TERM SHEET TRICKS: Learn and apply for best practices

First time entrepreneurs can be taken advantage of by investors. And visa versa. So it is wise to learn a few of the sensitive tricks that are done with term sheets. I've seen these over the past two years in real deals.

• Liquidation Preferences. This is a bonus by formula given to investors when the company is sold or goes IPO. If you take the time and effort to calculate the cost to the startup (or bonus to the investor) you will find it can cost a startup as much as 10% of the company, in addition to the cost (percentage) of a round of financing. I have listened to the pros and cons on this feature but in general I do not like this feature in a deal. I think the investors should take the same risk as the employees. Equals in the fight to greatness.

• Cumulative Dividends. Investors get preferred stock that is entitled to a dividend. If not paid in cash (it never is) the investors get additional shares instead. This also adds to the percentage of the company that investors get. It is expensive. I have seen serial entrepreneurs give on this in exchange for no liquidation preferences (or a cap in the range of 1X to 3X). That is smarter and less expensive than pro-rata liquidation preferences.

• Stock Option Pool. The shares reserved for employees are limited by the deal. They are not shares outstanding (yet) but will be. Your goal is to reserve enough shares for the life of your company (about five years of employees). That is easier to do if you take time and effort to calculate the number and level of employees you will hire over five years. Too few first time entrepreneurs do their homework. Then the result is guessing and hoping that the percentage (15% to 20% of the company at seed round time) will be enough. That is weak planning of something so very important. And do not forget to reserve shares for your outside advisers and consultants and contractors. They are inevitable and will need shares in addition to employees.

• Size and Makeup of Board of Directors. The smaller the board the quicker decisions will be made. Thus a five man board is most common in the early years: 2 from management, 2 from investors and 1 independent that both management and investors agree on. If you want your choice to be the independent, you must put that into the term sheet. If not, you are at a stalemate when disagreeing (2 = 2). Also, avoid allowing unlimited board meeting visitor rights to investors who are not on the board of directors. They make life difficult without adding significant value to board meetings.

• Vetos. A long list of detailed items that investors can say "No" to is not good for managing a company. It leads to micromanagement and worse. Serial entrepreneurs limit the veto authority of investors to a small list of less than half a dozen specific items related to subsequent rounds of financing. The rest of the authority issues are dealt with as part of the company's bylaws and board meetings.

Those are basics you should be familiar with and fluent in discussing. If you are not, then get a great lawyer to explain them to you before you go look for money from anyone, angel or VC.

BOTTOM LINE: Beware of the terms in a term sheet. They can be very expensive if you do not understand how to calculate their cost. And they can make your life miserable if you lack comprehension in how they will impact your freedom to run the startup as you want to. When you get this straight and feel comfortable with it, you are ready to go get your money. You'll have a significant advantage negotiating in your favor. I wish you the very best.

Comments

[Michael Ostendorff]

John:

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