Term Sheet Terminology 101

For Startup Founders

Photo by Gabrielle Henderson on Unsplash

Founders are typically offered a choice between a single investor (angel investment) or multiple investors (venture capital). When choosing between these options, the main difference is the degree of control founders should expect to maintain over the company.

When an angel invests, control over the startup remains with the founders. The angel provides funding and acts as a mentor, but does not have equity in the company. The angel’s involvement is often limited to providing advice and recommendations on how to run the business.

The VC route can be risky for a founder who prefers to maintain full control of their company because VCs are generally given seats on the board and much greater input into how the business is run. However, if you need more capital than an angel can provide and you do not want to give up too much control, then this might be your best option.

The higher amount of money you are hoping to raise from investors, then greater chance that they will ask for some form of “anti-dilution” clause in case they invest more money in your venture later on down the line, potentially diluting your percentage of ownership in your startup significantly if it is successful.

You may decide that dilution is an acceptable risk if this means investors will be more likely to invest now than at a later stage when there are more competitors or it has less potential for success than when it was first conceived.

A common anti-dilution clause used by venture capital companies is known as Pro Rata Rights which stipulates that if another investor puts money into your company then they have an equal rights claim over any future funding rounds that takes place at lower price points (meaning any subsequent investments will automatically have their price adjusted so that their stake remains proportional with all other existing investors).

This means that unless you are prepared to give up a larger percentage of equity in order for those future rounds to happen sooner rather than later, then you will likely need to wait until those rounds take place before further funds can be invested into your company by other sources.

This could have disastrous effects if a competitor takes market share or other negative events occur during that time period which stalls growth and forces you out of business before new rounds can take place.

It is also worth knowing that many angels will offer protection against dilution as part of their investment terms without insisting on pro rata rights being included so long as there is no prior agreement with other potential investors.

The valuation (or price) per share of your company is just as important as the size of the investment that you are looking to receive. The price per share is a function of how much cash your company has raised already, the amount of capital it needs, and the percentage that investors are currently willing to pay for this particular investment round.

As mentioned above, investors often look for anti-dilution clauses so that they can limit their risk in future rounds of funding.

This means that if an investor puts in $1m at a $5m valuation then they will demand a higher price per share than if they had invested at $2m or $10m valuations.

Your startup may benefit more from raising at a lower valuation round because it will not need to raise any more money for some time, but it also means that if you want to retain control over your company then you may have to accept a lower percent ownership yourself as part of the deal.

Understanding what factors determine how much equity each founder owns will be an important part of the negotiation process. In addition to learning about how much control founders are willing to give up, investors will also be looking for clues as to how much potential they believe the company has in order for them to be willing to pay a higher price per share.

This is an extremely important part of any term sheet that you will encounter as a founder. The length of the term sheet is directly proportional to the risk that your startup will have to take by accepting it.

In general, the shorter the term sheet is then higher the valuation and lower the amount of dilution that each founder can expect.

For example, if you are negotiating with an investor then they may say “we want your company but we only have 24 hours” in which to make a decision or else they will lose their interest in investing.

If you accept their terms then you are basically agreeing to any form of valuation and percentage ownership without even giving yourself time to look at other offers and options first.

This can be very risky if there are other better offers out there at lower valuations so it is important to know when these situations might arise so that you can avoid them if possible or ask for some form of extension from investors if it is required in order for your startup not to be forced into accepting unfavorable terms.

Finally, it is important for all parties involved in any investment round (investors, founders and employees) understand all of the legal clauses and terms mentioned above before signing off on anything.

It is easy for small print clauses or poorly worded conditions to go unnoticed and lead both founders and investors into unforeseen problems later down the road when things do not work out as expected or hoped between them during this initial stage of business negotiation which sets precedence for future relationships between these parties once capital has been invested into a startup venture.

For this reason, founders and investors should both seek out legal advice before signing any documents which might affect the future of their company. This is an important part of due diligence which helps to avoid future issues and set a strong foundation upon which the business relationship between all parties can be built.

About the Author

I am the Founder of Cudy Technologies (www.cudy.co), a full-stack EdTech startup helping teachers and students teach and learn better. I am also a mentor and angel investor in other Startups of my other interests (Proptech, Fintech, HRtech, Ride-hailing, C2C marketplaces and SaaS). You can also find me on Cudy for early-stage Startup Founder mentorship and advice.

You can connect with me on Linkedin (https://www.linkedin.com/in/alexanderlhk) and let me know that you are a reader of my Medium posts in your invitation message.

Founder of Cudy Technologies (www.cudy.co), a full-stack EdTech startup helping teachers and students teach and learn better. I am also a mentor and investor.