Receiving your first term sheet is a big milestone in your company’s journey. And because it’s one of your final steps in the fundraising process, making sure it doesn’t fall apart at this stage is critical. Outlining the conditions of the investment, your term sheet provides a foundation for your future rounds of financing and includes a number of technicalities you want to get right.
During an AWS Startup Growth event at the AWS Loft, Russ Heddleston, co-founder and CEO of DocSend, and Aaron Terwey, Counsel at Atrium, unpacked the Series A fundraising process and briefed the audience on the fundamentals of a term sheet.
The Q&A interview below gives you a peek into the real-world insights they shared and how founders can avoid some of the common term sheet minefields throughout the fundraising process.
Q: Starting with the basics, what does the anatomy of a term sheet look like? What goes into it?
AT: At the most basic level, the term sheet contains all of the terms that a company and an investor have negotiated on for financing. It’s not going to have absolutely everything that goes into financing because, well, lawyers would have a lot less to do and the term sheet negotiation process would take weeks/months, rather than days.
When you’re raising a Series A, you’ll have five core documents that add up to a hundred or so pages. Your term sheet, on the other hand, boils down all of the essential terms of the deal into a single document. It takes what can be easily distilled into a couple of pages and summarizes what each party has agreed to. It includes terms such as valuation, liquidation preference, board composition, and other protective provisions.
Founder tip: Before you even receive a term sheet, become familiar with its common terms and the implications of the different protective provisions. You can brush up on some of these terms here.
Q: How do most founders learn about term sheets and where it fits into the fundraising journey?
RH: Truthfully, there’s really not a lot of knowledge out there for founders about term sheets—you kind of have to figure it out as you go along. At the first company I started, we did a convertible note, which is a bit of a DIY setup. At DocSend, we raised a seed round, a Series A, and then a round of venture debt in between. Throughout each of these fundraising stages, I’ve ended up working with a bunch of term sheets and they’re all very different. In the beginning, it took me one-part Googling and one-part running around asking questions to friends who have gone through the process before.
Founder tip: Sometimes it can be hard to know what is standard and okay because it’s not really a thing that people talk a lot about. Do online research, consult with your attorneys, advisors, mentors, and experienced friends, and ask questions in community forums to learn as much as you can.
Q: How much time should founders spend on getting their first term sheet right—are there bad decisions that are difficult to come back from later on?
AT: It’s very exciting when you get a term sheet—especially if it’s the first term sheet you’ve ever received. But even though many founders might feel a sense of urgency to just “get it done” at this point, it’s still very important to be thoughtful and strategic and not rush the process.
For founders embarking on this fundraising process, before you even begin the process, I would advise you to sit down and think about what your dream financing looks like. Write down all the things you definitely want and, possibly even more importantly, all of the things you definitely don’t want. That will help you know where to make concessions and where to push back.
Founder tip: The best thing you can do is to take your time. While there may be deadlines outlined in the term sheet, investors who truly want to work with you are usually willing to lengthen that window of time—especially if it’s your first term sheet. They know you want to go through the process and do your due diligence.
RH: Getting your first term sheet involves a lot of processes: it takes a lot of pitching and building the right relationship with your investor. If you get married, you can get divorced. But if you take a round of financing, you can’t break up with that investor—you’re in it to win it with them.
People often over-focus on the general terms, such as the valuation and the amount raised…you know, getting the TechCrunch headlines. But in my opinion, I care more about the cleanliness of the terms, how they define the working relationship with my investor, and the rights I get to keep as the entrepreneur.
For example, think about if you’re trying to sell your company. The term sheet governs who gets which rights and governs things like liquidation preference—something that entrepreneurs don’t always think a lot about. Depending on the rights you and the preferred owners have, they might be able to block a sale of your company. So, you can see some really bad behavior that happens.
Founder tip: Remember, you need to like your investors and do your reference checks. As an entrepreneur, there’s no good reason to expose yourself to more risk than you need to. Once you’ve taken their money, you can’t really fire an investor.
Q: What are some examples of some undesirable standards and how to spot them before they happen?
AT: For better or worse, Silicon Valley has pretty common standards when it comes to term sheets. When I evaluate terms sheets for clients, it’s pretty easy for me to spot the red flags. What I typically look for are things like liquidation preference (1x non-participating), available option pool (8-10% post-Series A), board control (still founder controlled post-Series A), and the absence of founder reps & warranties.
Founder tip: The best thing you can do for yourself in the Series A process is to consult with an experienced attorney—one who has seen a lot of term sheets—and say, “Hey, does this pass the smell test?”
Q: What does liquidation preference mean and why is it important?
AT: Liquidation preference refers to the amount of money your investors get before your common shareholders (founders and employees) receive anything. As mentioned, 1x non-participating is pretty common in Silicon Valley and refers to how much of the investor’s original investment they get back before common takes anything. If it’s 1x, they get their initial investment back; if it’s 2x, they get double their investment, and so forth.
Think of a participating liquidation preference as double-dipping: The investors get their liquidation preference (say, 1x), and then share pro rata with common shareholders. Non-participating is far more standard and equates to downside protection: The investors get the greater of their liquidation preference or participate pro rata with common holders.
RH: A good example is to think about the importance of this from both sides. Let’s say you raise a $10 million-dollar round of funding, agree to a 1x liquidation preference, and end up with a $50 million post-money valuation.
If you were to turn around and then sell that company for only $30 million dollars, the investors just lost money on that deal. For them, it’s kind of saying, “I’m going to get my $10 million dollars back as an investor and if it’s huge, we sell it for hundreds of millions.”
On the founder side, think about it this way: Let’s just say you’re the same $50 million company and your investor has a 2x liquidation preference. The next few years didn’t work out as you hoped and you’re now only able to sell for $20 million. Well, all $20 million would go to your investor. As an entrepreneur, there would be no reason for you to sell that business, so you might as well not even try.
Founder tip: Liquidation preferences have long-term effects for both the entrepreneur and the investor. It’s important to understand the full scope of its implications to avoid tough spots in the future.
Q: When should entrepreneurs involve legal in the process—why does it matter if they wait until the end to consult with an attorney?
AT: Waiting until the end to involve legal can be disastrous for a founder. If you think about the reasons why people tend to wait, a lot of it comes down to running out of runway. If you are going out and raising money when you’re close to being out of money, then you might feel that you don’t want to involve an attorney until you have a sure thing.
This is largely because traditional law firms bill by the hour. If you send a term sheet, it’s going to rack up charges. If it’s not a sure thing, then you’re worried about these unnecessary costs. I will say—not to plug Atrium too much—that this is where Atrium’s pricing model can really put founder concerns at ease by allowing them to involve legal early and often.
It’s really beneficial to you and your fundraising efforts to get your attorney involved early on. First-time founders often have this feeling that they need to respond right away to the term sheet with no time to involve their lawyer. But there’s always time—and your lawyer will help you walk through the process and better strategize.
I recommend taking the college admissions approach to your term sheets and looking at them holistically. One term sheet might have a better valuation but provide the founders with less board control, while the other more board control for the founders, but a lower valuation. You need to take the time to sit down and weigh all of the terms with regards to what is important to you. You might take a lower valuation because you get to hold onto control of the company longer. That might be more valuable to you than a higher valuation.
Founder tip: At the end of the day, if a VC takes the time to send you a term sheet, they will take the time to walk through it with you. This helps you make the negotiations a better discussion around what you want your working relationship to be like with them. After all, when the negotiation is over, they become your closest business partner and you need to trust each other and get along.
To hear more term sheet insights, tips on how not to scare the money away, whether to sign or walk away and the steps after you’ve received your influx of cash, watch the full discussion with Aaron and Russ below.