The term sheet outlines the terms by which an investor will make a financial investment in your company. It includes:

  • funding
  • corporate governance
  • liquidation

Goals

When negotiating a term sheet, consider the investor’s motives and goals, as well as your own.

1. What is the investor trying to achieve?

  • Maximize the proceeds upon their exit from the company by purchasing convertible preferred shares in your company in exchange for their investment.
  • Protect their investment if the company performs poorly through provisions that allow them to gain a larger percentage of exit proceeds than would be determined by looking solely at their ownership percentage.
  • Retain vetoes over certain corporate actions that could affect their ultimate ownership position.
  • Maintain the ability to force the board and management to sell the company after the investors have been involved for a long time.
  • Make sure that the founders and key members of the management team are locked into staying with the company (as long as they are performing and adding value to the venture). After all, they’ve invested in the venture in large part because they believe in the team.

2. What is the entrepreneur trying to achieve?

  • Raise as much capital as possible to reach the key value-adding milestones without giving up too much of the ownership prize upon exit.
  • Ensure that, in agreeing to provide downside protection to investors, he or she has not given up too much of the upside potential. This can be accomplished by: (a) avoiding participating in liquidation preferences that provide investors a guaranteed return of their capital plus dividends and that portion of the remaining proceeds equal to their ownership position, and (b), capping the participation so that when the investor has reached two to three times their initial investment, the participation feature disappears.
  • Give up as little control as possible over the company’s actions.
  • Protect their personal position if the board decides that the founders are not performing and/or their services are no longer required to continue the business.

Ensuring alignment of goals

Investors can use different methods and tools to make sure that the interests of founders and key management are aligned with the investors’ goals for the corporation:

  • Reward the founder and key executives for value creation with a bigger piece of the pie upon completion of key milestones—via the founders’ shares and employee stock option plan (ESOP).
  • Use key vetoes and tag-along rights to make sure that the founders and key executives do not sell the company before the investors believe that sufficient value has been created and they are ready to sell.
  • Include a vesting schedule for the ESOP and initial founders’ shares to tie in the key people for the right amount of time.
  • Include non-compete agreements and intellectual property (IP) assignment agreements to make sure that the full energy of the founders and management team is fully committed to building a successful venture.

Throughout the negotiation process, each side rarely achieves all of their objectives. If there is limited capital, then the investor will have the upper hand. If there are competitive term sheets on the table, then the entrepreneur will win important negotiation points.

For more information on the elements in a term sheet, visit http://www.wsgr.com/WSGR/Display.aspx?SectionName=practice/termsheet.htm. It will not replace your legal counsel, especially since it is based on U.S. law and applies to early- and later-stage deals, but it provides valuable insights on all of the key term sheet components.

References

Cardis, J., et al. (2001).Venture Capital: The Definitive Guide for Entrepreneurs, Investors, and Practitioners. Toronto: John Wiley& Sons.
Berkery, D. (2008).Raising Venture Capital for the Serious Entrepreneur.New York: McGraw-Hill.
Houston, T., Johnson, A.,& Smith, E. (2006, September 15).Technology Startups: A Practical Legal Guide for Founders, Executives and Investors. Retrieved April 9, 2009, from Fraser Milner Casgrain website at http://www.techstartupcenter.com/