Decoding a term sheet: Four important points for entrepreneurs
“Term sheets are incredibly complex legal documents, and basically if you boil it down, in my opinion, there are really only three or four key terms that matter when you’re in that negotiation with your venture syndicate,” says Brian Garrett, co-founder of seed-stage venture capital firm CrossCut Ventures.
The most important of those term-sheet topics, he says, is pre-money value, or the ratio of an investor’s ownership versus an entrepreneur’s ownership of a company. But another important factor that affects the ownership structure of a business is the size of the unallocated option pool – or the pile of stock that an entrepreneur uses to hire and retain rank employees.
Third in importance comes governance-related issues, including board structure and voting rights. When determining the structure of a board, an entrepreneur should consider an equal number of investors and company management plus one neutral third-party member, Garrett says.
Lastly, and most complex, is participating preferred, a term that refers to investors’ ability to generate extra returns in the case of sub-optimal outcomes. For example, if the entrepreneur sold the company for a low dollar value, an investor could get his original money out plus still participate in the pro rata ownership of the remaining proceeds.
“You want to just be cognizant of not accepting terms that are onerous to you as the entrepreneur and aim for what I call the market standard…right now it tends to be a 1X participating preferred with a cap, and that is the common middle ground that investors and entrepreneurs seem to accept,” Garrett says.
Everything else on a term sheet is necessary legal jargon, he adds, but isn’t going to significantly affect the outcome of ownership of the company.
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