10 things every startup founder should know about Term Sheets

As an entrepreneur, being offered a Term Sheet is a very exciting moment. It means an investor is willing to put money in your company! But before signing an agreement, there are many things to look at. VC4Africa highlights some key aspects and opens the discussion on Term Sheets in the African venture capital context.

A Term Sheet is a document drawn up by an investor and an entrepreneur seeking capital. It outlines the key terms of a proposed investment and will be the basis for drafting the investment documents. Below some aspects of Term Sheets are highlighted. Entrepreneurs and investors who have experience with Term Sheets in the African context are invited to share their experiences in the comments below.

1. Valuation and payments

In order to determine the price per share, and therefore the purchase price, the investor and the entrepreneur will have to agree on the valuation of the company prior to the proposed investment. Most venture capital investors do not wish to make their investment at once, but step by step: a new sum is invested when certain agreed milestones are met (technical and/or commercial targets). When a milestone is not met in due time this does not necessarily mean that additional money will be denied, but it might be reason to negotiate other terms for further payments.

2. Preferred shares

A venture capital investor will normally require the company they are investing in to issue them a preferred class of shares. This means shares with certain rights attached, as opposed to ordinary shares (held by the founders and others). When a new investment round takes place in a later stage, a new series of preferred shares can be created, with distinguished rights.

3. Liquidation preference

The liquidation preference is a key example of a right attached to preferred shares. The concept of a liquidation preference is that if the company is ‘liquidated’, the preferred shareholders will receive a certain amount of money before other shareholders. The amount can be equal to the amount of the preferred shareholders’ investment, but can also be a multiple of it. In the world of venture financing this also applies to how the money is divided when the company is sold. It is important to understand exactly what is being proposed and what will be the impact at different stock valuations.

4. Dividend rights

Rather than paying dividends to shareholders, early stage companies often have to reinvest all profits (without which a dividend cannot be paid) to secure the growth of the company. The impact of annual dividend payments should be evaluated carefully, as it can add up quickly with multiple rounds of financing and a number of years to an exit.

5. Board of Directors

Venture capital investors often require the company to reserve one or more seats on the Board of Directors for the investor(s). If the seat(s) appointed to the founder(s) is the same as the CEO position, founders should bare in mind that appointing a new CEO could also mean losing their seat on the board. This could cause a shift in the balance on the board.

6. Founder provisions

Because founders and senior management are often central to the decision of venture capital investors to put money into a company, investors usually want to ensure they remain in place to deliver on the business plan. The Term Sheet could include provisions to incentivise the founders not to leave employment with the company in the short term.

7. Voting rights

The preferred shares as described in the Term Sheet may have a voting right similar to founder shares, but could also carry more than one vote each. This may be applicable under certain circumstances or with every decision, all depending on the agreement made.

8. Consent rights

Not only can investors require voting rights, they can also demand that their consent is needed for certain actions. Consent is often required for decisions that have a major effect on the company. Examples include altering the company’s capital structure, the sale of major assets, winding up or liquidating the company, but could also include appointing key members of the management team and making big changes to the company’s business plan.

9. Exit

Venture capital investors typically want to see a path leading to an exit with a certain return on their investment, within a limited period of time. If such an exit is not achieved, investors often want to build in structures allowing them to withdraw some or all of their investments.

10. After the Term Sheet

Once a Term Sheet is signed, venture capital investors can undertake various types of due diligence on the company. This process can take several weeks or even months. Some investors will ask for an exclusivity period during which the company is prohibited from seeking investment from any other parties. See a previous article we published outlining the resources you need to have in place and the various aspects you might come across in Due Diligence.

The above-mentioned points highlight only a few of the aspects of Term Sheets. Do you have experience with Term Sheets, as an entrepreneur or as an investor? Please share your experiences in the comments below! Questions can also be posted in the Questions and Answers section of the Venture Capital for Africa platform.