Term sheet fundamentals, part 1

The expectations and procedures regarding term sheets can be perplexing to the first time entrepreneur.  For the angel investor, it’s often a question of tagging along with a larger investor’s terms, which can be problematic as well.  We’ll discuss some of the procedures and issues in this post and touch on a variety of other facets in a subsequent post.

Potential investors often claim interest for months as they engage with the management team and watch the emerging company hit milestones.  The term sheet is the first indication that that interest is real.  Prior to the term sheet, entrepreneurs should be wary of investors’ claims of interest and should seek to cultivate interest from a number of investors because of the possibility, even the probability, that the interest alleged by any one investor is not going to result in a term sheet.

By the time of sending the term sheet, the investor has spent considerable time looking into the business opportunity, the management, the business model and its financing needs.  The investor knows that its interest is real and sends the term sheet principally to elicit some agreement on the terms of a transaction before spending even more time on due diligence.  The time and expense that an investor spends in generating deal flow and in performing due diligence needs to be recouped in the eventual proceeds of the deal.  The investor wants to avoid the situation in which the end of the due diligence process is reached only to find that the management will not accept pricing and terms that it feels are reasonable.  That can be a lose-lose situation for both parties because, by that time, the entrepreneur has also invested a lot of time in meeting the informational needs of the investor.

As a result, when initially sent, the term sheet is not considered to be a legally binding document but rather a description of pricing and terms proposed for discussion between the investor and the entrepreneur.  The investor probably already had an idea of the cash needs of the entrepreneur and a sense of pre-money valuation of the company that the entrepreneur had placed on the company.  The entrepreneur has some sense of the ability of this investor to provide cash now, as well as its possible interest and ability to provide additional capital at a later date.

The pre-money valuation is often a source of uncertainty and contention.  The pre-money valuation is the valuation of the company at the present time before any additional capital is invested.  In essence, it represents the value of the entrepreneur’s contributions to the present day and the potential for the future.  Naturally, the entrepreneur wants the pre-money valuation to be as high as possible and the investor’s eventual return will be greater if the pre-money valuation is lower.  The pre-money valuation is analogous to the price/earnings (PE) ratio by which publicly available stocks are measured.  The higher the PE ratio, the more expensive the stock.  Although few early stage companies yet have earnings, the principle is the same.  An investor may pay more, i.e., accept a higher pre-money valuation, for a company that it perceives to have greater growth potential.  Many investors in early stage companies are value investors, seeking bargain prices because they recognize that many obstacles remain to a successful venture.

Because the entrepreneur usually has much less experience than the investor, the entrepreneur is often at a distinct disadvantage in the negotiation of the pre-money valuation.  However, a significantly erroneous choice hurts both parties.  If the valuation is too low, the company may not have enough upside reward in order to motivate existing management or compensate new members of the team with stock rather than cash, which is an even more precious commodity.  A pre-money valuation that is too high, which may appear to reward the management team, may make further fund-raising difficult.  Even worse, when coupled with unforeseen circumstances that require unanticipated infusions of cash, the high valuation may result in a “down round” which penalizes both management and the existing investors and may sour everyone about the company’s prospects.

We’ll have more on valuation and term sheets in our next post but post a question or comment if you’d like some further explanation.

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