Welcome to the 37th episode of Deep Tech Catalyst, the channel by
where science meets venture!Today, I'm excited to host Samantha Huang, Principal at BMW i Ventures!
In our chat we deep dive into the mechanics of term sheets, crucial for any startup founder looking to understand investment dynamics.
Key Themes Covered:
📝 What is a Term Sheet and Why is it so Important for Deep Tech Founders?
🔠 Term Sheet Vocabulary
🎯 Decoding the Path to Get a Term Sheet
🍰 Governance Basics
⛔️ Control Rights in Practice
🎧 Prefer to Listen?
Before diving into it, an important disclaimer:
This content is provided solely for educational and informational purposes and should not be interpreted as financial or legal advice. Given the complexity and potential impact of these terms, it is crucial to consult with an attorney. Legal expertise is invaluable in navigating these technical aspects and ensuring that the terms are in your best interests before finalizing any agreements.
KEY INSIGHTS FROM THE EPISODE
📝 What is a Term Sheet and Why is it so Important for Deep Tech Founders?
A term sheet is a non-binding agreement issued by a lead investor during ongoing financing by a startup founder.
It applies not only to Deep Tech founders but to all founders seeking to raise capital.
Since it is non-binding, it outlines the key terms (valuation, amount raised, employee stock ownership plan (ESOP) pool, etc.) that founders should be aware of.
It is important for founders to negotiate the terms outlined in a term sheet because what follows are the final legal financing documents. These documents embody the spirit of the term sheet and govern the control and operations of the startup post-financing.
Therefore, receiving a term sheet is a critical and positive indicator—it means that your startup is performing well and is considered worthy of investment.
🔠 Term Sheet Vocabulary
Before actually accepting a term sheet, you have to run the numbers on your cap table and determine your ownership.
To recap, if the investor is interested, they may issue a term sheet.
This document is crucial as it outlines preliminary agreements before the final legal completion of the investment.
Before engaging with a term sheet, founders need to understand certain legal terms and what they imply. Key terms that a founder must be familiar with include:
Valuation: This is the price or worth of the company as determined by the investor. It reflects how much the company is valued, which can significantly affect the founder's ownership percentage and the company's equity structure.
Amount Raised: This refers to the total capital the founder is seeking to raise.
ESOP Pool: The Employee Stock Ownership Plan (ESOP) pool is especially critical. It determines the potential expansion of employee stock options during ongoing financing. Founders must pay particular attention to this as it affects their control and the company's equity dilution.
Dilution & Cap Table
However, investors can introduce certain mechanisms that may lead to further dilution of the company’s shares, particularly if expansions to the employee stock option pool (ESOP) occur before or after financing.
A couple of other terms that are important to highlight include:
Liquidation Preference: This term defines the amount of capital that an investor is essentially guaranteed to receive when the company exits.
Participation Rights: It’s crucial to understand whether the preferred stock issued in a given round is participating or non-participating.
Seniority versus Pari Passu: Growth stage investors may prefer seniority, meaning they get paid out first in the event of a liquidation, ahead of other preferred and common shareholders.
SEE ALSO:
🎯 Decoding the Path to Get a Term Sheet
The process typically begins with the founder pitching their startup to venture capitalists. If the VC is interested, they will issue a term sheet.
This term sheet distills many of the major terms we've previously described.
Usually, there is a negotiation period focused on these key terms because they set the framework for the subsequent financing documents.
Once the term sheet is signed, there is generally a 30 to 45-day period allocated to finalize the legal financing process. This timeline is often outlined in the term sheet itself. During this period, attorneys are actively involved, working to translate the terms of the term sheet into the final legal financing documents.
At the end of the financing phase, typically 30 to 45 days after the term sheet is received, the capital is transferred to the startup's bank account.
For those seeking what is standard for founders, you might consider downloading a sample term sheet from the National Venture Capital Association (NVCA).
Additionally, it's important to understand any blocking rights the investor might have regarding future rounds or major corporate decisions, and whether they will take a board seat.
🍰 Governance Basics
When financing occurs, the theoretical goal is always to balance the interests of the common shareholders, who are typically the founders and employees, with those of the preferred stockholders, represented by the investors.
The investors hold preferred stock because it carries additional rights.
There are 2 main ways an investor might exercise control over a company.
The first is at the shareholder level, where control is exerted through protective provisions included in the legal financing documents. These provisions typically require that for certain corporate actions, an affirmative vote from a preferred stockholder, sometimes a majority of a specific preferred share class (like the majority of Series B shareholders), is necessary to proceed with those corporate actions.
For instance, if a corporation wants to take on $10 million in debt, it likely needs approval through a board vote or by ensuring it has the requisite shareholder votes as stipulated by the protective provisions.
The second method an investor might exercise control is at the board level. Often, when a term sheet is offered by a lead investor, that investor will assume a board seat. For significant corporate actions, the majority of the board usually needs to approve. However, preferred stockholders, particularly the investors, sometimes have veto rights over certain corporate actions. This grants the preferred shareholders or investors, significant influence within the company, allowing them to exercise more power than a typical common or preferred shareholder without such veto rights.
⛔️ Control Rights in Practice
When things go right, usually, the investors do not exercise their veto rights or utilize blocking rights through protective provisions or at the board level.
Governance and control rights become particularly significant when there is a disagreement on the company's direction between the investor and the founder.
For example, there are situations where founders want to sell a significant portion of their shares, which diminishes their ownership stake.
Investors may become concerned because it could indicate that the founder might become less invested in the company's future.
Typically, such actions can be blocked by shareholders or at the board level, as investors prefer founders to maintain substantial equity in the company to ensure their ongoing commitment.
In practice, running companies involve inherent conflicts due to differing opinions. It’s important to note that disagreements aren't inherently negative.
The purpose of protective and control provisions is to balance interests among shareholders, investors, and founders to ensure alignment.
The overarching goal is to set up the corporation for success, which is the primary concern of both investors and founders.
BEFORE YOU GO…FUNDRAISING IN PROGRESS? 🤔
We’re rolling out a new beta feature to support Deep Tech startups actively seeking funding! If your startup or one in your portfolio is currently in an open funding round, drop us a line: info@thescenarionist.org
