The Term Sheet: 5 Things Startups and Venture Capitalists Need to Know about Term Sheets
At its core, the answer to the question "what is a terms sheet?" is simple: it's a document that is drawn up in collaboration between an investor and an entrepreneur who is seeking funding from that investor. Its purpose is to outline certain key terms in an investment regarding things like valuation, participation, preferred payments and more. It is also one of the most important documents involved in the process of raising capital, which is why you need to make sure you understand it fully before you move forward - regardless of which side of the table you're sitting on.
#1 The Term Sheet is a Non-Binding Agreement
One of the most important things to understand about a startup terms sheet is that it is a non-binding agreement. That bears repeating; anything written on a terms sheet is not something that either the startup or the venture capitalist will have to abide by in a court of law. What a venture capital terms sheet does, is act as a framework for the legal documents that are about to be drafted. Legal documents can refer to certain items contained in the terms sheet, but without the legal agreement itself they don't technically mean anything at all. Assuming that a term sheet will protect you in the event of a dispute is one of the biggest mistakes that startups and venture capitalists can make.
#2 Voting Rights & Term Sheets
Another one of the most important provisions dictated by a terms sheet has to do with voting rights. A VC sitting on the board of directors at a particular company may be allowed to vote on the direction of that company and on certain mission-critical decisions at some point in the future. The important thing to understand, however, is that depending on the terms sheet a VC may have more than one vote. This can mean great things for the venture capitalist if you have strong ideas with regards to the direction the company should take moving forward, but bad things for the startup if you assume your voice is stronger than it actually is.
#3 Liquidation Preference & Term Sheets
A term sheet will also detail a liquidation preference for original inventors, which essentially refers to exactly how the investors are going to recoup their money in the event that the company is sold or goes public. For example, a VC may have a liquidation preference with a 5X multiplier. This means that they recoup five times their original investment in the event of something like a sale. If they originally put $5,000,000 into a company and have a 5X multiplier, this means that they're getting $25,000,000 no matter what.
According to Tech Republic, the average investment in 2012 was around $7,000,000. Even with only a 2X multiplier, this means that a company would need to sell for at least $14,000,000 to both pay back its original investors AND make money for everyone else.
#4 Startup Valuations...
Another thing that will be specified by a terms sheet is the valuation of the company in question. This one number, regardless of what it is, essentially dictates the majority of what happens regarding investment moving forward. Nearly every calculation regarding stock, participation and more is based on valuation, which is why it is so critical to pay attention to. To determine valuation, an analyst will essentially look at the company from the inside out and will take into consideration things like current revenue, hypothetical future revenue, capital structure and more.
#5 You're Working With a Ticking Clock
Finally, a terms sheet will also outline the total commitment from venture capitalists who are investing in a business in the first place. According to TechCrunch, most of these deals are structured as ten year commitments. This means that for the best possible outcome, a company will need to start making serious money within that ten year timeframe before investors are allowed to start cutting and running whenever and however they'd like.
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