So, your company is growing at a rate of knots, you’ve built a strong team filled with key execs from previously successful growth companies and unit economics are accelerating into positive territory.
Churn is at an all time low, your new US business unit is setting records for sales growth and you now have term sheets for new capital. The term sheets all appear to be offering similar things. Or are they?
Even with a very similar headline valuation, term sheets can in fact mean fundamentally different things for an early stage business. This article runs through some of the main topics of term sheets, arranged as you might find them in a typical Series A round. It focuses on the impact that terms may have on your business, and why it is important both to understand them, and compare them on a holistic basis – not just to focus on the headline number.
General offer terms
Headline valuation is perhaps the most visible component of any term sheet, but the largest number does not necessarily mean the best deal. There are a number of other components that will impinge on this in many different ways. It is critical you take a holistic view.
Most share price offers will be quoted on the basis of a “fully diluted” share capital. This means that the number of authorised options and other equity instruments, not just shares is taken into account in the number. This is important to understand, particularly when the term sheet is calling for you to also expand your option pool as part of the round, or to convert any pre-existing loan notes prior to completion.
One common approach at Series A is to require companies to expand their share option pool as part of the round. New authorised share options will generally be counted in an “unallocated” pool and the board given the authority to allot them to new hires.
Whilst this is usually a sensible move given the likely need to hire and incentivise new talent post raise, expanding the share option pool prior to the round will dilute only the existing investors, with full benefit to the new investors. The effect will be to reduce the share price paid on a “fully diluted” basis by the new investors at any given valuation, who will therefore receive more shares for a given investment amount.
Investors will attach various conditions to a term sheet, to the extent that there is in fact no contractual commitment to funding the business. These conditions will often relate to satisfactory legal documentation, due diligence, “Warranties” (see later), approvals (of investor and other investors as necessary), no material adverse change in the circumstances of the company, and service contracts for executive employees to name but a few. It is important to remember therefore that a term sheet is not a commitment, but an expression of intent, and companies should maintain all momentum until the deal is closed.