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Understanding Standard Venture Capital Term Sheets

An article we liked from Thought Leader Alejandro Cremades:

What Are The Standard Venture Capital Terms

What are the standard venture capital terms every entrepreneur should know?  Standard Venture Capital Terms

A Venture Capital (VC) term sheet is the first formal document between a startup founder and an investor in the startup fundraising context.

The term sheet lays out the terms and conditions of the investment. It finalizes the terms, which a contract subsequently outlines in detail.

The investor prepares the VC term sheet which is usually less than ten pages. A strong VC term sheet balances the interests of the investors and the startup founders. This move is better in the long run for everyone involved (including the company).

Otherwise, a bad VC term sheet pits investors and founders against each other.

Funding Rounds

At each investment round, a Venture Capital term sheet is generated, which is usually denoted by a letter:

  • Pre-Seed and Seed stage: Angel investor or Family and Friends” round
  • Early-stage: Series A, B
  • Expansion stage: Series B, C
  • Late-stage: Series C, D, etc.

Deal volume has favored earlier stage investments. However, in recent years, there has been a clear shift toward larger-scale transactions.

As one might assume, the average deal size for later-stage investments is substantially greater. Yet early-stage venture capital investments have been rising across the board.

The Common Sections of a Venture Capital Term Sheet

Each term sheet may differ based on the circumstances of the startup and the needs of both the startup and the investor. However, there are a few topics that any Venture Capital term sheet should cover.

Valuation

You have to know what you’re negotiating about before you can negotiate terms. While determining the value of an early-stage startup can be challenging, there are common valuation methods that you can use.

You’ll include both pre-money and post-money valuations on a Venture Capital term sheet.

The difference between pre-money valuation and post-money valuation:

  • Pre-money valuation: The value of a company before a funding round
  • Post-money valuation: The new investment(s) after the financing round will be accounted for in the post-money valuation. The newly raised funding amount will multiply with the pre-money valuation to arrive at the post-money valuation.

Keep in mind that in fundraising, storytelling is everything. In this regard for a winning pitch deck to help you here, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.

Remember to unlock the pitch deck template that is being used by founders around the world to raise millions below.

Offering Terms

The following are included in the Offering Terms section:

  • Investor names
  • Closing date
  • Price per share
  • Amount raised
  • Pre-money valuation

The Offering Terms section often establishes a new class of Preferred Investor shares with particular rights that exceed those of common shareholders (e.g., dividends, investment protection, and liquidation rights).

Every entrepreneur should do their research on what are the standard venture capital terms and understand them carefully.

Charter

The Charter displays the dividend policy, protective provisions, liquidity preference, etc.

  • Dividend policy: The timing, amount, and cumulative nature of dividends are all clarified.
  • Anti-dilution protection: In the occurrence of a down round, Venture Capitals are protected so that their conversion ratio to common stock remains the same as new investors.
  • Liquidation preference: One of the most significant clauses in a term sheet is the liquidation preference, which reflects the sum that the startup will have to pay at the time of exit (after trade creditors, secured debt, and other company obligations). While most entrepreneurs are concerned with valuation, venture capitalists are concerned with the liquidation preference structure.
  • Pay-to-play provision: Unless preferred shareholders buy in the next round at a lower price (“down round”), they can lose anti-dilution protection. In this situation, preferred will generally convert to common.

Two Types of Dividends

  • Cumulative: Cumulative dividends favor preferred stockholders (i.e., investors) and disadvantage common stockholders (i.e., founders and employees). Every year, the company calculates the dividend. If the company cannot pay it, it carries forward (accrued) the dividend dues into the following year until it pays the sum or cancels or the right to dividends.
  • Non-cumulative: A non-cumulative dividend requires a company’s Board of Directors to declare the right to a dividend for that fiscal year. If this does not occur, no one is entitled to a payout for that year. For holders of common stock, this is an excellent deal.

Two Types of Anti-Dilution Rights

  • Full-ratchet: This is great for preferred stockholders and worst for common stockholders. It permits the preferred stock’s conversion price to be determined based on the cost of the new round of shares rather than the number of new shares issued.
  • Weighted average: Holders of common stock benefit more from weighted average anti-dilution rights than from full-ratchet anti-dilution rights. Weighted average anti-dilution rights are based on a method that considers both the share price and the number of new stocks issued. The price at which preferred stock converts to common stock gets calculated using this formula.

As a startup owner, take the time to understand what are the standard venture capital terms and what they signify.

Stock Purchase Agreement (SPA)

For the Stock Purchase Agreement, the SPA includes initial clauses on foreign investment regulatory stipulations, representations and warranties, and legal counsel designation.

Investor Rights

VC term sheets generally include a section concerning investor rights. Because the rights listed here can vary considerably, it’s a good idea to...

Read the rest of this article at alejandrocremades.com...

Thanks for this article excerpt to Alejandro Cremades. 

Image by mohamed Hassan from Pixabay

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