shareholders significant control over the company.