Zen And The Art Of The Term Sheet
Fine-Tuning Your Startup For Success
Zen and the Art of Motorcycle Maintenance by Robert M. Pirsig is a cultural icon in literature. Written in the past half-century, the book is about a summer motorcycle trip across America’s Northwest, undertaken by a father (narrator)and his young son. The narrator has an older motorcycle which he is usually able to diagnose and repair himself while most motorists choose not to learn how to repair the motorcycle instead of relying on professional mechanics to repair it.
The book, in my opinion, explores lessons learned from a philosophical and metaphysical approach towards honing your craft. The maintenance of the motorcycle blends the analytical and emotional process of problem-solving, something most successful founders understand. This is of the utmost importance especially when it comes to preparing your startup to be fundable and the often-times scary term sheet. In some respect, the term sheet can be as complex as repairing a motorcycle. Making a mistake, in either case, could be potentially fatal.
“Although motorcycle riding is romantic, motorcycle maintenance is purely classic.” — Robert M. Pirsig, Zen and the Art of Motorcycle Maintenance
A term sheet is a nonbinding agreement laying out the terms and conditions under which an investment will be made. The term sheet is essentially a template to develop more detailed legal documents. Once the parties (founder and investor) reach an agreement on what they’ll be respectively getting in return, a contract that conforms to the term sheet details is then drawn up.
The less complex a term sheet, much like a motorcycle operator manual, the more favorable the outcome will be when it comes to fine-tuning the vehicle. Term sheets can range between one to 10 pages depending on what round you’re raising. To best navigate through the language and to guarantee best practices is to familiarize yourself with templates that are readily available online at Angel Capital Association, National Venture Capital Association, The Art Of Startup Fundraising and Techstars to name a few.
It’s of your best interest to seek legal counsel when going through this process as the investor, in most cases, will be the one providing the term sheet. Listed in the order as they typically appear, common items in a term sheet include:
- Type Of Equity: Common stock, dilution, and preferred stock.
- Size Of Offering: Total amount being raised.
- Pre-Money Valuation: The valuation of a company prior to a round of investment.
- Post-Money Valuation: The valuation of a company immediately after the most recent round of financing.
- Price Per Share: Price of each share.
- Investors: The party (angel, VC, etc…) infusing capital in a startup.
- Discounts Or Warrants: Incentives to invest.
- Liquidation Preference: The payout order determining who gets how much when a company is liquidated, sold or goes bankrupt.
- Dividends: The payments designated by the Board of Directors to be distributed pro-rata among the shares outstanding.
- Voting rights: The common stockholders’ right to vote their stock in the affairs of the company. Preferred stock usually has the right to vote when preferred dividends are in default for a specified amount of time. The right to vote may be delegated by the stockholder to another person.
- Board Participation: An appointed or elected body or committee that has overall responsibility for the management of the startup.
- Employee Stock Options: A plan established whereby a certain number of shares is reserved for purchase and issuance to key employees. Such shares usually vest over a certain period of time to serve as an incentive for employees to build long-term value for the company.
- Antidilution Provisions: Protects an investor from equity dilution resulting from later issues of stock at a lower price than the investor originally paid.
- Founders Stock: Shares owned by a startup’s founders upon its establishment.
- Protective Provisions: Veto rights for investors on certain actions of the business.
- Drag-Along: A majority of shareholders’ rights, obligating shareholders whose shares are bound into the shareholders’ agreement to sell their shares into an offer the majority wishes to execute.
- Registration Rights: The right to require that a company register restricted shares. Demand Registered Rights enable the shareholder to request registration at any time, while Piggy-Back Registration Rights enable the shareholder to request that the company register his or her shares when the company files a registration statement (for a public offering with the SEC).
- Right Of First Offer: A minority-shareholder protection affording the right to include their shares in any sale of control and at the offered price.
- Investor’s Counsel: Who will pay legal expenses?
- Confidentiality: This term sheet is confidential to the parties and is for the use of the startup’s management and their advisors.
As witnessed in Pirsig’s best-selling book, maintenance is a very intimate practice requiring constant upkeep and care. However, there are hazards…if you’re not paying attention to maintenance then things can go wrong in a hurry. Beware of predatory investors. Look out for terms limiting future investment and financing that could potentially bankrupt you.
“If someone’s ungrateful and you tell him he’s ungrateful, okay, you’ve called him a name. You haven’t solved anything.” ― Robert M. Pirsig, Zen and the Art of Motorcycle Maintenance
Constantly run diagnostics in real time, troubleshoot before it becomes a major problem whether in this round of funding or the next. You are not just the motorcycle rider, you are the mechanic. This is the zen and the art of the term sheet.
For more information on terms and definitions, head to my previous posts on Cap Tables and Convertible Notes.
