All of the largest corporate empires today were once meek startups looking for funding. Rounding up all the needed funds can be hard, but with the right agreeable terms, everything can be settled. In setting forth these baseline conditions and agreements, the founder of the startup furnishes a business term sheet for the investors to take a gander.
Business term sheet templates lay out the groundwork of agreement for funding between a founder of the startup and an investor. It summarizes the agreement between the two entities and highlights the important parts. Essentially, business term sheets only cover the important aspects and do not entitle any of the involved parties to agree, unlike a binding business contract.
A term sheet is written to simplify the terms of an agreement between you, as the startup founder, and your investors. But given the weight it holds in business negotiations, it imperatively holds a certain degree of complexity, especially in its components. To acquaint yourself with its different parts, here are the basic elements of a term sheet:
1. Valuation: Business term sheets are furnished to fulfill an ultimate goal, and that is to reach an agreement where your startup can receive funding. But how can investors pool in funds when one doesn’t know the value of your startup? This is why it is essential to have a valuation or the estimated worth of your startup business.
2. Liquidation Preference: The liquidation preference in your term sheet guards the money of your preferred stock investors in a way that they will be getting some of their money back should your startup fail to get through. Even though failing is the last thing you want to happen in your startup, having a liquidation preference makes up for an attractive term sheet.
3. Option Pool: When building a startup, you do not only need investors for funding but also new talents for your workforce. Option pool is the amount from your pre-money valuation that is set aside for your future employees.
4. Types of Shares: Also known as stock options, the type of share in a term sheet determines the benefits and responsibilities of the investor. Investors can choose between two types of shares, which are preferred share and common share. An investor should be able to know what type of stock they will be getting so they can effectively manage their investment.
5. Pro-Rata Rights: The pro-rata rights determine if a shareholder of the startup will have voting rights in future business investment rounds. Every startup founder must have this so as not to lose the sense of ownership. An investor can also have pro-rata rights, but it is not a standard part of the term sheet.
6. Rights to Information: As a private startup business, you are not required to publish your financial statements. However, investors see this as a risk on their part as they will have no way to monitor the financial health of your company. To ease their minds, discuss your term sheet the rights to this information and provide ways on how you can communicate your financial data to your investors.
1. Determine your valuation: Trying to come up with a value for your startup can be difficult, but there are various methods that exist to ease the process. One of the most common valuation processes is the comparable financial analysis or “comps,” where you determine the value of your startup by taking a base on the current trading value of existing businesses that are similar to yours. Familiarize yourself with the other methods and know which type is best for your business.
2. Set your liquidation preference: Those who are investing in preferred stocks get the prioritization when it comes to benefits. One of these benefits is the fact they can get a bigger share in the money when a fallout happens on your venture. Usually, liquidation preferences are set at “1x the investment,” meaning the preferred stockholders will be able to get back their money first and the common stockholders will make do with what’s left.
3. Set aside an amount for your pool options: Pool options might seem like not much of a priority for now, as these are shares you set aside for your future hires and investors. However, pool options actually affect the valuation of your startup, which makes this part a required provision for your term sheet. The size of your option pool ultimately depends on the type of business you are conducting, but the most common percentages range from 10% to 18% of the company’s valuation.
4. Carefully draft up the controlling rights: There are various provisions you can use to determine the controlling rights of you and your investors. This starts with laying out the type of shares they can avail, the existence of pro-rata rights, the number of board seats there are in your board of directors, and the voting share classes. Take caution in choosing what provisions to include as there have been countless stories of startup founders who have been bought out of their company due to weak controlling rights.
5. Take a double-look: Completing the four steps above does not guarantee a fully-furnished business term sheet. Take a second, a third, and the fourth read on your term sheet to make sure you will not be caught up in legal and financial complications later on. Consult business acquaintances and lawyers to make sure that the provisions you have stated do not do any harm on your part.
A business term sheet is classified according to the type of investor that initially funds the startup. Most commonly, there are two:
Although both types entitle their holders to a percentage of ownership, common stock holders always retain a voting privilege in company offers for investments while preferred stock holder may not. But with the absence of this privilege, preferred stock holders get a bigger share in the company’s assets and earnings.
A practical and common approach in creating a business term sheet is to make it a non-binding document, since the point of making a term sheet is to arrive at a legally-binding agreement. However, legally-binding term sheets exist, though quite rarely and mostly with the phrase “negotiate on good faith”. To be safe, have your term sheet to be non-binding and be careful with the phrasing in your provisions.
A good business term sheet is one that is conceived by the shared interest between the startup founder and the investor. It does not pit them against each other but, instead, unifies their interests in one neat sheet. Rounding up investors may be hard at first, but believe in your idea and discuss what you want to happen clearly and thoughtfully, and your startup may just be one of the future big wigs that will shape up tomorrow’s industry.