How can you determine if a term sheet is fair?

Most early stage founders try to value their venture way too high, but also an early valuation is arbitrary and a moving target any way. What’s important is validating product market fit, having at least a solid MVP or V1, and finding value-add investors (aka Smart Money) who get the problem you’re solving, believe in you as a founder, and not trying to raise too early. Know the mandates of funds so you don’t waste their and your time. Having a realistic valuation can help move things along but only if there’s alignment beyond the valuation, so don’t stress it too much. Just know that lead investors often set the terms and avoid taking subsequent down rounds that value your company less than you had previously.

Understanding the valuation of your startup is like knowing the worth of your house before you put it on the market. It's a critical factor in a term sheet and determines the amount of equity you're parting with. The valuation can be pre-money or post-money, a distinction that affects your understanding of the company's worth before and after investment. To ensure fairness, your valuation should align with your startup's market potential, achievements, and unique selling points. Delve into research, compare with similar startups, and perhaps use valuation calculators. Keep in mind how this valuation impacts future funding rounds and the dilution of your shares. After all, striking the right balance is key.

Here is what many people won't tell you at early stage. Your valuation is almost entirely driven by 1) how much you're raising, 2) the hype around the sector you operating and 3) whether you're a repeat founder or not. How much you're raising is in turn driven by your business model (SaaS doesn't need as much capital as a robotics business). So forget about everyone telling you they are doing DCFs and exit multiple scenario calculation, it's just bs.

A fair pre-valuation of your startup is vital, as it influences the post-money valuation and the equity you give up for investment. The 409A valuation, typically done annually by cap table providers like Pulley or Carta, assesses your company's fair market value. This is crucial for IRS compliance and setting realistic stock option prices. A proper valuation reflects tangible and intangible assets, market conditions, and growth potential, ensuring credible negotiations with investors. Regular, objective third-party evaluations are key for a balanced understanding of your company's worth and equity distribution in funding rounds.

Diving into valuation is like navigating the heart of the deal, right? Pre-money, post-money—those terms can definitely make your head spin! But you're spot on; it's crucial to get it right based on your startup's potential and where you're at in your journey. Checking out comparable startups and using those online tools? Smart move. And yeah, keeping an eye on dilution and ownership down the road is key. It's a bit of a balancing act, but understanding these nuances can set you up for success in future fundraising rounds!

Shares are not just a piece of paper; they represent power and potential. In a term sheet, understanding the type of shares offered is crucial. There are generally two types: common and preferred. Common shares are what you and your team hold, offering equal voting and economic rights. Preferred shares, usually for investors, come with extra perks like priority in liquidation and anti-dilution protections. A fair term sheet finds harmony between these two, ensuring neither founders nor investors are disadvantaged. It's like a dance between both parties, where each step is carefully choreographed to maintain balance.

Let's face it, only a very small minority of star entrepreneurs can raise common equity. the rest is just prefs. So more than the type of shares, the most important thing is how your preferences stack up. At early stage it's not that important but as you grow it'll become increasingly complex. Make sure you keep a very good model of your cap table to know who you gave what preference to and how that impacts your outcome upon exit.

Beyond valuation and share types, a term sheet is peppered with various terms that can significantly impact its fairness. These include vesting schedules, board composition, voting rights, drag-along clauses, and pay-to-play provisions. Each of these terms weaves into the larger fabric of your startup's future. Vesting ensures commitment, board composition reflects control dynamics, and voting rights determine decision-making power. Drag-along clauses and pay-to-play provisions can influence future investment dynamics. A fair term sheet aligns the interests of founders and investors, fostering a mutually beneficial relationship without unduly restricting the founders' autonomy.

It is so easy to fall for the red herring of valuation. So many founders make this mistake. They optimise for valuation, to the detriment of other aspects in the term sheet like control. Seasoned entrepreneurs know that if there is a tradeoff between lesser economics or lesser control, it's almost always better to chose lesser economics. In more general terms, there are a huge number of resources online to educate yourself on terms and what they mean. What's maybe less evident is to know what is "market" and what isn't. My advice: make friends with a VC and have them tell you what's currently market and what isn't. It's going to save you time negotiate what really matters and the points that are too investor-friendly in the term sheet.

As you evaluate the deal terms you can assess for alignment of interests and long-term vision and not just immediate benefits. Look for founder-friendly terms especially as it relates to control mechanisms like board composition and voting rights, or terms around liquidation and anti-dilution rights. Depending on your current stage, the investors you want to get in now or attract in the future, the terms will have massive implications in later rounds. For example, a full ratchet clause may mean significant dilution for founders and early investors in case of lower-priced future rounds - as we’re currently seeing in this tough fundraising climate.

Comparing multiple term sheets is akin to shopping for the best deal. It not only gives you a broader perspective on what the market offers but also empowers you to negotiate from a position of strength. Beyond just the numbers, consider the added value an investor brings – their network, expertise, and reputation. While you weigh these offers, maintain transparency and respect with all parties involved. It's a delicate balance between negotiation and maintaining professional relationships.

Not everyone as the ability to have multiple term sheet and to organise a bidding war. If you do however, be very careful what you optimise for. As mentioned above, the term sheet with the highest pre-money isn't necessarily the best one for your business. It is completely ok to grill your investors and question them on the value they will bring you. They should not only welcome the questioning but also have very good responses. Lastly, always operate on a clear timeline with investors. State your plan and stick to it as much as possible. This is what creates the sense of urgency and allows the VCs to organise their workflow better.

To assess the fairness of a term sheet, comparing multiple offers is crucial. This provides insights into market demand, valuation norms, and standard terms for your startup. Utilizing this information as leverage can facilitate negotiations for better terms or create a competitive bidding scenario. Beyond financial aspects, consider non-financial elements like investor reputation, expertise, and network, evaluating how they can enhance your startup beyond monetary support. Maintain transparency and respect in your interactions with investors, avoiding tactics that may create false urgency or play them against each other. This approach ensures a balanced evaluation and negotiation process.

Navigating a term sheet without expert advice is like sailing uncharted waters without a map. Lawyers, accountants, and mentors can be your navigational stars, guiding you through legal, financial, and operational complexities. They'll help you spot potential pitfalls and negotiate effectively. Also, don't forget to involve your co-founders and team in these discussions. After all, a term sheet isn't just a document; it's the future course of your startup.

I've said it countless times and I'll say it again: cheap lawyers almost always end up being more expensive. They won't know what market standard is, they'll be aggressive on certain terms which risk alienating VCs or simply making you look like a fool, they'll create more billing hours because they're not 100% familiar with closing processes, etc, etc. I've seen cases for all 3 and it's just awful to watch.

Term sheets and investment deals are complex documents where seemingly insignificant clauses may cause major headaches down the line. Entrepreneurs should always work with both legal and financial professionals that focus on startup law to understand the implications of every term and clause. A founder does not create any value by crafting and analyzing legal documents, so don’t feel pressured to get it right. Get recommendations from other founders and trusted investors about legal and financial professionals who will support you throughout the process.

Every term sheet is unique and reflects the distinctive journey of your startup. Beyond the standard terms, consider the long-term implications of your decisions. Reflect on how the term sheet aligns with your vision for the company and its culture. Don't hesitate to share stories or seek advice from those who've walked this path before. Remember, a term sheet is more than a financial agreement; it's a partnership that shapes your startup's trajectory.

Especially for earlier rounds or first-time founders, it’s absolutely critical to understand the long-term implications and impact on future rounds and liquidation events. Get feedback from other entrepreneurs who raised funds in similar fields, similar amounts, or during a similar fundraising climate. Understand that there’s room for negotiation and that there’s value to be unlocked beyond the terms. Getting investment is a long partnership that will be tested time and time again. You need to partner with people who believe in your vision, and will support and guide you through inevitable challenges and pivots. Investors that will have the best interest of the company.