Strategy & Finance
The Strategic Importance of a Term Sheet
As a Chief Financial Officer (CFO), ensuring our company secures the right investment under the best terms is crucial. Whether negotiating with venture capital (VC) firms or private equity investors, the term sheet is the first step in structuring an investment deal.
🎯 Introduction: The Strategic Importance of a Term Sheet
As a Chief Financial Officer (CFO), ensuring our company secures the right investment under the best terms is crucial. Whether negotiating with venture capital (VC) firms or private equity investors, the term sheet is the first step in structuring an investment deal.
📜 What is a Term Sheet?
A term sheet is a preliminary agreement outlining an investment's main financial and legal terms. It acts as a blueprint before drafting legally binding contracts like:
✅ Subscription Agreement
✅ Shareholders' Agreement
✅ Convertible Debt Agreement
💡 Key Features of a Term Sheet:
🔹 Not legally binding (except for specific clauses like confidentiality and exclusivity).
🔹 Defines investment structure and rights.
🔹 Serves as a negotiation tool before formal contracts.
🔹 Provides a roadmap for future financing rounds and exits.
🛠️ Breaking Down the Key Elements of a Term SheetWee needs to understand the key clauses that can impact our company's future to negotiate wisely. Here’s what to watch out for:
📌 1. Type of Shares Issued
VC investors prefer investing in preferred shares 🏆 rather than common shares. Why? Because preferred shares come with special rights:
🔹 Liquidation Preference – Investors get paid before common shareholders in case of a company exit.
🔹 Dividend Rights – Investors may receive fixed or cumulative dividends 💰.
🔹 Conversion Rights – The ability to convert into common shares later.
⚠️ Be cautious of giving investors excessive rights that could reduce control over company decisions!
📌 2. Valuation: Pre-Money vs. Post-Money
Valuation determines how much of the company we are giving away. Understanding the difference is crucial!
🔹 Pre-Money Valuation 📉 – Company value before the investment.
🔹 Post-Money Valuation 📈 – Company value after the investment (Pre-Money + Investment).
📊 Example Calculation:
If a VC invests $5M at a $20M Pre-Money Valuation:
👉 Post-Money Valuation = $20M + $5M = $25M
👉 Investor’s ownership = $5M / $25M = 20% equity
🔎 Why it matters:
Misunderstanding these numbers can lead to over-dilution of existing shareholders or undervaluation of the company.
📌 3. Liquidation Preference: Who Gets Paid First?
💰 Liquidation preference determines how investors get their money back before common shareholders.
👀 Key Scenarios:
1️⃣ 1x Preference – Investor gets 100% of their initial investment back first.
2️⃣ 2x or 3x Preference – Investor gets 2x or 3x their investment before others are paid.
3️⃣ Participating vs. Non-Participating:
Participating → Investors get their preference AND a share of the remaining funds.
Non-Participating → Investors only get their preference amount.
📊 Impact Visualization: (Below)
⚠️ Caution: Too high a liquidation preference discourages founders and employees, making the company less attractive for future investors!
📌 4. Anti-Dilution Protection: Shielding Investors
📉 Anti-dilution clauses protect investors if the company raises capital at a lower valuation (down round).
📊 Types of Anti-Dilution Protection:
🛑 Full Ratchet – Investors get extra shares at the lowest share price. 🔥 (Most aggressive & unfavorable for founders!)
⚖️ Weighted Average – Investors get some extra shares based on a formula. (More balanced approach.)
🔎 Example: If an investor paid $10 per share and a down round happens at $5 per share, they get more shares to compensate.
💡 Negotiation Tip: Prefer weighted average protection over full ratchet, which can over-dilute founders and early employees.
📌 5. Founder Vesting & Employee Stock Option Plans (ESOPs)
🎯 Why do investors require founder vesting?This ensures key executives stay with the company long-term and don’t leave after securing funding.
📊 Typical Founder Vesting Schedule:
📅 4-year vesting with a 1-year cliff
🔹 1st Year: 0% vested ✅ (Must stay for at least 12 months to start vesting.)
🔹 After 1st Year: 25% vests every year.
⚠️ Investors may also require 10-20% of the company’s shares to be allocated to an ESOP pool for employees.
💡 Negotiation Tip: Ensure vesting terms align with business needs, balancing investor security and founder incentives.
📌 6. Board Composition & Voting Rights
Investors may demand seats on the board or special voting rights.
👀 Key Investor Rights to Watch Out For:
🏛 Board Seats – Investors might want a say in company decisions.
👀 Observer Rights – They attend meetings but don’t vote.
✋ Protective Provisions – Veto power over key business decisions (e.g., acquisitions, fundraising).
⚠️ Be cautious of giving investors too much control over business operations!
📌 7. Exit Strategy & Drag-Along Rights
💰 How will investors cash out?
📌 Investors typically target an exit within 5-7 years via:
🔹 IPO (Initial Public Offering) 📈
🔹 Acquisition by a larger company 🤝
⚠️ Drag-Along Rights – If most investors agree to sell the company, founders and other shareholders must sell,l too.
💡 Negotiation Tip: Ensure the drag-along provision only applies to fair and reasonable exit scenarios.
✅ Best Practices for Reviewing & Negotiating Term Sheets
📌 1. Align with Business Objectives – Does the term sheet support our growth strategy?
📌 2. Run Sensitivity Analysis – Use financial models to simulate different exit scenarios.
📌 3. Identify Investor Intentions – Are they strategic partners or just financial backers?
📌 4. Consult Legal & Financial Experts – Always get external legal and financial reviews.
📌 5. Negotiate with Confidence – Everything is negotiable—don’t accept lousy terms unquestioningly!
🚀 Conclusion: Smart Investment, Stronger Company
Mastering term sheets ensures we raise capital strategically without compromising long-term control. We secure fundingby negotiating favorable terms and aligning with investor interests while protecting our company’s future.
