Terms

Which key terms should you focus on first?

This chapter is not intended to introduce you to the intricacies of term sheets. There are far more knowledgeable and experienced people who have published very good books on the topic, including the one mentioned in the Homework chapter.

I am here, though, to share my experience with a number of critical terms you will be exposed to: valuation, share vesting and liquidation preference. The position of your investors on these terms will tell you whether they are committed to your venture and to you as founder(s), or simply looking for a quick return on investment.

Let’s start with valuation: if your lead investor accepts a valuation that does not dilute you as founders beyond the standard level of the raise you’re negotiating, it is a first sign that she or he has a genuine and long-term interest in your venture. Then, if their vesting clause lets you keep your vested shares in the event you decide to leave your company, she or he is genuinely interest in your well-being as a founder.

One other signal that your lead investor is not here to look for an early capital gain, is their stance in the event of a liquidation or a company sale. If they agree to a 1:1 ratio of their investment, you have the right investors on board. If they are looking to get twice their investment, it could be a sign that their primary driver is to exit as soon as the opportunity arises. Other control-related terms—such as drag-along rights, conversion, and protective provisions—will also reveal where your potential investors' true interests lie.

In 2017, we negotiated our first term sheet with the US-based hedge fund I mentioned in previous chapters. They were truly excited about our vision to create a new consumer model to purchase flights online and impressed by the work we had completed with a couple of hundred thousands euros. Their proposed term sheet reflected that enthusiasm with a very acceptable dilution for a solid seed raise (under 20%) and a 1:1 ratio in the event of a liquidation event.

Their vesting clause was more demanding on the founders since we would have had to sell our vested shares back to the company if any of us would want to leave the company. Not standard but fair given that the success of the venture depended on the long-term commitment of the founders. Interestingly, my original co-founder wanted to fight against this clause, giving me another clear signal that he wasn't fully committed to the venture.

The situation could have not been more different 18 months later. The terms pushed by the new investors were clearly intended to favor them in the event of an early exit or success. The founders dilution was out of line for a seed raise (over 40%). I won’t even go into details of the vesting and liquidation preference clauses we had to accept. Those will have any founders and respectable investors faint. However, we had no choice if we wanted to continue the journey.

Key Takeaway #17

When reviewing your first term sheet, focus on three critical elements: pre-money valuation, vesting, and liquidation preference clauses. Investor-friendly, standard terms that protect founders suggest you've found the right partner. If the terms are unfavorable, continue your search for a more aligned lead investor.