It’s crucial to have everything in order before you begin a Series A funding round. Whether you’re picking VCs or creating the perfect pitch deck, being prepared is necessary. When it comes to the term sheet, however, your negotiating abilities can make or break you. We can assist you in getting it right the first time.
In this post, we’re diving into the specifics of a term sheet. We’re providing you with insights from an insider’s viewpoint of the VC industry.
Let’s get started learning about one of the most important documents you’ll ever encounter.
Term Sheet Definition
A term sheet is a preliminary draft of a future legal agreement. It is not legally binding, but it lays out the conditions for a specific investment.
Terms sheets are sometimes referred to by other names:
- Letter of intent
- Memorandum of understanding
- Agreement in principle
What’s the purpose of a term sheet?
A term sheet is often the first piece of paper a VC gives you after they show interest in investing, and it’s the first concrete step toward securing funding. Instead of a debriefing or summary, a term sheet provides a detailed description of the proposed investment. Lawyers frequently use term sheets as a guideline when writing transaction documents because they are so precise.
Although the purpose of a term sheet is fairly obvious, it is a bit more complex than just “stamping the deal.”
Term Sheet Tips & Tricks
VCs are in the business of making deals, and they probably sign contracts in their sleep. Unfortunately, the VC world is small, so there isn’t a lot of bridge-burning going on. Therefore, while VCs aren’t out to cheat anyone or pull the wool over your eyes, they are treating this as an investment and want to get the best deal possible.
Every dollar spent by a VC is a business decision, so you have to convince them that this investment is a smart choice. It’s a sales pitch.
However, it is up to you to make the most of a term sheet for your company. A VC investor will not assist you in negotiating a term sheet. You and your attorney will handle that (as well as everything else).
The sections of a Term Sheet:
A term sheet lays out who will receive what money and what either party can legally do in nearly every scenario. This is the definition.
A term sheet includes more information about where to negotiate conditions, but here are the three primary sections:
- Corporate Governance
- Liquidation and Exit
Negotiating a term sheet.
Finding VC-backed success means knowing where and what to negotiate on the term sheet.
SaaS founders often err by trying to control too much or trying to negotiate the life out of the deal. On the other hand, a savvy founder won’t settle for an option pool shuffle that is not “fair” or an appropriate valuation. Mastering the fine line between compromise and control is an ability you should strive for.
During term sheet negotiations, VCs and SaaS founders naturally go back and forth. Remember, not all terms are created equal. Some aspects of the deal should not be bargained on, while others can be approached more leniently.
The following are the two most crucial terms of the term sheet (and what you will most likely be debating):
- Economics—Where does the cash go upon an exit event?
- Control—Who has control of the company?
Every firm values slightly different things than the next one. Therefore, advising you on what to negotiate in your term sheet would be a mistake. Instead, we will give you some examples so that you can determine what matters most to your SaaS company and what you can bargain on.
These terms should become like a second language. Since they get tossed so frequently, VCs know how to sugarcoat things—although the good ones won’t. Don’t just skate over these crucial terms. Instead, memorize them so your Series A (and future rounds) will help your SaaS rather than just the VCs.
Let’s look at the financial aspect of securing a VC funding round. Here’s your chance to find out where the money will go if the company is sold.
The pre-money and post-money valuations are the most critical aspect of a term sheet. They determine who owns what and how the cash from sales is divided among shareholders (including if the company sells). Once a difficult goal to achieve, they now are critical to the deal.
Median seed valuations have increased by a compound annual growth rate of 11.2% versus 16.2% and 15.0% for Series A and Series B, respectively is worth noting.
Maximizing capital investment while minimizing dilution is the main goal. Remember that the average pre-money valuation for seed-stage businesses this year will be over $10 million. You and the VC must work together to achieve a fair valuation—one that reflects the SaaS industry as a whole and your particular vertical.
SaaS founders and VCs value companies differently, so be sure to keep that in mind. VCs will dilute the option pool once they invest their money (explained below), so as a SaaS founder, you should account for it. VCs will expect you to have already done the math, which many SaaS founders overlook.
When a SaaS founder is thinking about an option pool, carefully crafted language is frequently used to avoid saying anything that would signal its presence. VCs expect the SaaS founder to know how to account for the dilution themselves rather than taking a proportion of it. Therefore, the “prior to the closing…” wording.
SaaS founders often get overly excited at this stage and fail to read between the lines of economics and get duped. When you plan to use investor capital to expand your business, make sure you account for the new employees.
The multiple is usually set at 1x the invested sum on a term sheet. VCs value their stake in your company more than the money itself. Of course, they’re hoping for monetary gain when your company succeeds.
However, if your company collapses and shatters, the liquid preference will ensure that investors get their money back before anyone else even if the company is sold immediately.
1x liquid preference is typically the go-to number. If your company is a trainwreck, it’s a surefire sign that your liquid preference is higher than the invested amount.
As a SaaS founder, you typically don’t want the invested amount to be higher than the liquid preference.
Investors may attempt “double-dipping” when liquidation preferences are not met. In this situation, investors may double-dip by receiving a 1x liquidation preference and then receiving an equal portion of their ownership share. Simply put, preferred stockholders are paid back before anyone else.
It’s great to have no participation rights, but “participating with a cap” is also a decent compromise.
Because of the way they are structured, preferred stockholders can build up an extra return over time, which is known as a dividend. It increases the liquidation preference, and you will see it expressed as a percentage on the term sheet.
When you’re negotiating a term sheet, be careful about how the words “noncumulative” and “cumulative” are used. “Noncumulative” is preferable whereas “cumulative” ensures that investors will receive some return.
This phrase includes some complicated math and refers to the next funding round. Investors are safeguarded from massive dilution if a “down round” occurs, which occurs when the share price is lower than in previous rounds. Anti-dilution protections can be found in a variety of forms:
- Narrow-based rated average
- Broad-based rated average
Down rounds are frequently the most damaging to full-ratchet, while broad-based is typically the most founder-friendly. VCs receive more anti-dilution benefits by investing more capital in a broad-based rated average during a down round.
Economics aside, control of the company is a key issue in this deal. However, there is no middle ground on this issue. You either have control of the company or you don’t. As for the Series A round, the following elements are crucial to determining the outcome and making decisions.
Board of Directors
The board of directors is the most important leadership body in any company. The structure and voting abilities of the term sheet are emphasized, indicating its importance.
A SaaS founder maintains control over a board of directors in the early stages, such as a seedling or Series A round. As a company progresses through more rounds, that control diminishes.
It is important that the board composition be well-rounded and somewhat diverse to ensure that VC-backed companies are served well. There must be equal numbers of VC-friendly and founder-friendly board members to ensure a level playing field.
A corporation should ensure that stockholder interests are well-balanced along with board of directors’ tendencies. Some decisions lie beyond the board of directors’ jurisdiction and are subject to stockholder sway.
The board either adheres to the VCs or to the founder(s), whichever group controls the most shares. Seeking balance is a smart strategy.
Before investors agree to fund a company, they usually insist on “protective provisions.” These clauses allow VCs to make crucial decisions or maintain control over certain elements of the business. In other words, an investor might decide how much debt the company can have without their consent.
Be careful when the list gets too long or too restrictive, as most provisions are fairly standard.
Investors should be aware of the firm’s organizational structure, which may influence their decision to invest. Is the corporation a limited liability company (LLC), S-corporation, or C-corporation?
It’s worth noting that VCs prefer to invest in C-corporations rather than the other two structures. Some firms pressure SaaS founders to switch from an LLC or S- corporation. The reason is primarily that LLC and S-corporate structures create complex tax implications for investors, and few VC firms want to jump through the hoops.
Investors are always seeking future profit in an IPO, for example. However, an IPO can only be conducted by a C-corporation, so most SaaS startups are set up as C-corporations at the beginning.