What You Need to Know about Term Sheets

by Fred Abramson on July 27, 2011 · 0 comments

If you are looking to raise funds you are going to encounter a term sheet.  A term sheet is a legal document prepared by venture capitalists that states the important terms of a proposed investment.  If you receive one, don’t celebrate too hard by acting like a rock star by recklessly smashing your old Macbook pro. Its time to contact an experienced attorney (yes that is yours truly) and negotiate the terms.

There are a couple of points that you will have to negotiate with your investors before placing your John Hancock on the dotted line.

  • VALUATION.   When you receive the term sheet for the first time, you will likely focus on what the company is worth. You will see the terms pre-money and post-money valuations. As you can probably guess, pre-m0ney valuation is the price of the company before investment and post-money is after investment. If you are an entrepreneur, your goal is to have your pre-money and post-money valuations to be as close as possible. These means that you get to claim more of your company.
    Preferred stock.

    Image via Wikipedia

  • PREFERRED STOCK. When you start your company, the shares you create are called common or founders stock. Investors do not like common stock. They want preferred stock, which grants them a number of protections.
  • LIQUIDATION PREFERENCES. If a liquidity event occurs you need to know how money will be shared. A liquidity event can include a variety of scenarios, including bankruptcy and a sale of the assets. Your goal as an entrepreneur is to limit any liquidation preferences.
  • NO-SHOP PROVISIONS. Toward the end of the Term Sheet, there is usually a provision that will not allow you to obtain additional funding. You should limit this provision to 30 days.
  • FOUNDER VESTING.  Once you learn about this concept, you may jump out of your seat.  You actually have to earn your shares. With reverse vesting a certain amount of shares are put aside and are earned over a period of time. Basically the founders want to ensure that you don’t leave the company.
  • ANTI-DILUTION. This provision is used to protect the investment if the start-up obtains additional financing at a rate lower than the previous round. As Brad Field explains, there are two types: weighted average anti-dilution and ratchet based anti-dilution.
  • OPTIONS.  Usually, the term sheets will reserve some stock for stock options. This will be used to compensate employees.  You may dicker with your investor whether the size of that pool is determined using the pre-money or post-money valuation.
Term sheets are complicated and this discussion is by no means complete. It is vital to understand the nuances of specific clauses within the term sheet as it could make a huge difference in the final sum that you earn when you cash out.
The Law Office of Frederic R. Abramson represents both entrepreneurs and investors in New York. If you have a question regarding term sheets, contact me at 212-233-0666. 


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