If you have founded a startup and need to raise an initial round of funding from a venture capital firm, you need to know the basics of how term sheets work. Doing so will make it easier when you are negotiating with a potential investor. By reading this article, you can master the basic elements of these documents so that you know how they work.
What Are Venture Capital Term Sheets?
When you start negotiating with a potential investor, one of the first legal documents that will be signed by the two sides is the term sheet. This document outlines the basic provisions of the final agreement that will be drafted in the future by the legal team. The goal is to present both parties with a brief summary of the agreement that focuses on the main points that have been negotiated.
However, it is important to realize that the terms of the agreement are not laid out in stone in this document. They can still be negotiated even once the term sheet has been signed, and this commonly occurs. Most of the provisions listed on the term sheet are not considered to be legally binding. A few, such as matters concerning legal fees, confidentiality, and a promise not to negotiate with other investors before a particular date, may be binding, but the rest are not.
Model forms for venture capital deals can be downloaded from the National Venture Capital Association’s website.
Understanding Equity And Debt
A venture capital company that wants to provide funding for a startup company generally does so in one of two ways. They either purchase equity in the company or they provide a loan. In the case of equity, the VC firm is purchasing a portion of your company in exchange for funding. In the latter case, you are borrowing the needed funds, which you will then have to pay back in the future.
If you prefer not to sell a portion of your firm to these investors, you can take on more debt. However, the preferred approach by many VC companies is to purchase equity rather than simply loaning you the funds. This gives them more potential upside should your company prove to be a great success.
Investors have different rights depending on whether they hold equity in your company or are merely owed a debt. Once your company has started to earn enough revenue to pay back the initial investors, those who hold debt get paid first. Those who hold equity then get paid if there are any remaining funds. From this point of view, debt can be preferable since it is more likely to be paid back.
However, as was mentioned previously, the potential gain from holding equity is significantly greater. This is because an investor who holds debt can only recoup as much as they initially loaned the company. In the case of equity holders, however, their gains are potentially unlimited. If the company becomes quite valuable, the equity can be worth many times the value of the initial investment.
For example, if a company was initially funded by a loan of $1 million and is then sold for the same amount, then the debt holders will get all of this money. However, if the company does very well and is later sold for $50 million, then the debt holders will still only get $1 million. Any investors who purchased equity in the company will get a much larger share of the remaining $49 million.
Common Versus Preferred Stock
Equity in a company is the same as owning a share of the company on the stock market. In terms of venture capital, most stock is issued as one of two types, either common stock or preferred stock. If funding is being raised in several different rounds, these shares may be divided into different series. For example, in the first round, there will be “Series A Common” and “Series A Preferred,” in the second round there will be “Series B Preferred,” and so on.
Owning preferred stock provides additional rights that are not available to investors who own common stock. Such investors have priority when they are getting paid, so that if the funds are limited, preferred stockholders will get paid first. However, debt holders still have priority over both types of equity.
Preferred stock can also carry additional voting rights, which can be a major priority for many venture capital firms. These give the investor additional weight when it comes to determining the future direction of the company. If there is a particular strategy or transactions that the VC firm has strong feelings about, owning preferred stock makes it more likely that their voice will be heard.
Most venture capital firms require the ability to convert preferred shares to common shares on a one to one basis. This is an important factor in certain situations. For example, if another firm is buying or merging with the company, or if the company is holding an IPO to sell shares on the open market, the VC firm may wish to convert its preferred shares. An IPO is another way to raise funds once the company is well-established enough to feel confident in its future growth.
Shareholders who own preferred stock get paid before those who own common stock, but they may only get a set amount of money. The remaining funds are divided between the owners of common shares. If this remaining amount is greater than the set amount for preferred owners, it can be sensible to first convert preferred shares into common ones.
Different Interests In A Deal
Any time that you are seeking financing for a business venture, there are many different factors to consider. Do not just focus on the big picture, such as the amount of financing or the percentage of control that is being obtained by the VC firm. You also need to consider all of the interests of each party in the deal. Closing the deal may have a different effect on each party.
For example, how many different people will own some of the company? How will this divided ownership affect the long-term strategy for your business? Can this be reconciled with the interests of the venture capital firm, which are usually focused on obtaining the maximum possible return on its initial investment? Using a venture capital term sheet can make it easier to find a way to manage these potentially competing interests as your business gets off the ground.
Getting Proper Advice
As with any complex transaction, negotiating term sheets and other documents should not be done without the assistance of a qualified venture capital attorney. Here are some links to a top-ranked venture capital lawyer located in Los Angeles, California that we recommend: YouTube Video; and Yelp Page.