The 15 most important points in the Startup Termsheet
At the beginning of every investment stands the term sheet and even though a term sheet is not necessarily legally binding (but rather a blueprint for the actual contract and future collaboration between the startup and investors), it is one of the most important documents and should therefore be taken seriously. Terms should ideally be negotiated only with the lead investor(s) in order to prevent a time-consuming skirmish between many parties.
We and our most trusted investors alike believe in a positive and long standing relationship with the startups based on mutual support. We believe in a fair and up to market standard legal documentation, incorporating the most important factors of a startup investment, protecting investors and founders alike. Having said that, a high-risk investment won’t get less risky just because there are more or even longer contracts, so we do approach this topic with a sense of pragmatism.
Our conceptualized term sheet is a fair one that upholds the primeCROWD standard and above all aims to achieve a quick consensus, as well as a timely, resource and time-saving deal settlement. While they can normally vary quite a bit, termsheets in general for us as angel investing platform are more standardised. In general, term sheets should not be about long and protracted negotiation processes. They are about having spent enough time at a company to really understand the opportunity it presents and to learn the basics of the politics and potential existing shareholder issues and objectives.
Thus, once a term sheet has been signed, we see it as morally binding for both parties (other than material reasons justifying a change or resignation). In most cases it is to be expected that there will be certain issues that will always be unique to each respective company that require negotiation but by the time a term sheet is presented to a company the majority of the economics have already been discussed, even with some give and take the nature of the term sheet that is initially presented is not is not going to be wildly different from the negotiated final document.
We will now take a closer look at the essential content and most important terms of a term sheet. These terms will make their way into legal documents relating to the deal as outlined above.
The goal is for our investors to
- Understand the basics of deal terms
- Get an insider’s view of crafting deal terms in startup investing
- Learn what to look for in a term sheet
Probably the most important part of the term sheet and indicates the maximum percentage of shares in the company that can be acquired by the new shareholders. The basis of assessment is the enterprise value after entry of the shareholders (= post-money).
Pre-Money: The valuation "Pre-Money" indicates the enterprise value in EUR before the entry of the new shareholders.
Post-Money: The "Post-Money" valuation indicates the enterprise value in EUR after the planned entry of the new shareholders. Is used as a basis for the assessment.
The difficulty with a valuation is to reconcile the ideas of the startup with those of the investor. Typically, the founders want a higher value for their business than a potential investor is willing to accept. Founders have invested a lot of time, money and nerves in building up his company and want to realize this performance in the valuation. In contrast, the potential investor calculates the duration of the amortization of the price paid. He expects a quick payback to keep his risk as low as possible. In order to reconcile the usually not inconsiderable discrepancy, one needs an experienced advisor. primeCROWD will realistically model the startups ideas with a professional valuation. This avoids frustrations in the investment process and achieves the highest possible - but market-compliant valuation.
Currently we observe that valuations are currently rather high in the DACH region, which leads us to believe startups are in a Hype phase now. As an Investors you should know this and should not accept just any valuation. Valuations are under even more scrutiny than before.
However, a low valuation does not necessarily mean a good term sheet, as this can also ruin follow-up financing rounds. Typically, the funding should suffice for 12-18 months (or until the next important milestone). A classic reason (besides team problems) why startups fail is not achieving follow-up financing and "marketability", triggered by an initial overvaluation. Furthermore: 3x return over 4 years means a ROI of 32% per annum for investors (which is considered not very good) - If startups are valued too high, the growth potential is limited and thus not interesting for investors. In our opinion a headline valuation is an important thing but that's not the part to mainly focus on.
So why do founders chase high valuations? They're tricked by misplaced ambition. They feel they've achieved more if they get a higher valuation. However, funding is not the real test. The real test is the final outcome for the founder and getting too high a valuation may just make a good outcome less likely. The one advantage of a high valuation is that you get less dilution. But there is another less sexy way to achieve that: just take less money. At the end of day: A Startup is worth exactly as much, as an investor is willing to pay for it...
Investment based on milestones or in tranches. Generally, it can be said that milestones /tranches are not widely used anymore, even larger VC are deviating from this path.We believe that these models are very difficult to implement as they are based on a certain expectation of the future and more often than not the development is different (Especially so when dealing with startups), which leads to the model and being inherently incorrect. The milestone that seemed perfectly clear on signing may actually be very vague when the deadline comes up and both sides might argue it has respectively has not been met. In almost all cases, there are some unexpected hitches that result in the realization of certain goals taking longer than expected.
In general, founders are glass-half-full kind of people. This is good when faced with all kinds of different challenges in starting a business, but in combination with trying to impress an investor it might prove to be counterproductive in the end. This positive attitude, perhaps increased with a little bluffing on the side of the founder to impress the investor, can result in unrealistic milestones. So, from a startup perspective, they can usually sell a higher valuation if they use milestone funding on the premise that they will grow into the higher valuation as they achieve the milestones. But it winds up putting the company under stress to meet short term milestone goals and if they are missed, they need to spend time convincing the investor or new investors to invest more in the company which wastes valuable time.
On the investor side, they start with a small investment and invest more if the company is doing well / hitting milestones. In theory this reduces risk but in reality, it tends to cause the investor to have to make funding decisions without enough information. It is very common for companies to miss milestones. At that point the investor needs to decide if they want to invest more to keep the company going or cut off funding and risk the company going out of business. More often than not the investor cuts another check and starts down a slippery slope of small investments every few months. It puts stress on the company and forces the investor to make micro decisions.
Also, milestones can cause unintended behaviour. A company will push to achieve a funding milestone, but it isn’t always in the best interest of the company. If the milestone is users, then the company may overspend just to get users for instance. If the milestone is product development, then the company may rush a product to market that isn’t optimal. Perhaps the company needs to pivot its strategy mid-course to be successful but doesn’t because it needs to achieve an artificial milestone set months ago.
This is a very high-level breakdown of milestones, but what’s important to comprehend is what all milestones boil down to: a possible re-evaluation of the price per share or the equity interest the investor gets in the company for the amount invested. The idea behind is to change circumstances of the financing deal according to how the company performs. So, for instance, if the company were to not achieve annual revenues of EUR 1 million in the year following the financing, valuation of the company could be reduced from EUR 12 million to EUR 9 million, effectively giving investors more equity for their money.
Investors and companies are better off making larger investments at lower valuations so the company has time to execute and hit longer-term value inflection milestones.
The Captable reflects the shareholder structure before/after the investment (including option pool, and other payouts or earnings participation, i.e. fully diluted). It indicates the % amount (As represented by share capital) that each investor holds post money.
Preconditions for Investment and Warranties / Guarantees
Every savvy investor does his due diligence before any money is spent and everything is signed. primeCROWD provides all the info from its DD to the investors. This section includes standard clauses and provisions of customary guarantees and warranties by the founders. Important to be very transparent here as this will be documented in the transaction documents and signed.
- Current versions of Business- and Liquidity Plan have been made available
- Necessary board/shareholder approvals have been obtained
- IP / License rights are with the company / will be incorporated into it
- Other customary warranties/guarantees
- Amount of Compensation in case of a breach
- Accuracy and completeness of all documents and information presented (such as balance sheets, financial plans, Ip contracts, etc..) and written information furnished by Company, not in any material respect untrue, incomplete, or inaccurate.
- Complete and accurate answers to all during the due diligence arising questions.
- The Founders and senior management will enter into standard non-compete and non-solicitation agreements with the Company in a form reasonably acceptable to the Business Angels.
- Instead of a EUR per EUR compensation, it is sometimes agreed that the investors may be compensated in shares, meaning that in case of a breach of warranty the investors receive additional shares (either by share transfer from the founders or by a compensatory capital increase) instead of cash compensation.
- In most cases, limitations of liability of the founders/company towards each investor for breaches of warranties are agreed upon, such as (examples):
- Liability cap (Haftungshöchsbetrag): The liability may be capped by e.g. the annual gross salary of the respective founder or the investment amount paid by the respective investor;
- De-Minimis Amount: Investors shall only be entitled to claims, which individually exceed a certain amount;
- Threshold (Freigrenze): Investors shall only be entitled to claims if the aggregate amount of all individual claims exceeds a certain threshold. If so, the investors are entitled to claim compensation of the aggregate amount of all damages and not only the surplus exceeding the threshold;
- Statute of Limitations (Verjährung): Claims become time-barred after a certain period of time.
Company shares, right of first of refusal & pre-emption rights
Governs the acquisition rights of shareholders in various cases, i.e. as soon as a shareholder wishes to sell, he must first of all offer the shares to other shareholders. Very important for investors to prevent any unwanted changes in voting rights or entry from any third parties. Also applies for trustors, however only for a sale to a third party and not within the Trustee syndicate.
Regulates how and in what way decisions are made. Basically, with a simple majority (50% + 1 vote), but important decisions with 50% and half of the investors (qualified majority). Among other things, regulates what important decisions are and what roles and authorisations the general meeting (GM) and Advisory Board play. As a rule of thumb the governance is divided in three parts:
- CEO and day-to-day decisions (Regulated in CEO Work contract)
- General Meeting decisions and authority (We usually include a catalog for that)
- Advisory Board decision and authority (We usually include a catalog for that)
Tag-Along & Drag-Along Right
The Tag-Along right includes the right for investors to a pro-rata sale of their shares (right of co-sale). The special feature of the tag-along is that the investor can claim this right as soon as other contract partners (founders or even any other shareholders) decide to sell their shares. It is determined whether and under what condition this clause applies.
If you go - I go too - logic
Drag Along requires the shareholders (co-sale obligation) to sell their shares on the same terms with a predefined majority of all shareholders, It is determined whether and under which condition this clause applies. This clause prevents small investors from blocking a possible sale of the company.
primeCROWD Standard: Several levels as a standard, based on post-money rating, to make an exit easier here. As Standard rule, the set qualified majority (i.e. incl. the majority of investors shares) is governing, to protect investors from having to sell without having achieved a meaningful multiple (VC money is expensive).
Characteristics can be:
- Only possible or applicable after a certain time (for example 2 years)
- Applicable only after reaching a threshold or minimum rating (floor)
- For investors / BAs Drag-Along: Drag Along should require a multiple of at least 3x
This is a customary agreement, according to which the investor is given priority in the distribution of the exit proceeds (for example: liquidation multiples, etc ...). Standard clause that protects the investor to a certain extent from a down-round / exit with less than the valuation at which he has entered. Sometimes an interest can be applied. A liq. pref. can be participating (First distribution of investment and pro rata % Share for investor) and non-participating (First Distribution of investment or pro rata % share for investor - whatever is higher). Any liquidation preference above 1x and participating we would consider as market-unusual.
Vesting and Founders Lock-Up
Probably one of the most important points in the term sheet and also one that investors should usually insist on. Is also very important for other co-founders - good founders have vesting rules in place. So that the founders do not withdraw to a (passive) role as shareholders after the entry of the new shareholders, but actively participate in the company's success, a vesting clause is agreed on. To founders, this clause often looks very hard and unfair, but it is essential, and it helps investors to continue their commitment to driving the company forward after the investment. If the founder terminates his activity at the start-up within a certain period of time (standard vesting period of 4 years), he must offer his unvested shares to the remaining shareholders (primarily the company) and then the investors (who then have the risk).
Founders Lock-Up: Generally, founders shall not be permitted to sell their shares to any third party until a certain date.
primeCROWD Standard: In case of the premature exit of a "founder" the unvested shares go to all other shareholders, but the other founders only get shares proportional to their already vested shares - that is a fair compromise between good-for-investor (all shares pass over to the investors) and good-for-start-up (shares pass over to all other shareholders). The nightmare scenario of investors is that important key founders drop out prematurely because they invest primarily and in the long term in the team. We expect founders to share this same view.
Accelerated Vesting: Regardless of this, all shares are deemed to have been invested if the employment relationship of the founder ends after a change of control (or exit)
The severity of the vesting clauses depend heavily on the stage of the startup and its dependency on the founders. Generally Vesting include:
If a founder leaves the start-up without fault (death, physical or mental illness, involuntary termination, notice in advance, etc.), he is considered a good leaver. For this it is agreed, how many % of his shares he keeps and also what happens to the remaining shares and at what price he has to assign them (Standard: Market value).
Should the activities of a founder end before the end of the vesting period, due to an important reason attributable to the founder the founding shareholder ceases operations or cooperation in the company and the respective founder must assign all of its shares in the company to the other shareholders in proportion to their shares in the share capital at nominal value, whereby only vested shares are decisive for other founding shareholders.
Cliff / no-cliff
Standard 12 months cliff calculated on a total of 4 years.
Subscription Rights & Anti Dilution
The "anti-dilution protection" allows existing shareholders, i.e. in case of a capital increase, to proportionally keep their shares. In order to do this, the shareholders already involved may participate in the capital increase in such a way that their participation is not diluted. This means that the shareholders can hold their previous share in the company by taking over new shares created by means of the capital increase at the same conditions as new investors.
A standard clause could also be:
In the event the Company issues additional shares in a subsequent financing round at a valuation lower than the pre-money valuation of this round (down round) the Investor shall be protected against dilution and entitled to subscribe for such number of shares to be newly issued that the total number of shares subsequently held by the Investor equals the number of shares the Investor would have received on such lower valuation according to a weighted average scheme. Standard exceptions apply (esp. ESOP issuances and stock splits).
The use of this downround protection depends on the stage of the startup and the risk perception of the investors but is commonly seen in pre-Series-A rounds.
Pooling / In-Trust Holding
All trustors will be pooled via the primeCROWD Trustee GmbH (Special Purpose Vehicle or “SPV”) through a trust agreement with investors. Especially important for follow-up financing and revision of captables. Benefits: Risk minimization, increases investment power and business influence, prevents fragmentation, better transferability of investors shares' and better for a follow-up financing. The main objective is to unify and strengthen the voice of the Business Angels at the level of the startup as well as to simplify the administration of the relationship between the business angels and the startup. Execution of business angels’ voting rights within the Trustee based on their instructions (majority principle). Generally, the SPV speaks as one.
We see certain developments in this area with a crying eye and as such absolutely insist on pooling. Particularly on the investor side: If founders have to spend 30% of their time on investor relations because 10 Business Angels are not willing to invest syndicated into a company, it is toxic for the startup, cause the time is missing to focus on technological & operational advancements.
Reporting and Information rights
A reporting system has to be implemented at the Company which enables the Investors to fully assess the financial and economic situation of the Company at any time. The reporting system shall include in particular the following components:
- monthly reporting and most important KPIs
- quarterly reporting
- annual reporting
In addition, the Founders shall inform the Investors of important events in a timely manner. As primeCROWD Investors shares are being held by a Trustee GmbH, we ensure that all investors are informed as best as can be via our proprietory platform.
Advisory / Supervisory Board
The board does not always have to be with decision making competency. We believe in a strong board that adds value rather than supervise. The Advisory Council is an essential advisory body for Startups and we, therefore, recommend an efficient design right from the start. Also, not having to convene a general assembly for every important decision leads to quicker decisions and also an increase in efficiency for Startups. For any pre-Series A (or before VC involvement) a board of three should suffice.
An advisory board is a valuable tool, especially in the initial phase of a startup: Mentor, strategy team, planning department, judge, and jury in one.
Employee stock participation (Phantom Shares, ESOP, etc..)
Our standard here is according to the international model. This clause governs employee participation such as employee stock option pools and phantom shares, how to treat these investments in the exit case (accelerated vesting), order, partial sales, etc ... Typical margin here is between 10-20%, with a lower standard in the DACH region of 5%-10%.
The standard here would be to calculate the pool post-money and thereby force the new investors to participate in the dilution, as it benefits all shareholders equally. Note: This pool can significantly change a company's valuation depending on size and time (Pre vs. Post-Money) (5% or more). Some investors reduce the pre-money valuation by pool size.
We would recommend using phantom shares: the virtual shares do not have any effect on shareholder law, but only contain a contractual debt obligation of the partners vis-à-vis the holder in the event of an exit, which is proportionate to the respective participation in the exit proceeds in relation to all holders of a virtual share. The payment of the proceeds by the shareholder is attributable to the respective virtual share from an exit in accordance with the more detailed specification of the virtual participation program.
Design of the pools:
- Normal shares for employees (ESOP): not ideal since one should not have "employees" with voting rights, as interests might be misaligned.
- If ESOP (i.e. Actual Shares), then the "employees" should not have voting rights or should be syndicated with founders or other shareholders.
- "Softest" but fairest solution: Phantom Shares
There exist as many different term sheets and practices as there is sand on a beach, and unfortunately, we won’t be able to cover them all but we try to adhere to our standards, experiences and market conform clauses.