4 Common Founder Questions About Term Sheets
While Elsewhere only has the chance to partner with a handful of founders every year, we feel strongly about demystifying the fundraising process for all entrepreneurs. Your ability to grow and scale your software business shouldn’t be limited by an alienating or misaligned fundraising process.
That’s why we decided to launch a new series—A Founder’s Guide to Term Sheets—with an initial post breaking down the four fundamentals of a term sheet’s structure: investment amount, valuation, option pool, and liquidation preference.
There’s a lot more to unpack about term sheets, so we followed up with a Q&A-style webinar, inviting founders to ask our Elsewhere VPs, Sloane Child and Nick Stoffregen, their most pressing questions. In case you missed it, we have the full webinar recording here. This post features a few of the top questions we received on navigating and negotiating term sheets.
How can I get a sense of my pre-money valuation before I go out and raise?
Let’s start with common misunderstandings about valuation first. The highest pre-money valuation is not always the best option for a founder. As the industry saying goes, “you name the price, I’ll name the structure.” In other words, investors will often offer up higher valuations when they can pair those investments with “structure” or terms such as liquidation preference and participating preferred that essentially lock in their base case investment return and skew distribution waterfalls. Make sure you understand what type of equity instrument they’re using and what it means when it comes time to exit.
Founders might also look at public companies or recently minted unicorns with similar products or in similar markets. This isn’t a very reliable way to think about your valuation because you’re comparing your startup to a business that has likely established market dominance with tens or hundreds of millions of dollars in revenue. Earlier-stage valuations have less to do with public and private unicorns and more to do with recent performance and future growth planning.
A number of key SaaS metrics are often more relevant guides for estimating valuation. For example, do you have best-in-class retention? How much are you growing year over year? What return are you getting for each dollar invested in sales & marketing? What is your cash burn rate and how has that trended over time? There are many benchmarking resources available that can be useful guides to plotting where your startup fits in the broader ecosystem like this survey from SaaS Capital.
How does being fully bootstrapped play into an investor’s valuation?
This question goes back to one of the metrics that a lot of investors use called “the rule of 40”—a metric that balances growth with profitability. To calculate the rule of 40, add your year-over-year revenue growth percentage to your profit margin. Ideally, the resulting figure is 40% or higher. For example, if your revenue growth is 40% and your profit margin is 20%, your rule of 40 number is 60%, which is above the 40% target. A bootstrapped business that is growing modestly but also profitable or cashflow break-even can make for a mutually lucrative opportunity to add capital and operational resources to accelerate growth.
If you have strong customer retention and you aren’t spending aggressively to acquire and keep your customers, you’re going to have a much higher net profit margin than a SaaS company that has raised 10 million to 20 million dollars already but has yet to hit a few million in run-rate revenue. While bootstrapping on its own doesn’t promise you a high valuation, bootstrapping can certainly help your valuation if you’re able to achieve meaningful scale.
What occurs if investors and founders cannot come to terms on a term sheet? Will investors give up some of their preferred terms if it means partnering with a company they believe is a great fit?
Negotiating a term sheet is a dance on both sides, but there are always levers to pull. One of the first places to negotiate and be on the lookout for is the liquidation preference, which determines who gets their money back first in the case of a liquidation event, such as a merger, acquisition or winding down of the business.
If a VC stipulates a 3x liquidation preference—meaning they will receive 3x their investment before anyone else receives money—ask if they will negotiate down to a 1x liquidation preference. We tend to favor this type of cleaner structure as it affords a modest level of investment protection while ensuring alignment across all other positive outcomes.
If the monetary structure is proving difficult to negotiate, consider other aspects of the investor relationship you may be able to utilize: What governance provisions are being proposed? Is there flexibility on the number of board seats for investors, or can the investor promise connections to Operating Advisors for your startup? The startup and investor relationship should be mutually beneficial, so both sides should be willing to creatively negotiate.
Besides capital, what else should I be asking for from an investor?
All money is green. While fundraising as a founder is no doubt a time-consuming and arduous process, there is a record amount of “dry powder” in the coffers of venture, growth equity, and private equity funds. That likely means that a business with solid fundamentals will have multiple funding paths to consider. Founders should consistently ask, “What will I be getting other than capital?” In our experience the highest impact results from strategically aligned Operating Advisors or board members.
Your investors should have direct ties to individuals with relevant expertise for your startup’s current stage. While many VCs have prestigious networks, don’t get too pulled in by the promise of former blue-chip CEOs or household name executives—instead, think about the direct skills and experience you need to take your business to the next level. Talent is becoming harder to come by—ensure your investor has the resources and track record that mesh with your growth path.
Can your investor connect you with Operating Advisors who have scaled early-stage SaaS companies or refined go-to-market strategies? Are they available to talk through your business challenges on a regular basis? Guidance through these critical business decisions will affect your performance and valuation in significant ways.
How do I get in touch with you?
Our favorite question! If you’re a B2B SaaS startup founder—especially one that is bootstrapped or navigating the first external raise—looking for the funds, connections, and expertise needed to achieve the next growth milestone, feel free to reach out to me directly by emailing michael@elsewhere.partners. If you have a question about term sheets that wasn’t answered here—or you want to see more posts like this—we would also love to hear from you.
We’re here to support your entrepreneurial journey, which includes providing the knowledge, tools, and resources you need to succeed.