Fundraising Terms: Introducing the Term Sheet & Valuation

Keeping your company capitalised is one of your most essential jobs as a founder. This requires that you raise outside capital, mostly equity capital, multiple times to help get your business to key milestones, profitability, and an outsized return for all your hard work over the years.

Most of us lead companies that, so far, have only had to raise using SAFEs (Simple Agreement for Future Equity). Soon, you will need to begin to raise priced rounds, which would require familiarity with other fundraising terms and documents. Understanding them helps negotiations move faster and saves time and money.

To help you prepare for this, over the next few months, we will discuss key fundraising terms commonly found in the Term Sheet, their meanings, implications, and how to manage negotiations.

Today, we will kick off with a brief overview of the Term Sheet, and the first term in it — Valuation.

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What is a Term Sheet?

A term sheet is a non-binding agreement that shows the basic terms and conditions of an investment. The term sheet serves as a template and basis for more detailed, legally binding documents. Once the parties involved reach an agreement on the details laid out in the term sheet, a binding agreement or contract that conforms to the term sheet details is drawn up.

The term sheet is critical. It lays the groundwork for ensuring that you and the investor agree on most major aspects, which reduces the likelihood of a misunderstanding or unnecessary dispute. What’s in the Term Sheet usually determines the final deal structure. Don’t think of it as a letter of intent; think of it as a blueprint for your future relationship with your investor.

In general, there are two main things that VCs really care about when negotiating using a term sheet: Economics and Control.

Economics refers to the return the investors will ultimately get in a liquidity event, usually either a sale of the company, a wind-down, or an initial public offering and the terms that have a direct impact on this return.

Control refers to the mechanisms that allow the investors either to affirmatively exercise control over the business or veto certain decisions the company can make.

Economics and control are important things to pay attention to, in and of themselves. They rule the day. An inexperienced VC will harp on other terms needlessly. You can give in to them or not, but the mere fact that a VC focuses on irrelevant terms is a sign of what that VC will be like to work with as an owner, board member, and compensation committee member.

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Valuation and Price

Let’s with the economic terms of the term sheet by diving headfirst into the thrilling world of Valuation and Price—two key factors that can make or break your funding journey. So, buckle up, and let's explore the financial wonders that lie ahead!

Valuation is like the ultimate "how much" game. It determines how much of your precious company you're selling and, of course, how much dilution you'll be facing in the process. Plus, it also determines the price per share at which you sell your stock. So, it's kind of a big deal 😉.

Now, there are two fancy ways to discuss valuation: pre-money and post-money. Pre-money valuation is the fancy way of saying, "Hey, investor, how much do you think our company is worth right now?" It's like a snapshot of your worth before the investment magic happens. On the other hand, post-money valuation is simply pre-money valuation plus the contemplated aggregate investment amount. It's like adding a dash of investor confidence to the mix! 

Traditionally, the way price is represented in a term sheet follows

Price: $______ per share (the Original Purchase Price). The Original Purchase Price represents a fully diluted pre-money valuation of $______ million and a fully diluted post-money valuation of $______ million. 

For purposes of the above calculation and any other reference to fully diluted in this term sheet, fully diluted assumes the conversion of all outstanding preferred stock of the Company, the exercise of all authorized and currently existing stock options and warrants of the Company, and the increase of the Company’s existing option pool by [X] shares prior to this financing.

Sometimes, the amount of financing takes the spotlight, and the price follows along:

Amount of Financing: An aggregate of $X million, representing a ______% ownership position on a fully diluted basis, including shares reserved for any employee option pool. Prior to the Closing, the Company will reserve shares of its Common Stock so that ______% of its fully diluted capital stock following the issuance of its Series A Preferred is available for future issuances to directors, officers, employees, and consultants.

Keep in mind, modern term sheets like to keep things simple and sweet. So, they might just lay it out for you like this:

Pre-Money Valuation: $______________

The price per share of stock, also known as the purchase price, will often be expressed in vague terms. As long as the valuation and option pool are agreed to, then the dilution is determined and the price per share is largely irrelevant as they are a calculated number. Here is some sample language that you might see in a modern term sheet.

The per share price of the Preferred Stock (the “Purchase Price”) shall be calculated by dividing the Pre-Money Valuation set forth in the Summary of Terms by the fully diluted capitalization (including the Employee Pool) immediately prior to the closing.

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As you may have noticed, in all the examples shared above, there is a common expression we are yet to discuss—the (employee) option pool. Without the inclusion of the employee pool, the calculation of the price per share and dilution is straightforward. But with the pool comes a layer of calculation that you have to be mindful of as it can impact the valuation of your company, the price per share at the point of sale, and the dilution of your ownership as a founder. This will be the focus of our discourse in our next post. Stay tuned for that!

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References:

• Term Sheets: Definition, What's Included, Examples, and Key Terms — Investopedia
• Venture Deals by Brad Feld