Before You Sign on the Dotted Line: How 2 Read a Term Sheet
Terminal value? Full ratchet? Protective provisions? What do these terms actually mean?
Angelo Santinelli, adjunct lecturer at Babson and founder of Dakin Management, joined us for the last How 2 Tuesday session of the semester and shared advice for entrepreneurs who are raising money and trying to decipher terms in How 2 Read a Term Sheet.
Get a lawyer
Professor Santinelli urged the room of entrepreneurs to get a lawyer – and to get one early. As he put it, “If you have a term sheet, you ought to have a lawyer.” Term sheets can be complicated and it is likely that you will never know as much as your prospective investor does about terms. Hiring a corporate lawyer, as well as doing all you can to get educated, will help you to understand and be more comfortable with the process.
Don’t just know your audience – know thyself. Putting aside any unicorns, or “unicorpses” for that matter, it is important to realize that the stage of your business, the risk an investor would experience upon investing in your business, and the amount you’re looking to raise usually dictates your funding source. Are you just beginning to explore an idea? Think family and friends. A little further along and working on your product? Try VCs. Growing your market? Aim for private equity.
Check the boxes
When is the right time to fundraise? Checking the boxes in certain areas can help answer this question for you.
- Team – Since “early stage investors invest in people first,” do a gut check on your team. Did you reference check your team? Do you have the right people in the right seats?
- Market – Investors are looking for markets that are “able to support multiple billion dollar companies.” They are placing a big bet on your company and knowing that there is a huge market will help to minimize their risk.
- Novel, intellectual property – Is your idea or product “something that cannot be easily purchased or copied”?
- Low capital intensity – Ideally, only a small amount of investment is necessary in order to produce your product or service.
Did you check these four boxes? If so, you are ready to raise a round. Missing one or more? Go back to the drawing board.
Settle on a reasonable valuation
Much of your term sheet will be based on your valuation – so how do you determine your valuation anyway? Discounted cash flow (DCF), which estimates the value of an investment based on expected future cash flow, is a popular valuation method. But Professor Santinelli warned entrepreneurs, especially early stage entrepreneurs, off of DCF because it relies on (often unrealistic) assumptions about growth. In Professor Santinelli’s words, “Are you going to put a DCF in front of an investor? Please don’t.” Instead, find comparables and look at the Series A valuations of similar startups, as well as other contextual factors. In this way, it should be possible to arrive at a reasonable valuation. Ultimately, “keep things simple and keep things consistent.”
Watch out for the fine print
There’s more to a term sheet than economic terms. There are also governance terms pertaining to voting rights and board structure. Don’t skip over governance just to get to the numbers – be sure to pay attention since you will want to have board representation and other rights.
Similarly, take note of the “no shop” clause. While a term sheet is not legally binding, the no shop clause, which prevents you from shopping your business to other investors, is binding. Even if a term sheet doesn’t result in a deal, you may still be bound by the specifics of a “no shop” clause for a period of time.
From dividends to dilution to double dipping, a lot can go into a term sheet – and there’s a lot at stake. Remember Professor Santinelli’s advice to get educated and get a lawyer. Looking for additional resources? Consider checking out Professor Santinelli’s online class Founder Finance.