It’s a lot more fun to think about securing funding and the dollar, dollar, bills, yo, than it is to think about the fine print. $8 million in venture capital sounds a lot more significant than understanding a term sheet. Yet, the term sheet outlines how much investors are prepared to fund and their conditions for parting with money.
The bootstrapped entrepreneur finally on the verge of seeing a huge influx of money may be tempted to rush formalities and ask, “Where do I sign?” Future control of the company, however, depends upon making sure a few safeguards are in place. It pays to slow down and keep a cool head.
Negotiating the term sheet is part of the due-diligence process, not too mention, signing a term sheet too quickly might appear amateur. Best not forget that a stock purchase agreement is a legal contract. Once the ink is signed it becomes much more complicated for startups to control stock ownership. No entrepreneur wants to scare away an angel investor or begin the relationship on a hostile note, so it pays to remain professional, while still making sure some protections are in place before signing any agreement.
ROFR
Right of first refusal requires that investors wanting to sell shares first offer those shares to the company before offering them to third parties on the open market. This allows the company to maintain control over its capitalization table. This keeps the company’s destiny in its own hands to a degree, and prevents later disputes over how much of the company different parties own.
Drag Along Rights
Should such a time come when the company will be sold or merged, these rights establish a threshold for investor consent. Agreeing on the threshold early, means that when it comes time to make important decisions, there is a measure in place to prevent reluctant shareholders from blocking or undermining the majority. Once the threshold is crossed, dissenting investors must accept the majority’s decisions.
Before the Shares are Issued
In the heat of the moment of important decisions, people respond to pressure emotionally and it’s much harder to reach accord. If there’s an agreement before the first round of funding, chances are much better that everyone can find common ground. In times of crisis or opportunity, the foresight to craft a smart term sheet might determine the company’s fate.
If the Term Sheet Doesn’t Include Protections
Once the paperwork is signed, all may not be lost, but the discussions become more strategic than legal. Investors may balk at restrictions. It’s important to voice concerns in a respectful manner so that they don’t feel slighted or betrayed. Be forthright. In exchange for a belated agreement, you may need to offer to buy back shares or offer to issue additional stock.
Here are some other features to keep in mind before signing off on a term sheet:
- Pre-money valuation
- Liquidation preference
- Option Pool
- Milestone or tranche closing
- Price protection
- Board Composition
- Founder vesting
Don’t let the blessing of funding turn into a curse.
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