Term Sheets and Closing

A term sheet summarizes all of the terms of an investment. Most importantly it specifies the pre-money valuation of the company, the amount to be invested and the post-money valuation. For example, the pre-money valuation might be $900,000 with $100,000 invested for a post-money valuation of $1,000,000. This gives the investor 10% of the company.

The term sheet also specifies what types of control the investor will have over the company – for example, will the investor have a seat on the board or observer status at board meetings? The investor may also specify many areas of the business that it would like to oversee, such as the company’s budget, salaries, etc. The term sheet will usually have something to say about liquidation preferences and will often contain anti-dilution language.

Sometimes the term sheet might make specific demands on the company. For example, the term sheet might dictate that the company set aside 10% of its shares to give to employees as stock options.

Having traveled this far together through the process with the investor, you might expect that the term sheet would be a formality. However, many deals can fall apart here because the investor asks more than the company is willing to give. For example, the investors may specify a pre-money valuation that the company disagrees with. A lower pre-money valuation lets the investor secure a larger percentage of the company’s stock, so it is in the investors interest to push the valuation number down as much as possible. The company, on the other hand, has an incentive to push the valuation number as high as possible. This negotiation back and forth over the valuation can sometimes create so much acrimony that the deal can collapse.

You should always work with a lawyer experienced in investment when negotiating a term sheet. If nothing else, the lawyer will be able to tell you what is reasonable and what is not. You should also check your own feelings. If you feel like the investor is asking for too much control or too many concessions, it may tell you that this is not the right investor for your company.

This last point gets to the crux of the company/investor relationship. In the ideal relationship, your investor adds real value to your company and becomes a partner in your venture. In the entrepreneurial community, a good investor that adds real value is often referred to as smart money. Smart money helps your company to succeed in a variety of ways. For example

  • The smart money investor will be able to line up the next round of investment.
  • Smart money will also be able to bring new customers to the company.
  • Smart money will often be in contact with the CEO on a weekly or bi-weekly basis to keep track of milestones and help where possible. This monitoring process may be a part of the term sheet, or may be an unspoken agreement.

Given a choice, you definitely want to take smart money rather than dumb money.

Assuming that the management team and the investor can reach agreement on the terms, the term sheet will be signed, then the legal documents to execute the term sheet will be drawn up, and the legal documents will be signed. The company will receive the money from the investor either as a check or a wire transfer. These legal documents can be hundreds of pages long in some cases – you definitely want a lawyer on your team to review them. This whole process can cost $20,000 to $50,000 in legal fees, and paying for the legal fees often becomes part of the negotiations as a result.

At this point, what happens next depends on the relationship between the investor and the company. The investor may have set specific milestones and dates for completion. Typical milestones might revolve around sales goals, completion of software projects, revenue targets, etc. Money might be released in stages, or tranches, based on the successful completion of milestones.

One possible milestone is the next round of funding. In some cases investment is a one-time activity. But it is also common for a company to seek multiple rounds of funding. The first round of VC funding is referred to as Series A funding, the next round as Series B and so on. VC funding is preceded by seed round funding, usually provided by angels. If you have investors who are providing smart money, they will help you raise the next round.