Understanding the Investment Term Sheet: 5 Things Entrepreneurs Need to Know
As you know, the path to startup success isn’t paved with gold.
Without a reliable funding source in place, your startup is destined to fail. If you’re like most entrepreneurs, finding funding can feel a bit overwhelming. First, you’ll need to find an investor that aligns with your business’s unique mission. Second, after you’ve received an offer, there are a few stipulations and requirements on the investment term sheet that you’ll need to work through quickly.
In this article, we’ll teach you the top five things you need to know about the investment term sheet. Use these expert insights to land a new funding round and scale your business to greater heights.
Investment Term Sheet: Here is Everything Entrepreneurs Should Know When Raising Startup Funds
An investment term sheet outlines the specific conditions between you and the investor. As you can probably imagine, an investment term sheet is one of the most critical documents that you’ll ever sign. The long-term fundraising success of your business depends on the unique conditions outlined in the investment term sheet. When raising a new round of startup capital, there are five things you need to know about the investment term sheet.
1. Valuation
The valuation section of the investment term sheet outlines what an investor believes your company is worth. There are four key valuation issues that you must address:
- Pre-Money Valuation: An estimate of the company’s worth before investment.
- Post-Money Valuation: An estimate of the company’s worth after investment.
- Capitalization Table: Percent ownership between the founder and investor.
- Price Per Share: The per share value of the company’s stock.
2. Liquidation Preferences
To help guarantee their investment against unforeseen roadblocks, investors will typically request what is commonly known as “invested capital liquidation preferences.” In short, the invested capital liquidation preference allows investors to receive, upon the company liquidation, a return on the money previously invested in the company before any other shareholder receives payout liquidation funds. Additionally, investors may have the option to convert their preferred stock shares to common shares. This allows the investor to receive a cash payout on their percent ownership in the company.
3. Binding vs. Non-Binding Agreements:
Occasionally, term sheets carry certain provisions that are legally binding and other provisions that are not. Meanwhile, some term sheets are explicitly binding or non-binding. In short, a binding agreement requires both parties to carry through with the terms outlined in the investment term sheet. “Some term sheets explicitly say that they are non-binding, with no agreement to enter into a definitive agreement,” says Attorney Aaron Hall. “In these cases, nothing in the term sheet is binding, rather it is simply an understanding between parties.”
- Options Pools: An option pool is the amount of stock a company sets aside for employee compensation and other internal matters. In most cases, companies typically allocate 10 percent of the total stock to the option pool.
- 5. Participation Rights: The participation rights section grants investors the right to “participate” in future equity sales of the company that they’re investing in. This is important because new fundraising rounds generally mean that the company is either doing exceptionally well or has fallen on hard times and needs additional “bailout” money.
In the first instance, investors are given the opportunity to participate in new funding rounds that are much better than those previously offered.
