You've just received your first venture capital term sheet. Congratulationsyou've earned it. Now what does it all mean? "Pre-money valuation," "liquidation preference," "pro-rata participation rights"? A seasoned venture capitalist (in this post, a VC or investor) has seen and invoked these concepts hundreds, if not thousands, of times. You? Maybe not so much. But this post can help: it aims to prepare you for a few of the most important terms you'll encounter in almost every term sheet.
The first step in understanding any term sheet is understanding its purpose. And, although term sheets can take many formsfrom summarizing the principal terms of a proposed merger to setting out a joint venture's product development timelinegood term sheets are meant to accomplish a few simple objectives, namely to:
Focus Negotiations, Provide High Level Agreement/Understanding and Increase Deal Certainty. A term sheet focuses the parties by putting the framework for a transaction and its most essential terms on paper. This allows the parties to identify key issues on which there is (and isn't yet) agreement and determine if a deal is more likely than not to happen. If the parties think a deal will happen, they'll be more amenable to taking the next step and committing additional time and effort to the transaction. When reviewing and negotiating a term sheet, it's important to keep these objectives in mind. For instance, a term sheet should not set out every detail regarding the company's relationship with its investors. There will be definitive agreements for that. At the term sheet stage, you and your investors should be able to understand the key terms and conditions of the investment. If you are all on the same page, then go forward together. If not, move on.
Down to Brass Terms
So what should be included in the term sheet and not deferred to the definitive documentation?
For one, the company's valuation, which sets a baseline for future financings and, together with the amount of the VCs' investment, determines how much of the company you and your co-founders will continue to own. When evaluating offers, it's important to remember that a higher valuation doesn't always equate with a better offer. Though a full explanation as to why is beyond the scope of this post, an inflated valuation can, for instance, lead to a later down round if results fail to meet expectations. Many unicorns, as Bill Gurley cautions, have faced, and others may...