What is an Equity Term Sheet?
An equity term sheet is a non-binding agreement that outlines the basic terms and conditions under which an investor will make an equity investment in a startup. It serves as the foundation for more detailed legal agreements and is crucial for setting expectations between founders and investors.
Main Points Covered in a Term Sheet
Valuation: This defines the pre-money valuation (the value of the company before the investment) and the post-money valuation (the value after the investment).
Investment Amount: The amount of money the investor is putting in.
Equity Stake: The percentage of the company the investor will own after the investment.
Type of Shares: The type of equity being issued, such as common stock or preferred stock, and their respective rights.
Board Composition: Details on how the board of directors will be structured post-investment, including who will have the right to appoint members.
Liquidation Preference: Specifies the order in which investors get paid in case of an exit or liquidation, often giving them priority over other shareholders.
Anti-Dilution Protection: Clauses that protect investors from dilution in future financing rounds, typically by adjusting their ownership percentage if new shares are issued at a lower valuation.
Voting Rights: The rights that investors will have in decision-making processes, including veto rights on key decisions.
Vesting of Founder Shares: The terms under which founders’ equity will vest over time, ensuring they remain committed to the company.
Exit Provisions: Details on how and when investors can exit their investment, such as through an IPO or acquisition.
What Startup Founders Need to Know
Non-Binding Nature: The term sheet is generally non-binding except for certain clauses like confidentiality and exclusivity. However, it sets the stage for final negotiations, so it should be taken seriously.
Understand Valuation and Dilution: Founders must clearly understand how the proposed valuation affects their ownership and control of the company.
Board Control: Be cautious about giving up too much control over the board, as this can affect decision-making power.
Liquidation Preferences: Ensure you understand how liquidation preferences work, as they can significantly impact the returns for founders and other shareholders in an exit scenario.
Vesting Schedules: Founders should negotiate vesting schedules that reflect their commitment and contribution to the company while protecting themselves from premature dilution.
Seed Round vs. Series Round Term Sheets
Seed Round: Typically simpler and more founder-friendly. May include fewer investor rights and simpler terms like convertible notes or SAFEs (Simple Agreements for Future Equity). Valuation is often lower, with fewer structured protections for investors.
Series Round: More complex, with detailed investor rights, protections, and governance structures. Involves larger sums of money, higher valuations, and stricter terms. More negotiation over board seats, liquidation preferences, and anti-dilution clauses.
Acceptable vs. Unacceptable Points
Acceptable Points:
Reasonable Valuation: Aligns with market standards and company potential. Standard Liquidation Preferences: Typically 1x liquidation preference without participation. Balanced Anti-Dilution: Weighted-average anti-dilution protection is standard.
Unacceptable Points:
Excessive Liquidation Preferences: Multiple liquidation preferences (e.g., 2x or more) can be detrimental to founders. Full Ratchet Anti-Dilution: This can heavily dilute founders in future rounds. Excessive Board Control: Investors demanding too many board seats or veto rights can stifle the founder’s ability to lead.
Conclusion
Founders should approach a term sheet with a clear understanding of its implications on their company’s future. Negotiating terms that protect their interests while also attracting investor support is key to long-term success. Understanding the difference between seed and series term sheets, and what is acceptable versus what is not, can help founders navigate this critical stage in their startup journey.
