Remi Goncalves is the founder and CEO of SharpSheets, a financial modelling services firm that helps entrepreneurs build financial forecasts for their fundraising.
Follow these tips as it's important to prepare startup term sheet negotiation ahead of time because you'll be able to negotiate in better terms.
You've pitched investors to raise money for your startup, now is time to receive term sheets from potential investors. Yet, unless you're a lawyer, term sheet negotiations can be intimidating. That's why it's important to prepare ahead your term sheet negotiation to get the best deal out of your fundraising round.
What's your startup valuation and how does it impact your equity ownership? What are the key red flags to look out for in a term sheet? These are examples of questions you must answer before you start negotiating term sheets with investors.
In this article, we'll go over the 6 things you need to do before you start reviewing term sheets for your startup fundraising round. Let's dive in!
First, what exactly is a term sheet?
A term sheet is a legal agreement that defines the terms and conditions of an investment into a company. The investment can either be in equity (most common) or debt (for example, convertible notes).
What’s interesting to note is that a term sheet is an agreement yet it’s non-binding. It’s simply a short document (2-3 pages maximum) that serves as a first step to agree on the terms of the investment later on between new investors and the company’s existing investors.
What is included in a term sheet?
A term sheet is a standard legal agreement that includes key investment terms and conditions of which the most important ones are:
- The amount of the investment (for example $2,000,000)
- The instrument used (straight equity, SAFE notes, etc.)
- The valuation for the business (for example $10,000,000) that will be used to determine the ownership percentage given to new investors coming into the deal
- The rights associated with the instrument (voting rights, conversion rights, liquidation preference, etc.)
1. Assess a (fair) valuation for your startup
The first step when preparing a term sheet negotiation is to come up with a fair valuation for your company.
By fair, we mean realistic: the wider the gap between potential investors' valuation and your own assessment, the less likely you'll ever find any investor.
Valuation is very important to assess before you receive any term sheet for 2 reasons:
- It will help you filter out term sheets later on. The valuation of a startup is all about expectations and forecasts. How valuable will your business be in the next 5 years? You will need to make sure your investors have a similar idea of where your business can be in the future. If not, there's a mismatch in expectations which will very likely affect your strategy and decisions later on
- Valuation will define how much equity you will leave to investors. The higher the pre-money valuation, the lower the ownership percentage you will need to give investors. Make sure you clearly understand the impact of your startup valuation on the dilution percentage to avoid losing too much control
What is pre and post-money valuation
When we refer to a business valuation, we often use pre and post money valuation together. These are very different terms:
- Pre-money valuation is the value of a company before the investment round
- Post-money valuation is value of a company after the investment round has been raised
The 2 are interrelated of course, and the formula is:
Post-money valuation = Pre-money valuation + investment amount
For example, if a company would raise $2 million at a pre-money valuation of $10 million, then:
Post-money valuation = $10M + $2M = $12M
So what’s pre-money valuation then? How do we determine the $10M pre-money valuation in this example?
The pre-money valuation is the hardest part. In layman terms, pre-money valuation is the fair valuation of a company today, before it receives and spends the new investment round coming in.
Indeed, by spending this amount of money, one expects to make a return on investment right? Otherwise no company would ever raise capital from investors.
In the example above, we consider that the company is worth $10M today: that’s what the business is worth today (it’s goodwill, technology, patents, brand name, etc.). Logically, if a $10M company raises a $2M equity round, the new valuation is $12M.
So what’s a good pre-money valuation?
As explained earlier, as an existing investor (like a founder), the higher the pre-money valuation, the lower your equity dilution (so the more ownership and shares’ worth you keep after the investment).
Unfortunately, more isn’t always better.
As explained by EU Startup, outsized valuations can be a big problem down the line as investors will always expect your valuation to increase at the next funding round.
Therefore, setting a valuation that’s too high today may lead to delusion as you might not be able to justify an even higher valuation the next time you raise money (if you do).
2. Agree on the minimum ownership you want to maintain
Once you've assessed a fair valuation for your startup, you will need to agree with your co-founders what's the minimum ownership you want to give away as part of this fundraising round.
As a rule of thumb, startups often give away 15-20% of equity to investors for each round. The earliest the round, the higher the percentage. Indeed, early investors take a bigger risk when investing in your business. As such, they require a higher percentage of your startup's equity.
Later, when reviewing term sheets, you'll need to model changes in ownership of your capitalization table. When doing so, make sure to understand the impact of convertible debt too, as it can seriously dilute your ownership if done wrong.
Finally, you'll need to understand important clauses such as preferred investors' anti-dilution and liquidation preference terms. If these terms are excessive, founders' equity can seriously suffer too.
3. Identify deal breaker terms
Before you even start to review a term sheet, make sure you understand what are the terms you'll want to avoid and push back on.
Generally, most investors will not include these as they're mostly off-market, yet be careful not to be too lenient either.
To save you some time, below are a few examples of terms you'll need to push back on:
- Participating Preferred Stock
- Liquidation Preference > 1x
- Non-standard Protective Rights
- Full Ratchet Anti-Dilution Clause
- Cumulative dividends
4. Agree on founders' vesting schedule
Often overlooked by founders, founders vesting schedule is one of the most important thing you'll need to agree on internally before you start negotiating term sheets with investors.
Why? An appropriate vesting schedule ensures founders' interests are aligned.
If a founder leaves suddenly early on and you haven't agreed already on an appropriate vesting, she/he can leave with substantial equity. This can have major implications on the efforts and motivation of the remaining founders.
Most startups opt for a 4-year vesting schedule, with a 1-year cliff. This means that you'll only be entitled to 25% of your equity after 1 year, and 1/36 each month for the remaining 36 months after that.
5. Agree on ESOP
ESOP (short for “Employee Share Ownership Plan“) is a pool of options you reserve to issue to your employees (or some of your employees) in the future. Companies use ESOP in order to align shareholders’ interests with those of the company’s employees.
Before each round, investors will ask you to either create an ESOP (for the first round) or increase that pool. This pool typically represents 10 to 15% of the total share count.
Why is it important to agree on ESOP internally before negotiations with investors?
ESOP is created using the pre-money valuation. Therefore, by creating say a 10% ESOP pool during a round, the existing investors (and not the new investors coming in) suffer from a 10% equity dilution.
That’s why you should create a pool for ESOP that’s big enough to make sure all new employee hires get the ESOP they deserve when they join, yet not too big either else you will (as an existing investor) suffer from an outsized equity dilution.
An example of a ESOP pre and post round can be seen below:
|Number of shares||Pre round||ESOP||Post round|
|Existing investors||900,000 (100%)||900,000 (90%)||900,000 (75.0%)|
|ESOP||-||100,000 (10%)||100,000 (8.3%)|
|New investors||-||-||200,000 (16.7%)|
In other words, existing investors’ ownership decreases from 100% to 75% after the deal. Assuming ESOP would have been taken out of post-money valuation, existing investors’ ownership would have been higher instead as the dilution would have been shared with new investors’.
Therefore, you shouldn’t let investors dictate their terms when it comes to ESOP. Indeed, investors may want to increase ESOP for key hires in the future, which will come at the cost of your own ownership.
6. Aim to get multiple term sheets, fast
You'll get the best terms out of your fundraising round if you can gather multiple term sheets from investors. So if you're only negotiating with one investor, you will risk letting them dictate their terms.
As a rule of thumb, 2-3 term sheets are a good proxy. This will ensure investors are aware they're not the only one around the table, which will help in negotiations.
Of course, the more the better. Yet, be careful: term sheets typically have an expiration date after which terms aren't valid anymore.
That's why you should strive to pitch lead investors quickly, to get the more term sheets possible within the same timeframe. Therefore, to best prepare your startup term sheet negotiation, first schedule your potential lead investor meetings as closely as possible.
If you’re raising money from investors for your business, you will need to review a number of term sheets. These are the investment terms offered by investors which you should compare to pick the investor(s) that suit you the most.
Logically, the more term sheets the better as it gives you more headroom to negotiate. Yet, in order to obtain the best terms for the investment, you must be well prepared.
This means you must not come to the table empty handed: you must do your homework and decide what is a deal breaker and what’s not. From valuation, ownership, vesting schedule, etc. there are a few things you must have a clear idea about before you discuss at the negotiation table.
Subscribe to weekly updates
You’ll also receive some of our best posts today