📝How to read a term sheet - this can be the difference between a great deal…and a not so great deal!

Whether you are an investor or an entrepreneur, you need to know how to read a term sheet. This can make a massive difference in your financial outcomes. As current valuations are going upside down, this understanding is getting even more important now than in the past.

Valuation is the main number we tend to read about in the context of fundraising…however there is much more than meets the eye, for both entrepreneurs and investors.

The big challenge for angel investors is not having any visibility and very often no say in the terms agreed upon in subsequent rounds. So if an institutional investor requests terms that are detrimental to early-stage angel investors, the latter will most often only realize it at exit… when their financial returns are far from what they had been expecting based on straight marked-to-market valuation.

It is very important to make sure that entrepreneurs protect their early-stage investors in subsequent rounds.

Having a board representation of angel investors, or even an honest discussion with the founder when investing , will help to ensure that angels are protected from potential predatory institutional investors.

I have seen many times founders taking angel money and then, accept terms from institutional investors that were highly disadvantageous to the very people who took the most risk in investing early in their company. In many cases, founders might not have had the choice, but in other cases they could have push back or even accept terms that might have been less favorable to them but more fair to their angels.

Whether you are an investor or an entrepreneur, keep in mind this dynamic that can have great impacts on your financials (and reputation) — forewarned is forearmed!!

If you want to read more on the lessons I learnt as an investor, please check out “Top attributes I now ABSOLUTELY avoid when I invest 🛑”.

Below are some of the main terms to be on the lookout for in a term sheet, they fall under four main sections: 1) deal economics, 2) investor rights & protection, 3) governance management & control, 4) exits & liquidity.

📝 Valuation: pre-money valuation & post-money valuation.

📝 Type of stock: common & preferred.

📝 Liquidation preference

📝 Anti-dilution provisions

📝 Redemption Rights

📝 Right of First Refusal/Right of Co-Sale (Take-Me-Along)

📝Employee Stock Options

📝 Drag Along

Many other terms will be present in a term sheet, such as the amount raised, the price per share, the name of the investors, the capitalization, the board of directors, dividends, and so on. These terms usually are pretty straight forward and are unlikely to be the ones creating future challenges.

📝Valuation: Two types of valuation are usually present in a term sheet. Pre-money valuation and post-money valuation. Pre-money valuation represents the value of the company before investment. This is where the beginning of the fundraising negotiations usually focus on and where all the gazes converge. We got used to extremely high valuation in the tech space in recent years, sometimes (often?) completely disconnected from the underlying business economics. Today, as interest rates are getting higher and money tighter, we are seeing a cooling down in valuations for most tech companies implying future down rounds (meaning the latest round of investment will be made at a lower valuation than the previous round). As an investor (and early-stage founder as they tend to be significant investors), it means that your investments are taking a hit, sometimes a very significant hit. BlockFi is a great example of that with a valuation divided by 3 between their latest funding round ($1bn valuation in June 22) and their previous round in March 2021 (at $3bn valuation). Again, in private markets, valuation tends to be the main metric when assessing a company’s success. Which becomes an issue when there is a large disconnect between the valuation and the underlying economics. Post-money valuation is simply the pre-money valuation plus the investment (amount raised in that round).

📝 Type of stock: common & preferred. There are a few differences between common and preferred stock. Notably, preferred shareholders have priority over 1) a company’s income, 2) a company’s assets. So preferred shareholders will be paid dividends before common shareholders. Preferred shareholders will also be paid out before common shareholders in the event of an asset monetization. On the other hand, common stock will give shareholders voting rights. As you can see, there are significant impacts when shareholders are given preferred shares. This is a scenario I lived through when a company I invested in allocated preferred shares to subsequent investors. As I owned common shares, my equity was totally wiped out at liquidation, despite having been an early-stage investor taking the most risk in the company.

📝 Liquidation preference: As seen above, preferred stock has an embedded liquidity preference over common stock. Institutional investors may also add a liquidation clause requesting that they must be paid a certain multiple of their original investment before other equity investors are paid. This clause is also extremely detrimental to earlier investors who will be getting whatever is left to be paid, after all the institutional investors who added a liquidation clause are paid. As you can see, even when a company is a ‘“10 bagger”, an early investor who has been unprotected might end up with 2X her/his investment. Despite having been an early supporter of the business.

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