Whether you are an entrepreneur hoping to raise money or an investor looking to participate in the next new, great opportunity, you will eventually encounter that staple of angel investing: the term sheet. However, for those new to the game the term sheet, which can often be as concise as one or two pages, can seem daunting. At the ‘Cane Angel Network, we try to follow the advice of William of Ockham who observed that “other things being equal, simpler explanations are generally better than more complex ones”; a rule that has come to be known as Ockham’s Razor. This helps entrepreneurs and investors alike; we have applied this razor in a brief discussion of term sheets and related matters.
Why Form a C Corp?
Any company going into business should understand the differences between an S Corp, C Corp, and a Limited Liability Corporation (LLC). If a company is planning to stay small or within a family unit an LLC is the most tax advantageous. The owners of the LLC can elect to be taxed as a S Corp or C Corp as opposed to a partnership or sole proprietorship. An LLC also affords the owners protection and separation between the business debts and personal debt. While an LLC is great for small businesses investors and some financial institutions prefer to offer money to corporations. An S Corp is limited to the number of investors it is permitted to take on and cannot have multiple classes of stock which is common when seeking outside investment.
So, many companies seeking to raise money from Venture Capitalists (VC) or Angel Investors structure their company as a C Corp. You should also consult a lawyer who specializes in this area before deciding on what is right for you, but it is helpful to be familiar with some of the main points to discuss.
What is a Term Sheet?
Under a C Corp, corporate bylaws act as the company's operating agreement and include corporate governance provisions. When an entrepreneur is ready to seek investors, it’s best to put together a term sheet. The term sheet is in essence a nonbinding advertisement used to attract investors and lay out negotiation points in a cohesive document. If the term sheet proves effective, and an investor expresses interest then shareholder’s agreement will be created to act as a more formal and legally binding step which outlines the rights and obligations of all parties involved.
While handshake deals have occurred in place of a term sheet, that is the exception not the rule. The Term sheet acts to protect both sides and make all players involved in the deal more comfortable. A term sheet is an opportunity for companies to present to investors a cohesive and attractive document from which to start negotiations. It is an opportunity for the company to show off what they know about the investment they are trying to attract. On the investors side it is a starting point from which to negotiate and create some degree of comfort.
Keys to Understanding a Term Sheet
The 2 primary elements of a Term Sheet are the economic and control terms. On the economic side investors want to know what is on offer: how much of the company are they getting and for how much of an investment. The valuation determines what amount of the company is being sold which then informs the dilution of the company and consequently the stock price per share. Valuation can be negotiated as either pre-money or post-money. This sometimes confuses entrepreneurs, but it is a simple calculation once you are used to the methods. Pre-money is the value of the company going into the negotiation. Post-money is the value of the company going into the negotiation plus the investment from the investors. For example, if you are raising $1M at a $4M pre-money valuation, then the post-money valuation is $5M and the investor will have received 20% of the company for their $1M investment. Pretty simple, right? Be sure to keep these terms clear during negotiation so that the dilution of the business is clear to all parties involved.
Another major element of the Term Sheet is the employee option pool. The employee option pool is the amount of equity earmarked for distribution to employees as an incentive. Depending on the needed work force the employee equity pool can have a significant impact on the valuation of the company. Investors will often want to see an employee option pool of at least 15% prior to their investing so that they are not diluted later when new employees are brought on or existing ones are further incentivized.
Effective valuation is key to a strong term sheet. Understanding what stage, the company is at, competition among funding sources, experience of the company’s leadership, market size, role of the investors, and economic conditions can all be effectively relayed to investors through the term sheet. Having honest and well thought out numbers to demonstrate the position of a company can make or break how appealing the venture is to investors at any stage. At the end of the day, valuation is simply a function of the market’s supply and demand, so the best way to improve valuation is to improve company performance and engage with as many investors as possible.
Other ways to make an investment appealing could include putting in place appealing terms such as a liquidation preference or pay to play provisions. A liquidation preference outlines how money is to be returned to stockholders in case of the dissolution of the company. A Pay to Play provision requires preferred stockholders to provide future investment in instances in which outside investment can be acquired or else their stock is converted to common stock to make room for new investment. A term sheet with attractive terms that benefit and provide protections to both parties can be an effective way of demonstrating an entrepreneur's confidence and understanding of the investment being sought. Another key negotiation point on a term sheet are the control provisions. The most important part defined in the term sheet is the Board of Directors. The make-up of the board should be carefully structured to ensure that the interest of all parties to the deal are met. The Board dictates the direction of the company and has the sole power to fire the CEO. The term sheet should include an outline of who the board will be made up of and is a chance to make sure it is balanced so that the different parties with interest in the company are sufficiently represented.A key provision in the term sheet that protects investors interest are protective provisions which provide veto powers over defined decisions within the company. These can include whether the company can incur debt, sell or merge itself, enter into new lines of business or other material events. These are not uncommon, so entrepreneurs shouldn’t be put off when they are asked by new investors for these sorts of provisions.
While the terms in this list are not exhaustive of what can be included in a term sheet it does give an overview of a few key considerations and terminology that are helpful to familiarize any entrepreneur seeking capital investment. Many books have been written on the subject of terms and provisions for venture capital investments, one can always improve one's chances of a successful negotiation for all parties by keeping it simple and apply Ockham’s razor where possible.
This post was written by Jared Gentry and Jeffrey Camp. Mr. Gentry is a member of the Cane Angel Network investment team and will receive his JD and MBA in May 2021. Mr. Camp is the Managing Director of the Cane Angel Network.
