As a startup owner planning an exit strategy, information is your friend. The more you know about how potential buyers might view your company, the easier it will be for you to appeal to them when you approach them about a deal.
At NorthStar Venture Partners, we work with startup owners every day. One thing that can be helpful is learning how to read a startup term sheet. Here’s what you need to know.
What is a Term Sheet?
Let’s start by explaining what a startup term sheet is. A term sheet outlines the conditions that apply for investors. For example, it explains:
- The valuation of the company
- The price per share
- The economic rights of new shares
While a term sheet is an important document, it is not legally binding. However, it does serve as a guide for the attorneys who draft formal documents that are legally binding.
What Should Be on a Term Sheet?
Certain financial specifications must be on your startup term sheet. Here are the things you need and why you need them.
Valuation
You probably already know a bit about business valuation, but there’s an art to including a valuation on your term sheet. When you first create a term sheet, you’ll be setting a standard for all future term sheets.
Your best bet is going to be using a fair valuation. The last thing you want is to over-value your company, but a lot of startup owners make the mistake of thinking that a high valuation is the secret to an advantageous deal. That may not always be the case.
Liquidation Preference
Making a mistake with the liquidation preference – which specifies what investors will receive if you liquidate their shares – can lead to big problems. The most common liquidation preference is 1X invested capital. That means that any of your initial investors will receive money equal to their investment before common shareholders receive anything.
You may find that some investors push for a higher liquidation amount, but it’s not standard and you should resist it. Usually, a 2X liquidation means that a company is in chaos.
Option Pool
The option pool is used to set shares aside for future officers, directors, employees, and consultants. Most venture capitalists prefer the option pool to require existing shareholders to absorb any dilution that results from setting shares aside. The more owner-friendly option is a post-money option pool, which requires new shareholders to absorb some of the dilution as well.
Getting the option pool right is essential because it can have a significant impact on the valuation of your company.
Capitalization Table
The capitalization table is where you’ll list shares by owner to detail who owns the company and who has a controlling interest. In addition to the shares owned, you’ll also need to account for options and warrants to buy shares.
Keep in mind that liquidation preferences may mean that there are differences between the percentage of shares held and the liquidation breakdown after a sale.
Other Terms to Know
We’ve listed the most important things you’ll need to know as you create your startup term sheet, but here are a few more items that should appear on the sheet:
- Vesting options: time-based milestones that specify when a shareholder may exercise their rights
- Stock options and warrants: terms that extend the right to make an equity purchase to a specified party
- Employee pool: unallocated shares that are set aside for future option grants
- 83(b) election: the right to buy back stocks
Understanding these terms can help you create a term sheet that will be attractive to venture capitalists while still protecting your interests as an owner.
How to Protect Your Rights
Your term sheet may not be legally binding, but it can make a big difference in your ability to attract investors as well as impacting your eventual exit strategy.
The most important piece of advice we can give you as experienced M & A advisors is not to draft the term sheet yourself. Working with an experienced M & A advisor and an experienced attorney is the best way to make sure that you have a startup term sheet that makes your startup attractive to venture capitalists while also protecting your rights.
A term sheet with too high a valuation or liquidation options that are too generous can make it difficult or impossible to sell your company. We recommend striking a balance that makes your company valuable to investors without putting you in a bad position for your exit.
Conclusion
Understanding startup term sheets is essential because it will minimize the chances that you’ll make a disadvantageous deal with investors. It’s the document that will lay the groundwork for future legal documents – and allow you to exit the way you want to.
Do you need help with your startup term sheet? Click here to work with us!
