When an investor plans to make an investment in a startup, one of the things in the forefront of his or her mind is: what are the terms of the deal?
Well, luckily a document exists whose sole purpose is to delineate all the deal terms. It is agreed upon by two parties, the startup and the investor, and called, fittingly, a term sheet.
Term sheet: investment specifics
So what does the big scary term sheet look like “in real life”?
While I was reading through terms sheets during my internship here at OurCrowd, I realized that after parsing away the legal jargon (and parsing away some more…), they are basically lists—lists of terms that the investor and the startup have agreed to adhere to in this investment.
Note that the term sheet (other than the confidentiality agreement therein) is not legally binding, but under most circumstances, these same terms will make their way into legal documents relating to the deal.
The list of terms can be broken down into two categories by asking a simple question: as an investor, what matters to me? Money and power. Or put in VC terms: the economics of my investment and the control I have over the company.
The economics: what am I investing in and at what price?
When I invest my money into a startup, my money buys me a chunk of the startup itself, or what is called equity. The size of my chunk is measured in terms of shares of stock. In other words, if we think of the whole startup as a pie (yum!), each share of stock is a slice of the pie. The equity I get in return for my investment, or my chunk of the company, is just how many slices of pie I’ve got.
Calculating an investor’s share of the pie
So how do I calculate that equity?
We need a few bits of information about the company, listed below:
- $company: The company’s pre valuation, which is how much the company is worth prior to the investment (ie the size of the whole pie).
- #S: The number of shares the company is divided into (ie the number of slices of the pie)
Of course, we also need some information about the investment we’re making:
- $me & $others: The amount of money I’m investing and the amount of money my co-investors are investing.
- PPS: Price per share (ie how much I’m paying for each slice I buy).
Thus, equity=$me/($me + $others + $company)
You may ask, as I originally did, “Wait, what happened here?” Why is my investment divided by company valuation and all the invested money? Aye, there’s the rub: the capital invested in the company literally becomes part of the company. So the whole pie grows by the amount of investment, as if your money had magically transformed into extra pie.
Understanding how an investor owns less as the company raises more
The growing pie brings along quite a few problems, especially if another group of people invest after you and your co-investors. Your percentage of the pie is inevitably going to shrink, or in VC terms, you’ll be diluted.
I’m sure you’ll be relieved to know that in the term sheet are two clauses that can swoop in and save you from the evils of dilution: anti-dilution and pre-emptive rights.
A “pre-emptive right” refers to your right to acquire new shares issued by a company, usually up to a proportional, or pro-rata, percentage. For example, if you owned 12.5% of the company after the first investment, in the next round, the pre-emptive right guarantees you the option to buy enough shares to still own 12.5% of the company post-dilution.
The “anti-dilution” clause protects you against severe dilution. It usually kicks in if in the next round of investment the company offers a cheaper buy-in (ie a lower price per share), which means the investor can buy the same chunk as you did, not only later in the game, but also at a lower price. Anti-dilution mitigates this by recalculating your equity based on how much cheaper the new price per share is.
Having your say: an investor’s take on company control
One of the key clauses related to control is board representation. Board representation is important because it enables the investor to know what is going on in the company and have some impact on company decisions. Carrying on the pie example, I may have bought a big chunk of cherry pie (which I love) before, but since the company decided to drastically change direction, I’ve ended up with peach pie in my hands (which is disgusting to me). How do I keep that from happening? A seat on the board.
While there are often more terms and nuances involved, investors can always use the two questions “What are the economics?” and “How do I exert control?” to wade through the terms. Of course, the term sheet for each individual company is very different. Accredited investors can refer to the “Deal Terms” tab for each company to see what the specific terms are for that specific deal.
I hope this blog post helps when you’re reviewing OurCrowd deals! Now I’m off to have some pie…
Has this introduction to term sheets tickled your fancy? On the prowl for more? Below are some more in-depth resources on term sheets:
- Term Sheet Series (Brad Feld and Jason Mendelson)
- What’s in a Term Sheet? (Bruce Gibney)
- Want to Know How VC’s Calculate Valuation… (Mark Suster)