Should You Have A Term Sheet Before Meeting An Investor?
Term sheet is the first document between an entrepreneur and an angel investor. You do not need to have it in your first meeting with angel investors. An angel investor term sheet highlights the terms and conditions for the investment. These non-binding documents are used to negotiate the terms before drawing up the final contract.
What Is The Purpose Of A Term Sheet?
An angel investor term sheet is a step towards gaining the required investment. All the terms and conditions of the investments must be clearly explained. Both the founders and investors should agree on the documents to be able to move towards the final contract.
This document will serve as the legal contract to which both parties must adhere to.
A good term sheet that addresses the interests of both parties is important. This gives them the opportunity to discuss and negotiate and be on the same page.
What Does The Angel Investor Term Sheet Include?
Depending on the nature of the investment, each angel investor term sheet differs from one another. But here are some areas that this document should include:
1. Valuation Of The Startup
Before the negotiation even begins, both parties should be aware of the value of the business. It is evidently difficult to come up with a value for a startup. But there are many methods to execute the valuation of a startup like the standard earnings multiple method, human capital plus market value method, 5x raise method, etc. You need to include pre-money and post-money valuations in an angel investor term sheet.
2. Liquidation Preferences
It is added for the safety of the investors with preferred stock. In a situation where your startup is failing, this aspect offers investors an opportunity to get some percentage of their money back. Generally, this preference stands at 1x the investment. If you agree to pay more than that, it would mean that the investor will get their invested money before the holders of common stock could get anything.
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3. Option Pools
An option pool refers to a block of stock that is reserved for employees. You may need to create an option pool on your angel investor term sheet. If you already have it, then there should be a provision to expand it. This will give the investors a clearer idea of how the stocks will be diluted in the future. But the pre-money option remains in favour of investors. In this, the founders have to take up all the future dilution. But in the case of post-money, future dilution would include investors.
4. Rights Of Participation
Participation rights benefit angel investors in two ways:
- They would get the return on the investment prior to any investors.
- They would also get a predetermined percentage of profit that is left at the end.
However, this is the stage where founders and investors don’t meet the eye to eye. Investors prefer participation right because of the higher returns. However, founders do not want to give participation rights at all. If the investors persist on the participation, then you can put a cap on the participation. This will limit the amount the investors will get in addition.
5. Investors Rights
There needs to be a section that highlights investor rights.. The right can be broad, so startups should get a lawyer’s consultation. It basically highlights certain actions that investors have the right over.
6. Board Of Directors
Initially, it may seem like an absurd idea to talk about the board of directors. But as a company grows, it becomes essential to determine the board of directors. Subsequently, an angel investor term sheet generally encompasses a section about the Board of Directors. The provision should encompass equal representation of founders and investors.
7. Dividends
Dividends are the distribution of profit among the shareholders of the company. Generally, companies offer a percentage of profit as a dividend that accrues with time. The company pays them either in cash or stock. You may offer an additional bonus for preferred stockholders. There are three types of dividends; cumulative, non-cumulative, and anti-dilution rights.
8. Ownership Of Share Classes
A company’s board makes big decisions, but some decisions are made from the votes of the shareholders. So an angel investor term sheet should have a section regarding the ownership percentage of share classes.
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9. Right Of Redemption
In this, investors have the right to ask for their investment back. If your company is a success, you won’t have an issue paying them back. Even if your company fails, there won’t be an issue. This is because nobody will be getting anything in this case. However, redemption rights can be an issue when your company is going through hard times.
10. Milestone Finance
After the initial financing comes another round of financing, depending on the milestone the company hits. If the company does not accomplish its milestones, investors may have the right to change the terms of the contract. You will only receive the next set of funding only upon achieving the set milestone in some cases.
11. Unfair Costs
Monitoring fees, board fees, etc., are some examples of fees you may have to bear. Investors charge you for their presence in a board meeting or monitoring investments. These are unfair fees that may upset future investors.
The Bottom Line
When both parties agree on the terms of the document, it is ready for the final signature. Moreover, it should also include the date when the agreement was finalized. Preparing an angel investor term sheet can be arduous, considering the kind of information that goes into it. You can reflect on a term sheet template to create a professional-looking term sheet. But you will have to ensure that all information is written in a clear manner. You need to take care of specific information like percentages, numbers, rights etc. A poorly created angel investor term sheet can pave the way for future conflicts with the investors. So make sure you protect your company and investors interests by being diligent while preparing the term sheet.