Firstly, if as an entrepreneur, if you have gotten far enough in your business to seek financing and you have received or are about to get a termsheet, I must congratulate you already, you are in a select group.
If you don’t belong to the above category and a have a more academic interest at the moment, then I must quickly describe a termsheet for you. When companies seek equity financing from professional investors, once investors have made up their mind about investing in your company, they give you a legal document detailing the business terms of the financing. This document is called the termsheet.
It lays down valuation, amount of investment, and the key terms of investment. This is usually followed by a due diligence process which is then followed by full fledged agreements before the investments come in. The time from termsheet to investment can be anywhere from 2 to 4 months.
A large majority of deals do happen once they reach the term sheet stage; hence it’s a serious milestone. Its usually a 3-4 page document that founders can Google and decipher on their own and with a little bit help.
In spirit, investors seek 3 things:
1. Information and Control rights: They want to know what’s going on. This can happen by them taking Board positions, veto rights on certain issues (like key person hiring, taking a loan etc.) and rights to obtain financials of the company etc. Since investors are minority shareholders, they need these rights explicitly.
2. Upside rights: It’s important for investors that if the company is doing well, they are able to stay with the company and continue to maintain their stake by investing more. This is fundamental to early stage investing since there are only a few big winners.
3. Downside rights: These are all kinds of scenarios where bad things may happen. 1 or more founders may lose interest, company may not do well and may have to raise money at a lower valuation in future and so on and so forth. Early stage investors want to protect themselves by taking what is called liquidation preferences. Very simply, they get their principal and return first before entrepreneurs. Sometimes, depending on the market situation etc. these preferences can be very draconian especially in a downside situation.
As an early stage entrepreneur, here are the things I would care about the most:
1. That the deal should happen quickly: An entrepreneur is in a precarious situation if the deal does not go through. Entrepreneurs being entrepreneurs, optimistic as they are start planning and even incurring spend once they feel confident that investment is coming. If it does not happen, then they may be in a really bad situation because they would have cut chords with other potential investors as well and will have to restart the cycle. So the entrepreneurs want to limit the term sheet to a small duration – I try not to do more than 60 days extensible by mutual agreement so that the pressure is on.
2. Complete transparency: If the company has skeletons in the cupboard, its best that they are brought before the termsheet and captured in the termsheet. You don’t want any surprises to come out in the diligence, it will unnecessarily delay things and even put the deal at risk. You should assume, expect and ensure that every things which is hairy is captured pre-termsheet.
3. Out of the category rights: I would care about the downside protection rights the most. Again entrepreneurs being the optimistic being think more about building billion dollar companies in which case nothing matters. In real life thought, there are lot mid-successes and in those cases, depending on how the preferences are stated, they can make a significant impact. This is not an article on liquidation preferences, but its important to understand that completely before you sign up. It’s the second most important after valuation.
In the bigger picture, getting a termsheet is a positive step forward with somebody validating your business and willing to invest capital. So enjoy the negotiation process and know that you are in a select group already!
[About the Author(s): This article, first in the series on “The Science of Entrepreneurship”, has been written by the faculty of Sunstone Business School, who are part of NextBigWhatSelect, a curated set of regular contributors to NextBigWhat.
Sunstone provides a one year part-time online PGPM program for mid-career Technology professionals, helping them transition to entrepreneurial & business roles. Click here to know more about Sunstone’s PGPM program. Contact id: firstname.lastname@example.org]
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