Term Sheets: Key Terms for Angel Investors To Know
If you are making investments in startups, you’re soon going to come across a term sheet. A term sheet is a bullet-point document outlining the terms and conditions of a round of fundraising.
Term sheets are a simplified way of understanding all the key points of a deal, like valuation and your rights as an investor. Generally most high-level negotiation will happen at this stage.While term sheets are non-binding, it is not good practice to agree to or sign a term sheet when you do not agree on all points.
As you see more and more term sheets you will get better at pulling out key information and will start to notice when anything unusual or non-standard.
Here are some key terms for angel investors to know:
Valuation
As they are negotiating, the founder(s) will set a valuation for the round. The term sheet will specify the pre-money valuation (or the value of the company before any capital is invested) and the post-money valuation (the value of the company after the capital is received as an investment).
Pre-Money Valuation + Amount Invested = Post-Money Valuation
Depending on the business, investors will use different valuation methods. Generally, recent comparable financings of companies in a similar sector and stage and the potential value at exit are the two main factors that will impact the valuation.
Why it matters: the valuation of the company will determine the ownership percentage that an investor receives in exchange for their investment.
The valuation can also impact the company in other ways. A valuation that is too high can make it more difficult for the company to reach the targets that will increase overall value, making it difficult for the company to raise another round of funding. A valuation that is too low can mean that the company raises insufficient capital in this round. Low valuations can also overly dilute founders early on, removing some of the incentive for them to stay on and build a successful business.
Liquidation Preference
Liquidations preferences determine which investors get paid first in the case of a liquidity event, and how much they will receive.
Why it matters: Liquidation preferences are generally designed to protect your investment in a situation where the proceeds of a liquidity event are less than the amount originally invested. Holders of preferred stock receive proceeds first, before anything is distributed to common shareholders.
For example, a 1x liquidation preference would mean that investors with that term would receive 1x their investment (or return of capital) before any other shareholders received any of the proceeds of a sale.
Follow-On/Pro-Rata Rights
Follow-on or pro-rata rights maintain an investor’s ability to make follow-on investments in future rounds. These are sometimes called “pro-rata” rights because they often give investors the right to purchase a “pro-rata” percentage of future rounds.
Why it matters: Pro-rata investment rights give you rights to invest in future fundraising rounds, and to maintain your ownership in the company. While some angels are indifferent because they don’t plan to follow on in later rounds, some angel investors, like Joanne Wilson, will insist on pro-rata rights (see her explanation here). If the ability to invest in later rounds is important to you, you’ll want to keep an eye on this in any term sheets you review.
Board Seats/Observation Seats
The term sheet will generally outline whether investors receive a board seat, or have the ability to sit in on observe board meetings. In later rounds, the lead investors will often take a board seat. This is less common in friends and family and pre-seed rounds.
Why it matters: Most early angels will not take a board seat. But while terms outlining board and observation seats may not directly impact you as an angel, it is important to understand the overall plan for governance and control of the company. Knowing who, if anyone, is on the company’s board may impact your investment decision.
Founder Vesting
Terms that impose vesting on a founder’s stock outline a schedule which gives the company or other founders the right to buy back unvested shares if a Founder leaves the company. Typically, founders’ stock is subject to a one-year cliff, with monthly vesting over the ensuing three years.
Why it matters: Terms that impose vesting on founders’ stock ensure that if a founder walks away, they don’t maintain ownership of a large part of the company. If a founder leaves, their unvested shares can instead be repurchased by the company or other founders, often at a nominal value.
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These are just a few key terms that a term sheet may include. For a more detailed look at Term Sheets and the ramifications of specific terms, check out the Feld Thoughts Term Sheets Series.
Questions? Comments? Let us know at hello@femalefunders.com