In Part 1 of this post, we focused primarily on the people aspect of deciding on a term Sheet. In Part 2, we’re going to look at the actual terms themselves, some of the issues they raise and how you should be thinking about them.
It’s easy to assume that the highest valuation is going to be the one that you should go with. But actually, it’s often not the right criterion to use. Taking outside investment means that you’ve already accepted the principle that owning less of your company should mean that you’ll get further, faster on your journey. You should apply that principle to the valuation question — it could be that working with the right partner will accelerate everything, so your share of an eventual exit will make you considerably more, even considering of the increase in dilution of this funding round.
It’s also worth thinking about the round strategically and in the context of future funding plans. If the valuation is too high, there is a possibility that the next round might have to be lower than the current one (a “down round”). Down rounds generally dilute the management before the investors suffer, so this is going to be more important for you to think about.
If you are comparing offers though, the fully diluted post money is the relevant comparable here. How does the founders’ fully diluted holding after the investment compare among offers on the table.
There’s an added complexity to the valuation question, as the highest valuation rarely seems to come from the best investors.
2. Cash runway
Generally, this investment should give you an 18 month runway to the next funding round. This is because it normally takes 12 months to prove enough to attract a new investor, bearing in mind that most startups find that everything takes longer than they thought and is also more expensive. It then takes 6 months to raise the money at the other end. It can be quicker, but plan for the worst.
You should also be thinking about that next round and what new investors would look for in the business at that point. Can this new investor help you think this through?
3. Devil in the Detail
There’s an old joke among investors. A founder tells a VC that he’s going to set the valuation of the round. The VC smilingly agrees, providing that she can set the terms.
OK, I didn’t say it was a funny joke. But the important point is that the terms can be crucial in determining the eventual outcome. As an example, it’s currently rumoured that if all the current crop of unicorns sold today at the value of the last funding round, the first investors/founders would get no return — in over 75% of cases.
The main points to watch out for are
Decision making rights (what can they veto?)
You should get familiar with these terms and get a great lawyer (not just a good one) to help you understand exactly what you’re getting into and the consequences of each one.
And remember, there’s no such thing as a stupid question, so ask away until you understand.
4. Board members
Gianni Agnelli of Fiat once said that Boards should always have an odd number of directors — and never more than two! While it’s unlikely that you’ll have that luxury, it is important that you think through who will be on your board.
In our experience, the best board size will be a relatively small number of people at this early stage — three or four is ideal. As you’ll be meeting frequently in the coming years, make sure you like and trust them.
5. Skin in the Game
Investors are keen to make sure that founders have enough incentive to need to make their startup succeed. However, it’s much rarer that the question is asked of the investor. How much skin in the game do they have in their fund? In other words, how much have they invested in the fund?
It’s very different if an investor needs you to succeed as much as you do, as opposed to doling out other people’s money and hoping all will be well.
When the funds finally arrive in your account, it’s rarely a case of celebration. Oddly enough, the overwhelming feeling is just relief — the grueling process of fundraising is over (for now), allowing you to get back to real work.
How relieved you feel may largely be determined by the time elapsing between signing a Term Sheet and final close. So it’s important that you take into account what needs to happen in terms of due diligence and documentation, at their end, before making your final decision.
While it may not sound important, it really is worth understanding what the investor might expect of you in the way of due diligence, reporting and their ongoing decision-making. Some funds can be surprisingly demanding and represent a significant drag coefficient on your need to get on with running your business.
8. Exclusivity and drop dead dates
Sometimes investors can be very aggressive around Term Sheets, insisting that you immediately agree not to talk to other potential investors and demanding a very quick decision.
This seems unreasonable to us, especially for first time entrepreneurs. Getting the right match of founders and investors is too important on both sides to be rushed and regretted later. Make sure you’re not pressured into a decision before you’re ready.
9. Fund Strategy
It’s worth getting a broad understanding of the strategy of the investor you’re considering. Their follow-on investment policy and allocation is probably the most crucial consideration, assuming you’re planning a future investment round.
Some investors charge startups for their participation in a funding round. This can take various forms ranging from Due Diligence and legal costs to monthly “monitoring” fees. Make sure that you understand what they’ll be charging for (if anything) and if you and other (non-charging) investors are comfortable with the proposal.
If you’re not, it’s worth pushing back and seeing if they can be negotiated down, or if they can be waived altogether.
That’s a quick tour of what we think are the most important issues to think about term sheets. We’d love to hear what others think, so please leave a comment if you have anything to add.