Learning that investors are interested in your company is one of the most important milestones for a startup. There’s finally someone out there who sees what you see: a promising upstart brimming with potential. But in the midst of this exciting time, you have to ensure that you understand the terms that the investor is proposing – whether it’s an angel investor or VC. And the best way to do that is by looking at the term sheets.
The term sheet is a document that outlines the terms by which an investor will make a financial investment in a company. They are generally non-binding, acting similar to a letter of intent.
Term sheets tend to consist of three sections: funding, corporate governance, and liquidation. We’ll start by breaking down the fine points of each.
The Interest Rate: In terms of funding, investment rates often range from 2.5% to 9% and the payment of interest is almost always deferred until the note matures or is converted.
The Time to Maturity of the Note: The time it takes for a note to mature may range from about 18 months to about five years. For investors, the longer it takes a note to mature, the better. This is because it allows a note holder a longer period of time to monitor how the company is progressing.
The Value (Cap or Pre-money): Startups and investors must come to an agreement when converting a note into stock of the company.
The Discount: The discount from the Cap Value if there is a qualified financing. This often ranges from 0% to 25%.
Optional conversion into stock: Some notes may have this term and others may not. A non-qualified financing option may be used if there has been an equity financing that does not count as certified financing. If the note holder is given this option, then the discount is usually the same, as with a qualified financing. With such a provision, the note holder has the right to convert into the same class of stock (common or preferred) as was issued to the new investors in the non-qualified financing.
“Change of ownership” provisions: A regime change is always a difficult hurdle to overcome. When regarding your term sheet, it is important that you understand what will happen if the company goes through a change of ownership as well as what criteria must be met to qualify as a change in ownership. This makes sure that both founders and investors know the exact terms that must be met to trigger the provisions in the Note that are dependent on a change in ownership. Some of those provisions may be beneficial to the note holder. Some may be adverse. The Note should make clear what the note holder will be allowed or required to do when the situation occurs.
Note maturation with no qualified financing, no optional non-qualified financing and no change of ownership: If this happens, the terms should allow the note holder the right to (i) convert the note into common stock (usually at a discount of 15%-25% from the Cap Value; but sometimes at the full Cap Value), or (ii) the note holder may be repaid the amount owed on the note in cash.
Option to convert at the Cap Value per share (if non-priced round): This affords the note holder protection in case the company is doing well with a value above the Cap Value but the company hasn’t had:
- a qualified financing
- a non-qualified financing
- a “change of control”
Avoid deals that would otherwise allow the note holder to convert at a value per share below the current value. This protects against the company deliberately avoiding the three examples listed above; financing itself from positive cash flow or conventional loans, and waiting for the convertible notes to mature so the company may pay off the note holder in cash rather than stock. The right to convert into common stock at any time at the Cap Value protects the note holder.
Now you have a basic overview of how term sheets work and how to handle a variety of situations should those terms change.