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A Founder’s Guide to Term Sheets: Navigating the Basics

Pre-money valuation. Option pools. Liquidation preference. These are just three of more than 40 terms you might find in a typical term sheet (a formal, but non-binding, document between a founder and an investor) during investment negotiations. The promise of fresh capital can make it all too easy for founders to sign on the dotted line without a full understanding of the agreement they just made—especially when many entrepreneurs come to the table with deep technical knowledge, but not necessarily a background in finance.

In a “billion or bust” world where VCs make investments with a high-risk, high-reward mentality, the first thing to understand about term sheets is that a high valuation alone does not protect founders’ equity, especially with respect to distributions from a future sale or liquidation event. Here at Elsewhere, we believe there’s a better way to structure deals: We work with your company to define mutually beneficial terms based on a likely exit, not a lofty one. Leveraging a clean structure, with a modest level of downside protection, helps keep us aligned with founding teams long-term.

That’s why we’re breaking down fundraising terminology and little-known negotiating tactics in this new series, a Founder’s Guide to Term Sheets. As investors and operating advisors, we’re here to guide you through the process—not add to the confusion. In this first part, we dive into four main aspects of a deal’s structure and how each impacts your financial stake in the company.

Investment amount

“Investment amount” may seem straightforward at first—how much money you’re raising—but different types of investments impact your piece of the pie in different ways.

The first is primary capital, or dollars that go onto your balance sheet and dilute everyone else’s equity (ownership of the company) ratably. If you’re early in your funding journey after bootstrapping your business, primary capital (with the right operational resources) can and should add valuable fuel to scale your business that will more than offset the amount of initial dilution. But it’s also important to not take on too much primary capital too early, as you will both increase dilution and risk launching into “hypergrowth” mode where organizational growth outpaces revenue growth. Work with your investor to determine a realistic growth plan to ensure mutual alignment from the outset.

There’s also secondary capital, or dollars that buy out existing shareholders. Rather than going onto your balance sheet and diluting ownership, the money goes into someone’s pocket in exchange for their existing equity. In early stages, this usually means buying out angel investors or family and friends (people who aren’t involved in your company in a strategic way, and likely want a return on their investment sooner rather than later). In later stages, it sometimes means buying out a founder who’s ready to step back from the company or buying ownership from prior investors.

Valuation

With startup fundings making headlines every week, founders are accustomed to associating huge valuations with success. While they are correlated, the reality is more nuanced—big check sizes and large valuations are often a function of large fund sizes, rather than actual near-term startup potential. So, what does your valuation really mean, especially in terms of your equity?

Investors communicate valuation in many different ways. Often, they will frame it in the most favorable light (i.e., higher dollar amount), but you want to make sure you understand who owns what percentage of the company (both at time of investment and at exit) and have a way to compare terms sheets apples-to-apples.

A common framing comprises two parts: pre-money valuation (the value of the business before an investment round), and post-money valuation (the pre-money valuation plus the newly raised primary capital amount). Your valuation is a helpful negotiation point, but the valuation number alone matters less than its relationship to the investment amount in terms of your equity.

Why? Your investors’ percentage in the company is determined by the investment amount (primary capital) divided by the post-money valuation. For example, let’s say you get an offer for $5M at a $15M pre-money valuation:

  • Pre-money valuation: $15M
  • Investment amount: $5M
  • Post-money valuation: $20M
  • Investor’s equity: Your investors receive a 25% ownership stake in the business.

In this case, you might assume you retain the other 75% as founders. But it’s also important to consider how to incentivize employees with equity, which brings us to our next term: option pool.

Option Pool

Your option pool is a select percentage of company stock that’s set aside for current and future employees or advisors. The size of the pool impacts your own equity stake as founders. Using our example above, if a fund is entitled to 25% of your equity after a $5M round, and you want to allocate 10% of shares to the option pool, then both your and your investors’ equity would be further diluted.

Liquidation Preference

Most term sheets are designed to protect the investors more than founders, and those seemingly impressive valuations are often paired with a host of tricky liquidation terms.

Liquidation preference determines who gets their money back first in the case of a liquidation event, such as a merger, acquisition or business collapse. Oftentimes, VCs will offer much higher valuations alongside much higher liquidation preferences. For example, a 3x liquidation preference means the VC gets 3x their investment before anyone else receives a dollar. As a founder, if you double the value of the business in a year (an impressive feat!) and decide to sell, you will get a proportionately smaller share of the proceeds with the 3x liquidation preference.

There is also a difference in the types of equity instrument investors offer: participating preferred or convertible preferred stock. Participating preferred stock is often referred to as “double dipping.” If your company sells, these stockholders will receive their liquidation preference and their portion of the remaining proceeds before founders get anything, for example:

  • Liquidation event: Let’s say your company sells for $40M.
  • Preference: Your investor has a 3x liquidation preference with participating preferred stock on a $5M investment with 25% ownership.
  • Investor return: They’ll receive $15M plus 25% of the remaining $25M, or a total of $21.3M.
  • Your return: That leaves just shy of 47% of the proceeds for you and your employees, a big difference when you might have thought the investors just owned 25% of the business.

Founders are often left stunned in these situations, because they didn’t understand the impact of liquidation preference or participating preferred stock when they first signed the term sheet. This gets even more complicated with each successive round of funding and new investors on the capitalization table (an overview of everyone’s equity ownership during each investment round).

As Elsewhere, we’re committed to terms that benefit both investors and founders: We typically ask for a 1x liquidation preference and convertible preferred stock. In the case of a sub-optimal liquidation event, we get the money back that we put in—largely to ensure we are being responsible with our limited partners’ capital, not to hoard proceeds. When it comes time to distribute funds, we have the option to take our liquidation preference (in other words, receive our original investment back) or convert our stock to common stock and receive the ratable portion of proceeds. Using the same example:

  • Liquidation event: Your company sells for $40M.
  • Preference: Your investor has a 1x liquidation preference with convertible preferred stock on a $5M investment with 25% equity.
  • Investor return: Your investor can choose to receive either $5M (liquidation preference) or $10M (by converting their shares). In this case, we would convert into common.
  • Your return: With $30M leftover, the founding team and employees receive exactly 75%, the same ownership stake that was originally agreed upon.

Remember that bigger isn't always better

The best piece of advice we can give is that bigger numbers aren’t necessarily better. Receiving more money than you need may sound like a great deal, but in reality, over-capitalizing a business can lead to excessive burn rates and outsized expectations for an exit. Make sure you’re evaluating term sheets on more than just the investment amount and post-money valuation, researching the fund’s approach, and negotiating where you can.

Most importantly, build a network of impartial advisors so you can ask questions if you’re confused. As an early-stage entrepreneur, you’re likely seeing a term sheet for the first or second time ever, while investors deal with term sheets every day and often benefit from your confusion. Ignorance, in this case, is far from bliss. Don’t sell yourself short from the beginning.

Tune into our upcoming webinar, A Founder's Guide to Term Sheets, to learn more about navigating term sheets from Elsewhere VPs Sloane Child and Nick Stoffregen.

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