Whether you are looking to start investing in startups, or you have done so several times and you know all there is to know about how to invest in startups: every term sheet presents opportunities and risks. It is important to know what to look for in a term sheet.
At LawTrades, we believe that having your legal questions answered should be as easy as one-two-three, and we have therefore compiled this list of five things to look out for in a term sheet:
It is common industry practice to express a startup’s valuation in the term sheet as the pre-money valuation (i.e. the value of the startup before your investment is made). If the startup is using a standard term sheet template, this will be the case. However, confirm whether valuation is stated as pre money or post money. This small difference in wording changes the percentage equity that you receive. It is worth double checking!
2. Type of Shares Issued
Ensure that you have a complete understanding of the type of shares you will receive in exchange for your investment. Will you receive preferred shares with special voting rights, liquidation preferences, and/or dilution preferences? If you get preferred shares for your investment, you will face less risk, but you will also have no voting rights. If you are getting common stock, do you have the same voting rights as other shareholders? And, most importantly, do you have the option to convert your preferred shares to common stock?
3. Pro-Rata Rights
Do you receive rights to participate in future investment rounds? On what terms? Even if you don’t intend to, it is prudent to always ensure you have the right to participate in future investment rounds. This protects the value of your investment.
4. Option Pool
What is the size of the option pool? Is it expressed as a percentage of the pre-money or post-money equity of the company? The option pool affects your percentage stake in the startup, and in general, as an investor, you benefit from a larger option pool. By contrast, startup founders prefer smaller option pools. Be sure that the option pool determined in the term sheet presents a reasonable compromise between your own and the founders’ interests.
5. Vesting Schedules
In general, employee stock option grants and founder stock will be subject to a vesting schedule. Check to see how founders shares will vest before you sign–you don’t want to see key contributors to the startup’s value being able to walk away with a chunk of the company’s ownership right after you sign.
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