Q. What should I know about term sheets? I want to raise money from angel investors and venture funds for my cell phone and PDA user interface design business. Why are people telling me I need to hire a lawyer to develop a written offer of deal terms before approaching potential investors? Isn't it the investor's job to write up the final terms of a deal? Why can't I get straight answers on how to raise venture capital?
A. Not too long ago, a startup entrepreneur expressed the same sort of frustration you do today about the summary document of proposed deal terms called "term sheets." She said she felt like Alice in Wonderland as she tried to make sense of the venture world puzzles and personalities.
She complained that nothing ever seemed to be what it was! Still, she persevered and attracted $500,000 in venture funding for something that seemed equally illogical – a wine production business in the heart of Texas.
So how do you make sense of term sheets or "letters of intent?" Let's start with your first Alice-like absolute: Not all investors invest in the same way or for the same reasons. Yes, at some point they hand over a check in exchange for some ownership in a business, but how they go about making investment decisions and negotiating with entrepreneurs varies.
As an "early stage" company, it is likely you will solicit three different types of investors: (i) "friends and family" angel investors; (ii) highly experienced, individual investors or "angels", and (iii) well-organized venture funds.
Whereas friends and family investors tend to make angel investments as a gesture of personal support; angels and venture funds invest strictly for financial gain. Success to them is protecting their original capital and driving management to multiply their investment by 4 to 10 times.
In most cases, entrepreneurs don't need a term sheet for friends and family investors. These generous angels don't quibble over investment terms and just trust the entrepreneur to do the right thing. Money changes hands after the friend or family member signs the more formal subscription agreement, which absolutely should be drafted by a knowledgeable securities lawyer.
Unfortunately too many entrepreneurs take in friends and family money at a premium over the real going rate for startup capital. Entrepreneurs find out the sobering reality check when they start to solicit so called more "sophisticated" investors. These investors will use words like "unrealistic" or "over valued" to indicate that deal pricing is "too rich." What this really means is "too bad." They aren't going to invest at the price you've set.
Before investing too much of your money in preparing formal legal agreements with unworkable deal terms, I encourage all first-time entrepreneurs to first get a strong sense of the investor appetite for their business concept. Are investors interested in learning more? Test it out before committing to expensive legal documents and deal pricing. Be flexible, practical and collaborative. Most important, listen to the feedback you are receiving! Prepare your docs when you know you can sell the deal!
You are right; preparing a term sheet for early stage venture fund consideration is probably a waste of your time. Funds will issue a detailed term sheet after some amount of technical and market due diligence and the fund's partners are reasonably confident they will go forward with the investment.
For most young companies, receiving a term sheet from a respected venture fund is cause for celebration. It's quite an accomplishment. Every fund has its own statistics, but most fund managers issue say 10 term sheets for every 500 to 1,000 business plans reviewed.
What should you know about venture fund term sheets?
First, there is no one-size-fits-all venture fund term sheet. The reason is simple. Each company comes to the capital market with different risk factors, management teams, funding requirements and business objectives. A first round term sheet for a raw startup would be considerably less complex than a third round financing term sheet for a more established company with stock option plans and debt loan covenants.
Second, term sheets are not legally binding documents. Assuming there is no nasty hidden skeletons that emerge against a company or entrepreneur during due diligence, most reputable venture funds stand by their terms sheets. This means they won't re-negotiate the terms promised in the original term sheet. However, more opportunistic venture funds will aggressively negotiate deal terms to their best advantage right up until deal closing.
Third, and perhaps most important, first time entrepreneurs often get too hung up on what the investors say is the company's current worth. This is known as a company's "pre money" valuation. I say, pay equal attention to stock "liquidation preferences." This is where entrepreneurs can lose money big time.
Here's how it works. Most angels and venture funds insist on receiving preferred stock rather than the same common stock that founders own. They insist because this different class of stock gives investors several advantages over founders. The extent of these advantages is limited only to the creativity of the investors' attorneys.
Liquidation preferences come into play in the worst of times and the best of times. If a company does build up to a successful sale, then preferred shareholders get paid back in full before common shareholders before founders receive a penny. But here's the real kicker. Most venture fund term sheets will ask for a liquidation preference of 1 to 3 times their original investment. Ouch!
Investors can further beef up their position through annual dividends. Some term sheets forgive unpaid dividends while other term sheets stipulate that any unpaid dividends continue to add up or "cumulate" year after year until the company is sold. Again, founders have to wait in the wings until investors get their liquidation preference multiple plus all accumulated dividends.
Other provisions that can bite unsuspecting entrepreneurs in the butt ratchet back a founder's ownership position whenever key operating milestones are not met. Does this happen? Oh, yes! It's the payback to entrepreneurs who overstate their position and prospects to sophisticated investors.
My message here is not to scare entrepreneurs away from venture funds. Rather, my intent is to encourage entrepreneurs to do the math on an entire term sheet proposal. Sometimes it is better for entrepreneurs to accept a lower up front valuation and more lenient liquidation preferences and dividend terms, than a high valuation with lots of ways for investors to compensate for added investment risk.
Lastly, should entrepreneurs sign seemingly onerous term sheets if no other funding alternatives exist? I'd say this decision is easy. With money, entrepreneurs have the opportunity to live out their business building dream. Without it, they don't. The latter seems to be the more tragic sacrifice.
Do you need time-saving tips to help fund and grow your business? Ask Susan How! Write to small business funding expert Susan Schreter at susan@takecommand.org