8 Important Term Sheet Items to Evaluate Before Investing in a Start-up

Bill Clark is the CEO of MicroAngel Capital Partners, a venture firm that gives more investors access to alternative investments. He also gives investors the ability to invest in startups online through crowdfunding. You can follow him on Twitter @austinbillc.

After you've done your due diligence and finally start investing in startups, you'll have to review the term sheet.

If you're lucky, you will be working from a standard term sheet like the one that Y Combinatorpublishes on its website. Not only does this help keep the legal costs down, but you could instead be looking at an 8 to 10 page document so complex that only your lawyer would understand it.

Let’s review the most important items on a term sheet and what they mean so that you are better prepared for any legal issues that may arise.

1. Valuation

It is common to see the valuation of the startup as a “pre-money” valuation. That gives the value of the company before the investors in the round participate. Investing pre-money versus post-money can make a big difference in your equity stake.

Let’s say you are going to invest $1 million in a startup and the pre-money valuation is $10 million. If you invest pre-money, the new valuation of the company is $11 million and your equity would be 9.1%. If you invest at $10 million post-money, the valuation is $10 million after your investment and your equity is 10%.

A .9% difference might not seem like a lot, but if it was an investment in LinkedIn, which was justvalued at $8.9 billion, a small percent of equity can equal big money.

2. Liquidation Preference

This is what is used to determine how the money is shared once the liquidity event happens. The preferred shares might have a liquidation preference of 1x the common shares. That means that when the company is sold, the preferred shares will be paid first and then the common.

Let’s look at two scenarios to see the difference between a company with liquidation preference versus one without.

·         Scenario 1: The startup has $10 million invested in common stock and none have liquidation preference. If it's sold for $5 million, all shares lose 50% and are paid back equally.

·         Scenario 2: The startup has $10 million invested, but $8 million is common stock and $2 million is preferred shares with 1x liquidation preference. If the startup is sold for $5 million, the preferred shareholders will get back their original investment of $2 million and the remaining $3 million will be distributed to the common stockholders. The common shares would lose a value of 63%.

You can see that having liquidation preference is important, and would have saved you 13% of the loss amount. It is also important to look at liquidation preference multiples which are not as common as they were in the late '90s. A 2x liquidation preference means you will double your investment before the remaining shareholders see any return.

3. Type of Shares Offered

You will want to understand the type of shares you are getting in order to know how best to manage them. Will you get common shares with voting rights, and is your vote weighted equally among other shareholders and founder stocks? You could also be getting preferred shares, which typically don’t have voting rights.

Those preferred shares could have an option to convert to common shares, which would lead to voting rights (but more risk). Weigh these options against what you're hoping to get out of your investment.

4. Pro Rata Rights

This determines if you have the right to participate in future investment rounds. Make sure you have the ability to invest in future rounds, even if you don’t intend to. You always want to have the option. You are taking a lot of the risk in the early rounds, so it is only fair to have the right to continue to participate. It also allows you to make sure your investment is not diluted with each additional investment.

5. Options Pool

These are shares which are set aside and will be issued to new employees, advisors and others during the current investment round. Having available stock for this purpose is important because it is needed to bring in new talent. This pool is typically part of the pre-money valuation of the business. You need to understand the option pool because it can dilute pre-money shares. Also, if the pool is not large enough, it might not attract good talent to the company. The startup’s plan for option pool shares should be based on their hiring plan. 7-10% is a good range.

6. Founder Vesting

The vesting period for founder shares should be three to four years. You don’t want to have all the shares issued immediately and then have the founder walk away with a huge part of the company. There may also be an accelerated vesting section based on change of control. This is OK, because it protects the founders if the company is acquired. Check to make sure how founders’ shares are going to be managed before you sign.

7. Anti Dilution

This is an important provision because it can protect your investment if the startup raises an additional round of funding at a lower valuation than your previous round.

There are a few forms of it that Brad Feld does a great job discussing on his blog. The basic premise is that if a new round is raised at a lower valuation, your previous round’s price gets reduced to the current round's valuation, which will give you more shares.

8. Information Rights

One of the reasons it is riskier to invest in private companies is that you don’t have access to a lot of recorded public financial data. Public companies report and publish quarterly results, while private companies are not required to do so. It is critical that the term sheet outline some provision for reporting on financials to shareholders.

Typical startup term sheets state how unaudited quarterly statements are communicated. It should give you enough information so that you can track your investment over time and make sure the company is healthy.

I hope this list helps you understand what you should be looking for when reviewing a term sheet. You should not only conduct your own thorough review, but have a securities attorney look over the term sheet to get the full picture prior to any investment.