Here's What it Takes to Successfully Organize Your Term Sheets | Cooley LLP Partner, Sally Kay J.D.

So what I've given you is examples of 2 different term sheets. One for a seed financing and one for a Series A financing. What you call things is irrelevant. You can call it Series Purple. You can call it Series 9. It doesn't matter what you call it. The names are somewhat irrelevant. But the thing I think generally people think seed, relatively low valuation. We don't know much about this company, so we're gonna come in. We're gonna ask for some terms. Not anything too terribly heavy-handed, but we're gonna ask for something. Series A, you've probably already done a Series Seed. The company's a little farther along. Higher valuation. They're gonna give you more money. They want more stuff in exchange for their money. All right? There are 2 websites here, seriesseed.com and then NVCA, the National Venture Capital Association. Both of those websites have form documents that many of us use now as a starting point for most of our deals. And I think probably 80% of the seed deals that I've done were using the Series Seed docs as the starting point. And so, in the term sheet that I gave you for seed financing, it actually says there as one of the terms, there'll be the docs from seriesseed.com with the exceptions being the things that are otherwise enumerated in the term sheet. So, it would be really good for you guys to take a look at those. The ones definitely on the NVCA form, they're annotated. So, there's a lot of explanations. There's lots of alternatives. You know, if you want this, pick this one. If you want this, pick that one. And it would be important to understand them and how they work. You and the investors are gonna have a conversation about various things. What the terms are. So, they're gonna give you $1 million, $2 million, $20 million. In exchange for that, you're gonna give them shares equal to some percentage of your company and all these other rights. In the negotiation of a term sheet, if not at any point prior in the existence of your company, do not sign a term sheet without talking to a lawyer. Do not sign a term sheet without talking to a lawyer. Why? Unless you really understand what it is that you're agreeing to. And nothing in the term sheet is generally binding except the no-shop provision at the end, which basically says if you sign my term sheet, you can't go talk to anybody else about money for a period of some number of days or weeks or months. And the confidentiality obligations. So, anything that you learn about the investor, anything the investor learns about you, that has to be kept confidential. The rest of the deal isn't binding. So, they don't have to invest. This is this term sheet where we've all agreed to these terms subject to completion of a bunch of stuff, right? They're gonna do diligence to make sure that what they think they're buying is really what they're buying. They're gonna check you out. Sometimes at some point they may actually do a background check on you. So, don't be surprised by that. For some investors that is pretty standard. But it really is just mostly an outline of what your financing documents are gonna contain. Like I said, what is the security? Series C, Series A, Series 42, generally preferred stock. What's the price? Whether or not they're gonna put somebody on the board, insist to put somebody on your board. Whether they're gonna put any additional restrictions on your founder stock, registration rights, whole series of things. Exclusivity, which I said was binding. No shop. Usually 4 to 6 weeks, 'cause you can usually get a financing closed in 4 to 6 weeks. If it takes longer than that, you start getting nervous that you're gonna lose the money, that these guys are gonna go find something else to do. So, you wanna try and be somewhat expeditious. The big things that you talk about, the most important issues in a term sheet, valuation, dilution, right? So, you today, You and your co-founders own 100%, right? 3 of you, right? 33% apiece, right? You own 100%. Somebody wants to give you $1 million. You guys, do any of you guys watch Shark Tank? OK, so Shark Tank, right? Same thing, right? I'm looking for $750,000 for 4% of my company. God, those people are so stupid. It is amazing to me. It's like, at least come up with something realistic, right? So they're going to make a valuation. They're gonna give you so much money, and that backs you back into how much of your company do they think they're buying for that amount of money. Right? Heavily negotiated. Heavily negotiated. Most importantly, invested. The other piece that falls into this, and we don't have a huge amount of time to talk about this today, is this concept of the option pool. Right? So they say, okay, well, pre-money valuation of the company, eh, $2 million. We're gonna put in $1 million. We want 50%. Or we want a third. So, you have $2 million pre. We're gonna put in $1 million. $3 million post. They own a third, right? But they're also gonna say, but we also want you to have a 20% option pool available to grant to future employees. Generally, they make you treat that as though it is outstanding, those option pool shares. before their money comes in. Which means you as the founders take the dilution from those additional shares, but they don't. Right? So, it's a little complicated and I don't have a lot of time to go through it today. But it's something that you should understand. The other things that are really, really importantly negotiated. We'll go through these in a little bit more detail. Liquidation preference. Who gets their money back first if you sell the company? Board structure. How many people are gonna be on the board and who are those people gonna be? Protective provisions. The things that they get a vote on. They basically have a blocking right. They have to vote in favor of something for it to happen. Founder vesting, which we talked about before. And then anti-dilution protection. How are they gonna try and protect their percentage in the company so that you can't do something to dilute them without their consent? So the option pool, like I talked about, I'll just show you here in— oh, we're running out of power, huh? No, we're good. OK. So say we have a company. The pre-money valuation— you get a term sheet. Pre-money valuation is $4.5 million. And they're going to make a $1.5 million investment. And you currently have about 5% shares available to make grants to employees. This is a little hard to see, but in the first, assume that they're not gonna make you put any more shares in your option pool. 5% is enough, right? So, founders have $10 million. You've got 5% available in the option pool. Series A comes in and at the end of the day they get their 25%. The founders drop from 100% to 74%, fully diluted. And then you've got an option pool of like 3.8%. So, So, no increase to the option pool, right? So, the founders go here from 100% or 95% fully diluted to 71% or 74% fully diluted. Or vice versa. Now, if they come in instead and say, well, we want a 15% option pool post-money so that that's available, look what happens to the founder stock. Where the founders had 95% fully diluted, they now only have 70%. 70%. 60% post. But the VCs still have 25% because they're not suffering any of the dilution from that. So you will generally be unsuccessful in convincing them that you don't need to increase your option pool or that you should increase your option pool after the financing so you all experience the same dilution from those shares. So the thing that you want to try and do is limit the percentage that they think that you need to have after the financing. That requires some very careful explanation to them. Because they're gonna say 15 to 20% standard. Everybody does 15 to 20%. You need to be really thoughtful about after I take in this money and my financing closes, who do I need to hire? How many key hires do I need to make in the next 12 to 18 months? And how much equity do I think I'm gonna have to give to those people? Because if your company, if you don't think you need to hire anybody that's kind of high-level executive that you think you need to give a substantial equity stake to, Maybe you don't really need 15%. But the lower you can keep that post-money option pool number, the less dilution you as the founders are gonna take in the financing. Does that make sense? Yeah. Okay. It's math, which is also not my favorite subject, but it does affect. You probably will not have any success in getting them to not increase your option pool unless it's already pretty reasonable. We just talked about that one. So, all of these, most of the terms that you're gonna negotiate end up in your certificate of incorporation. Some of them are gonna end up in some other documents. But let's talk about liquidation preference 'cause this one's important. So, if you sell the company today, you and your co-founders own 100% of your stock. So, if you own a third, a third, a third, and you sell the company for $9 million, you each get $3 million, right? Pretty simple. Once you take investment, most, most all investors that are purchasing preferred stock, they require a liquidation preference. And, and the preference part means that before any money goes to the common holders, we get some amount of money first, right? At a Series Seed stage, it's generally they just want their money back. So, 1x, 1 times whatever their investment is. So, in my prior example, $1.5 million of investment, right? So, if you sell the company for $7 million, well, say you sell the company for $4 million, they get the first $1.5 million and then the remainder gets distributed among the common stockholders, right? If the valuation were $20 million, I mean, if the Sale price was $20 million. They don't want their stupid $1.5 million back. They want more. So, they would convert their stock to common. And then the preferred and the common would all share together, divide up that $20 million. So, they would be situated identically to the common holders, right? You all share in it together. Some investors, usually not at the Series Seed, but as you become more mature, you do a Series A or Series B. That liquidation preference number goes up. So it may be 1.5 times their original investment. It may be 2 times their original investment. Maybe 3 times their original investment. And that money comes right off the top before any other money is distributed within— to the common holders. In addition to preference, there's this other thing called participation. And what participation says is that after we get our preference, We also get to participate in the distribution of the rest of the money. So, if they have a 1x liquidation preference and then they get to participate up to 2x more, that means that the first $1.5 million goes to them and then any other remaining money gets distributed pro rata to the common and preferred together until the preferred holders reach a cap. 2 more x, so another $3 million. So, participating preferred really brings down the money that gets spread to the common. So, that's why liquidation preference is really important. Because in a sale of the company scenario, they may be taking a lot of money in preference ahead of you getting paid any money. And then if they're also participating, they're continuing to share.