Many entrepreneurs are in the process of fundraising. However, many are unaware of the most favorable terms for raising money from investors and confused about what terms to focus on in a term sheet. We have recently seen a substantial increase in questions on this topic at LawPivot, and want to help entrepreneurs better navigate these waters. Here is a top 5 list of things an entrepreneur should understand about term sheets from potential investors:
Valuation. Valuation. Valuation.
Valuation is perhaps one of the biggest traps in a term sheet. Valuation means what the value of your company is before you accept the investment. A valuation that is too low is one an entrepreneur will soon regret. Essentially, you have given too much of the company to the investors relative to their investment dollars. On the other hand, a valuation that is too high may cause future investors to avoid a “pricey” deal. The solution is to do your homework by studying similar deals and consulting folks in the venture industry, as the valuation of private companies can be a “black art.”
Look out for the fist in the velvet glove. Investors have a strong interest in imposing incentives on entrepreneurs to stay fully committed. One dial that they love to tweak is your vesting schedule. A typical vesting schedule will be based on a four-year time period, in which your shares vest monthly in 1/48 increments of total shares. Often entrepreneurs are well into their vesting by the time money is within sight. Investors, however, want to make sure there is enough runway to keep the founders motivated all the way through an exit. Be prepared to be flexible, but keep what you have fairly earned in terms of equity.
Ignore this at your peril! The liquidation preference is the part of the exit consideration that the preferred stockholders get in preference to the common stockholders (that means you!) upon an exit. A high liquidation preference formula can leave entrepreneurs out in the cold or greatly reduce what they receive upon exit of the company. Liquidation preference provisions come in many flavors and seemingly slight differences in the wording can have a huge impact. The best one to hope for is a non-participating 1x preference.
What are protective provisions? They are a series of promises about things that a company will not do without the consent of their investors, including raising a future financing round, changing the bylaws or certificate of incorporation, or selling the company. These protective provisions are considered “negative” controls because they prevent the company from doing something but cannot be used to force the company to do something. If there are too many conditions or they are too restrictive, the company can find its ability to make decisions greatly reduced.
Expanding the option pool.
Investors will often insist that a company greatly expand the size of its stock option pool on a pre-investment basis. While this is to be expected to some extent, make sure that your option pool does not get too far above norms (20 percent or lower of the fully-diluted capitalization is a normal range). Practically speaking, the size of the option pool should be no greater than the amount of equity incentives for employees that are needed to get to the next round.
Jay Mandal is the co-founder and CEO of LawPivot, an online marketplace for businesses to receive crowdsourced legal advice from lawyers.
Yusuf Safdari is an attorney from Pillsbury Winthrop Shaw Pittman LLP who provides advice on LawPivot.