Termsheets: need-to-know advice for founders

So, you’ve got a termsheet from your lead VC, Congratulations! But let’s take a step back, what is a termsheet, why should you care what’s on it and what are the key negotiating points?

Laurence Tan

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Pre-Seed
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In its simplest sense a VC termsheet is a framework which outlines the key points of the deal which instruct how the full form legal documents are drafted.

It is worth spending some time on negotiating the termsheet with your investors, as aligning on all the key areas at the termsheet stage can remove any surprises in the long-form legal documents. This can save you both time and money in the process.

In this article we are going to go through the key aspects of the termsheet, what they mean, the key emotive points, and where to spend your time negotiating. A key point to make your life easier as a founder is to get a lawyer who is experienced in Venture capital deals!

What should I be looking for in a Termsheet?

Termsheets differ from investor to investor, but all will broadly cover the same aspects of the deal. This should outline the valuation, control matters, investor rights, any conditions and exclusivity period. We will go through these one by one, looking at what they mean and what to potentially negotiate.

Valuation🔗

The valuation of the business, in the simplest terms, is how much the business is worth. This is important, as when an investor is coming in, the valuation determines how much of the business they are getting.

A word of advice

It may sound counterintuitive, but a larger valuation does not always lead to better outcomes. It is worth understanding the whole structure of the deal as the valuation may bring into play other aspects of the termsheet such as preferences.

There are two valuations you will see – this is the pre-money and the post-money – and it is worth understanding what these mean to your business. Pre-money is the valuation of the business before the funding round goes in, this dictates the share price of the round. The post-money is the valuation of the business once the investment has been completed and this dictates the overall shareholding of the business for each party.

The valuation of the company is a key negotiating point, as this impacts the amount of the business which is being given to investors and how much the founders of the business are diluted. However, valuation like most of the terms, they cannot be looked at in isolation as it will interact with other terms elsewhere in the termsheet.

Preferences🔗

Preferences, what are they and why do they matter? Preferences determine how money is distributed to shareholders (and founders) in an exit scenario. Broadly, a preference can be a tool to bridge a gap in valuation expectations or to provide investors protection if there is significant risk in the business.

There are several scenarios to be aware of with preferences and how they work in the real world but the two key aspects which you need to consider is the participation and the multiple. The key scenarios are participating preference, non-participating preference and no preference.

The following explanations assume a 1x multiple:

No preference

This is the simplest distribution, with all shareholders treated equally in an exit scenario and they receive capital relative to their shareholding.

Example: A business sells for £10m an Investor owns 20% of the business and Founders own 80% of the business. Investors get £2m and the Founders get £8m.

Participating preference:

In this exit scenario, the investor would get their initial investment back first multiplied by the preference multiple; if they invest £1m at a 1x participating preference it would be £1m x 1 = £1m. Following the investor getting their money back first, the rest of the capital would be distributed relative to the shareholding in the company but importantly this would include the investor.

Example: An investor invests £2m into a business with a 1x participating preference and now own 20% of the business with the founders owning 80%. The business sells for £10m; the investor would get their £2m initial investment first leaving £8m to be distributed to the other shareholders. However, the investors would participate in this so the investors would get £1.6m of the £8m with the founders taking £6.4m.

Non-participating preference

In this exit scenario, it is an either or case where the investor chooses whether they are exercising their preference or not. In a scenario where the exit is higher than the valuation when the investor put money into the business, they would likely not exercise the preference, and returns would be distributed relative to shareholding.

In a worst-case scenario

....where the exit is lower than the valuation the investor put their money in at then they would likely exercise their preference which would mean they would get their initial investment out first.

Example: An investor invests £2m at an £8m pre-money valuation giving the investor 20% in equity; with the founders owning the other 80%. The business exits for £4m, the investor would exercise their preference and return their initial £2m investment and £2m would be distributed according to shareholding; investors would get an extra £400k with the founders taking £1.6m.

In a best-case scenario...

...where the exit value is higher than the valuation the investor put their money in at, the investor would not exercise the preference and distribution of capital would be by shareholding.

Example: An investor invests £2m at an £8m pre-money valuation giving the investor 20% in equity; with the founders owning the other 80%. The business exits for £30m, the investor would not exercise their preference. This would mean they would receive £6m from their investment and the founders would get £24m.

The type of preference and the multiple should be negotiated with the investor during the termsheet stage, and you should really understand the rationale behind why they want to add a preference in. It is likely most investors would want to see a preference in the termsheet but the aim for founders would be to ensure this is a 1x multiple as a maximum and that it is a non-participating preference where possible. However, you do need to really understand the reasoning from the investors, so have an open and honest conversation around this topic.

Option pools🔗

Options are a way to incentivise current and future employees in the business through the ability to have shares within the company. This helps build alignment in the team when salaries in start-ups may not match market rates elsewhere. In early-stage companies, where explosive growth is anticipated, this typically goes hand in hand with increased headcount within the business. At this point, investors will likely look to ensure the option pool is sufficient in the business to support this.

Typically, investors will like to see at least a 10% option pool in the business to ensure there is a sufficient pool but this may vary from company to company and deal to deal. In a termsheet there is usually a stipulation on whether an option pool increase is needed. It is worth double checking whether the option pool increase or establishment is happening pre- or post-investment. This is because if it occurs pre-investment, the current shareholders take the equity dilution to establish/increase the option pool from their shareholding whereas if it occurs post-investment then the option pool affects all shareholders including the incoming investors.

What have we learned so far?

The above terms are economic aspects of the termsheet and affect how much of the business is sold, at what price and how money is distributed to shareholders in an exit scenario. These are all key negotiation points between investors and founders but again it is worth really understanding the rationale behind each term both from an investor standpoint and how it will affect your business. My advice would be to try negotiate the simplest deal structure possible in all scenarios.

The next section looks at other aspects of the termsheet which will likely be present and how to negotiate them. It’s worth pointing out at this stage there are a lot of emotive points within a termsheet from valuation, founder vesting, to drag. It’s worth remembering that these terms can absolutely be negotiated but it needs to be done in the context of the entire termsheet and not each individual item.

Compulsory transfer or vesting🔗

This is where the founder’s shares are transferred to be earnt back over a specified length of time. This is understandably a highly emotive term for founders, but this is typically a required term for investors. This is to say, it should be negotiated with your investors in terms of vesting schedule, time-period the shares will vest over. Typically, a proportion of shares will be given back on completion, the largest proportion then given back over 3-5 years with a proportion held back until exit.

NEED-TO-KNOW

From an investor perspective, vesting is used to ensure alignment between the founders in the business and the shareholders to deliver the business plan being invested in. There are few terms to provide protection for investors if founders turn around the day after investment and walk away from the business therefore founder vesting is seen as a deterrent mechanism. However, founder vesting is useful for businesses with more than one founder, as if a co-founder is able to walk away with a significant shareholding in the business without recourse it can make future investment rounds impossible to structure and can leave the business in jeopardy.

Drag🔗

This is again a highly emotive topic where on paper it sounds like an investor can force the founders to sell. However, in reality drag is rarely ever used and if it is used it’s typically against minority investors to force a sale with alignment with the founders and management team.

A scenario where drag is enforced against the founders would rarely occur as founders not wanting to sell or engage with the sale process would negate any value in the business making it futile for investors. This is a term which is unlikely to be removed from a termsheet as it is seen as a needed just in case term.

Warranties🔗

are a process in which investors want to ensure the information which they are basing their investment decision on has been provided as a true reflection of the state of the company. This can be a key area to negotiate as the warranties usually have a liability cap and timeframe for claims to be brought forth. This can typically be a liability cap of 1-2x annual salary over a 2-year time-period for claims to be brought forth

Points on the termsheet to be aware of...

The key negotiated terms in the termsheet have been broadly covered but there are other aspects within the termsheet to understand and consider before signing.

Restrictive covenants

Restrictive covenants are non-competition agreements for a certain period after a founder leaves the company. This is standard to ensure a founder doesn’t leave, set up a new business as a competitor to the original company and solicit customers. Restrictive covenants are usually in place for up to 2-years but this can be negotiated.

Exclusivity and Termsheet expiry

Expiry is relatively self-explanatory but beware of short expiry dates as you should have adequate time to negotiate key points. Exclusivity is used for investors to balance protecting their position in a deal while they undertake their due diligence (DD). This is dependent on the amount of DD required. This should be detailed under conditions precedent where it outlines the workstreams, which must be satisfied for the investment to be made.

It is worth reviewing the list of conditions precedents (CP’s) and ensure they align with what you have discussed with investors to that point. The Exclusivity period usually provides a timeline for the CP’s to be satisfied. As a founder you can negotiate this exclusivity period but ensure you are pragmatic to the length of time DD takes depending on the list of CP’s but you would likely want to try and keep that exclusivity period to 8-12 weeks.

Pre-emption rights

Pre-exemption rights are standard practice, which means that for future funding rounds, shares in the round must first be offered to the current investors around the cap table proportional to their shareholding in the business (Pro-rata). Investors exercising or going above their pre-emption sends a strong message to the market when raising capital to help you close funding rounds! This would not be a point to negotiate.

We have now been through all the key points of the termsheet with where you should negotiate and the implications of terms in the real world. It is important to ensure investor alignment before signing as taking bad money can be as detrimental for your business as no money. Always do your own DD on your prospective investors with their portfolio companies and most importantly, hire a good lawyer who is well versed in Venture Capital deals!