The first round of investment from a venture capitalist or ‘angel investor’ is called a Series A round and that is defined by the terms included in the Series A Term Sheet. Each round of investing has its terms and definitions and this one defines the terms the first time an entrepreneur or small business seeks outside capital funding.
If you’re a small business owner or entrepreneur and have just been handed a Series A Term Sheet by a venture capitalist, whatever you do don’t sign it just yet. Many business founders have been dazzled by the numbers and signed a term sheet that was not in their favor simply because they missed a sneaky clause or discovered an term too late.
Here’s an important thing to note – term sheets are non-binding which means they are just a way of moving along the process of negotiation with some terms that open the basis for a discussion. A ‘term sheet’ is an expression of intent only and not to be construed as a binding agreement except for the ‘Exclusivity’ and ‘Confidentiality’ provisions contained within.
Terms Important to Founders Reviewing a Series A Term Sheet
A Series A term sheet for a private company round of funding can be as much as 4,000 words long, but that’s usually too much detail. What the founders need to focus on are the following terms:
1. Type of Shares and the Option Pool
The venture capital investor at this stage usually subscribes to a preferred class of shares. These shares enjoy rights that are not offered by ordinary shares held by the founders, employees, and others.
Distinguishing the rights is common practice because the investment is made at a specific point in time based on the company valuation and risk profile at that time.
2. Valuation and Milestones
This section outlines the agreed-upon company valuation prior to the new cash infusion. It’s used to determine the price per share to be paid by the investors. In many cases, investors do not wish to make the full investment upfront but instead invest in stages, called trenches, that are subject to specific milestones to be completed.
Failure to meet a milestone does not automatically mean the investors will bail on the deal, it just means potentially seeking different terms for those amounts.
Venture capitalists like to live life on the edge and the invest in early stage companies in order to realize the best possible return on their investment. This portion of the Series A term sheet outlines what investors want to do with the dividends they receive from the success of the company – either re-investing them or taking them as payment.
This section defines the liquidation preferences of the investors in the event the company is liquidated for some reason. Preferred shareholders typically receive a certain amount of the proceeds before other shareholders, but the structure of the liquidation preference is negotiated to reflect the risk inherent in each investment round. The higher the risk, the higher the required return.
5. Founder Shares
Founders, senior employees, management and others involved in building the company are central to the decision by the investors to plunk money down on an idea. Thus, investors are usually keen to ensure key players remain engaged with the idea, so this section outlines the terms for founder shares should they leave the company within a certain period of time.
There are many other terms including redemption, conversion, voting rights, anti-dilution, and other protections designed into most Series A term sheets for both founders and investors. It’s very important to work with an experienced lawyer who can explain the document in plain English and ensure that you understand what the terms mean before you sign.