How term sheets work

- When you accept investment, it's not quite as simple as trading a percentage of ownership for cash. Actually, there are quite a few terms that the entrepreneur and investor need to agree upon. All of these deal terms are detailed out in a term sheet, a non-binding agreement that lays out the specifics of an investment deal. Once you agree on a term sheet, a legal binding agreement is drafted to reflect those terms. There are two main concerns for an investor going into any term sheet negotiation: economics and control. Economics refers to the financial return an investor can earn on an investment. Remember that you and your investors generally want the same thing. You want the company to be successful and make you all a lot of money. But that doesn't always happen. So negotiating a term sheet, investors will use a few terms to protect themselves against things not going well. And control terms are mechanisms for investors to influence decisions on behalf of the company. I've included in the exercise files a Sample Series A term sheet from Ycombinator. Let's break down some of the most common economic and control terms that you'll see. The most common economic terms in a negotiation are valuation, liquidation preferences, employee options and vesting. Your valuation, often referred to in term sheets as price, defines how much of the company you're selling. Liquidation preferences determine how money is distributed to investors after a liquidation event. Typically, these liquidation preferences are designed to both allow investors to recoup as much of their investment as possible if a company is failing while also letting them participate in the upside of a successful sale. Employee options, or the option pool, is the amount of ownership made available to current and future employees of the company. Investors like to see that employees have incentive to work at a company long-term, but that employee ownership either comes from the pockets of the founder or the investors. And vesting refers to how ownership is earned over time. Even if the founders or employees have the potential to earn a percentage of ownership in the company, that ownership is typically granted over time to keep people at the company longterm. If an employee leaves before their ownership is fully vested, that potential ownership will return to the employee option pool. The most common control terms are the board of directors, protective provisions and conversion. The board of directors is the most powerful part of the company's management structure and typically has the ability to fire the CEO. They can be any size, but typically range from three to nine members, often including seats for the investors. Protective provisions give the investor the ability to veto certain actions the company may want to take. These include creating more stock, changing the size of the board, borrowing money, and even selling the company. Conversion refers to the investor's ability to convert their ownership from preferred stock to common stock. While the preferred stock that an investor purchases allows them to be the first paid in the event of a liquidation, common stock is typically where the greatest financial gains are earned. So when your company is successful, investors want the power to convert their preferred stock to common stock to earn as much as possible from the sale. There could be and are entire courses dedicated to understanding the nuances of term sheets. There are several other terms that we don't have the time to discuss here. They're all important and they're all open to negotiation. So it's up to you to consider what's most important to you while you determine what's most important to your investors too.