Raising Money

What to Look For in a VC Term Sheet

Written by James Garvin for Gaebler Ventures

If you've gotten to the point where you've been handed a term sheet from a potential venture capitalist or investor, congratulations, but the road doesn't end here. Term sheets over the years have gotten more and more complex and investors insert more terms that tilt the favor in their direction.

In its basic form a term sheet includes the terms under which the venture capitalists or group of investors will be investing into your venture.

This will include the amount of money that will be invested in return for a certain percentage of ownership of the company. The simplicity of term sheet ends there though.

Venture capitalists have moved toward favoring convertible debt as the investment vehicle of choice rather than simply taking equity in return for the lump sum payment. Convertible debt typically provides investors with a minimum dividend that is paid out by the corporation while offering investors the option, but not the requirement to convert the debt into a pre-fixed percentage of equity at a to be determined valuation at some point in the future (usually during the next round of financing). This essentially means that should your business do well in the future, we will convert our debt to equity.

An often confusing and potential deal breaking part of the term sheet are the pre and post money valuations. The pre-money valuation is what the investors value the business before they invest any money. The post-money valuation is the sum of the pre-money valuation plus the amount invested into the firm. As an example, if investors decided that your 3-person start-up had a pre-money valuation of $1million and they invested $2million, the post-money valuation would be $3 million.

Seems straight forward enough, but there are many contingencies to be aware of.

The option pool is the stock options that are expected to be granted in the future to reward and incentivize future employees. Most start-ups set aside about 15% of their total stock in the option pool to cover their expected future requirements. However, venture capitalists may include the option pool in the post-money valuation of your firm after their initial investment.

From our previous example, if the post-money valuation was $3 million, with $2million owned by the venture capitalists, they will add a 15% to the post-money valuation raising the total post-money valuation to $3.45 million. This additional post-money option pool usually dilutes the founders, while allowing venture capitalists to maintain their original equity percentage.

Other terms to look out for are pay-out requirements. Venture capitalists may require that they get paid out a minimum of their initial investment before the founders or any other investors get paid out. If investors invested $5 million into your company, but your company only got bought for $5.5MN, $5MN would be returned to the venture capitalists and only $500,000 returned to the rest of the shareholders.

Anti-dilution is also a common tactic used in term sheets to protect venture capital equity shares from being diluted in future financing rounds.

Raising venture capital can be a huge milestone for any entrepreneur, but getting to the term sheet is only half the battle. It is easy to be swept away in the emotion of closing your first round of funding, but don't give away the house in the term sheet. Stand your ground, understand the fine print, and make sure your interests are protected while still offering investors a sound opportunity to make a good return.

James Garvin began his education studying biotechnology. In recent years he has turned his interest in technology to helping two internet startup companies. The first business was an online personal financial network and the second was an e-marketing platform created to help entrepreneurs demo their web sites. Currently a student at University of California Davis, James is spending his summer incubating two new online businesses and writing about his entrepreneur experiences.