Term Sheet Clauses: A Necessary Evil

For an angel investor, there is little that is more exciting than putting a deal together, watching the company take-off and then enjoying a tidy profit from the venture. After all, this process is the exact reason most angels get started in this level of investing in the first place. The only problem is, the process is never as clean and smooth as it sounds.

As an angel investor bent on putting together that successful deal, you’ll find you can run into a lot of bumps in the road. When you fail to do some careful planning and strategic structuring of the deal, you may find yourself in a less than favorable position when things really get off the ground. Sure, you want to avoid complexity, but you also want to protect your interests. To do so, special attention should be paid to the term sheet.

The term sheet outlines the material terms and conditions of the business agreement between you and the entrepreneur and once it is executed, provides legal counsel with guidance in the preparation of the proposed final agreement. Sure, it is boring paperwork, but is a “must” in every investment deal. And, keep in mind that the term sheet is not the final agreement, but instead outlines what you expect out of the final deal.

While you may have some of your own ideas of what the venture should produce and your involvement in it, there are key points that should be articulated in the first term sheet. This not only helps to protect your interest, it also communicates to the entrepreneur your expectations so there are no surprises later.

According to Auren Hoffman, CEO of RapLeaf and co-founder of BrightRoll and AdRocket, the most important term sheet clause is the one relating to legal fees. For Hoffman, this advice is aimed at entrepreneurs as a way to protect their vision and maintain costs. For angels, understanding what to insist on and what is negotiable is important in making the deal work. Give some wiggle room in the area of legal fees as it can lead to a cleaner process. [1]

CEO and Founder of Startup Professionals, Inc., Martin Zwilling offers his own set of advice for angels when it comes to drafting the term sheet. While every term sheet is likely to be different as every angel has his or her own opinions on what should be outlined in the document, there are some key points that should take priority each and every time.

• Price – Calculated as “investment/post-money valuation”, the price is the percentage of ownership given to the investor. Pre-money valuation is the value of the company today. Post-money valuation is the pre-money valuation plus the amount invested.
• Board – Whether you have ten angels or just one investing in this startup, a seat on the board needs to be reserved for you or a representative of your company.
• Define Equity – You must specify whether you will accept common equity or if you will demand preferred convertible shares. Common equity is typical in first round investing, but if you expect more, that must be clarified.
• Tranches – In an effort to reduce the investment risk, many investors will provide money in stages or tranches based on defined milestones. This puts more pressure on company founders to perform and you keep your money longer.
• Anti-Dilution Protection – This clause can be vital in protecting your investment as it maintains the conversion price of stock, keeping it from being reduced to a price equal to the price per share paid in a later down round.
• Right of First Refusal – To keep a tighter grasp on those investing in the company, you may want the right to purchase shares held by other angels in the deal before they are sold to an outside party. This clause will allow you to consolidate ownership.
• Liquidation Preferences – This clause should always be present to prevent the entrepreneur from selling early at a loss to the investor. The term communicates that the angel wants the option to get his investment back or negotiate ownership, whichever is more. [2]

As an angel, you can enjoy the flexibility and low-pressure structures that generally accompany your startup investments, but don’t be so laid back that you fail to protect your interests. Practice due diligence in structuring your term sheet to ensure the deal stays as close to your intentions as possible. It won’t guarantee a sure thing, but it will ensure a much smoother process.

Notes:

[1] Legal Fees: Most Important Term Sheet Clause

[2] Startups: Coming to Terms with Angels