Demystifying the VC Term Sheet

You might be spending sleepless days and nights getting things right for your Startup venture. Is it the only idea or the value that investors see in your business that compels them to inject money into your Startup?

The hard reality is there are not just one but several factors that investors look at while investing.

However, whenever you reach out to potential investors, make sure you do extensive due diligence before you sign the VC term sheet. Be sure that your investors are trustworthy, and they should have a history of walking out of a deal midway.

The investors walk out. It is the worst nightmare for any Startup founder, leaving a pile of legal fees with no deal at hand.

On that note, let us understand what a term sheet is and why it is important

What is a VC Term Sheet?

As the chief architect and the core founding member of your Startup, you might have spent sleepless nights and extremely long hours conceptualizing your venture from scratch. It is immensely challenging to look out for a venture capital firm or an investor who will align with your Startup idea and eventually invest in the Pre-Seed stage and beyond. However, before coming on board, these VC firms and investors would like you to showcase the valuation and worth of your Startup, complete the due diligence framework, and so on. These technical and legal details form a part of the term sheet.

Venture Capital Term Sheet incorporates all the proposed terms and conditions, mentioning the venture’s financial, legal, and operational aspects and proposed investment. The lead investor sponsors the transaction and prepares the term sheet in the case of institutional venture capital firms. They value the Startup venture with assumptions and inputs used. These term sheets are very detailed.

As you approach and pitch your Startup ideas to potential investors and VC firms, the term sheet will help to attract them. This document will act as a legally binding contract or agreement carrying out the terms and conditions of the investment.

What is a Venture Capital Fund?

As a first-timer in the Startup community, you can be very stressed if you are unaware of whom to reach out to in case of initial funding and later stages. In the early stage, any venture is extremely risky, with a lower probability of success. Moreover, industry research has shown that Startups fail in the first three years of existence. Many such Startups fail due to cash flow challenges. Problems arise from not having a solid business plan and not being well funded. Be sure not to find yourself in such a situation.

The question here is whom to reach out to for funding. A Venture Capital Fund does a fabulous job bridging the gap between investors seeking funding and VC fund having adequate funds to finance emerging businesses.

A Venture Capital Fund is known to manage a pool of investments which they invest in promising Startups and early-stage companies with high growth potential. The financing of these foreign or home country Startups is undertaken by High Net Worth Individuals, investment banks, etc. In India, the Securities and Exchange Board Of India (SEBI) regulates the workings of venture capital investments.

Some of the types of Venture Capital Funds you should be aware of are as follows:

• Early Stage VC Fund: The fund raised in this stage is used to develop products and other research.
• Expansion Stage VC Fund: The funds raised are utilized in marketing products and strategic expansion.
• VC Fund for acquisition: As the Startup matures, it may need funds to acquire other companies or divisions at a later stage.

 How to Read a Venture Capital Term Sheet?

If it is your first time encountering and drafting a Venture Capital term sheet, the financial jargon and the complex language may puzzle you. If you have a finance and accounting base and find legal aspects complicated, it is advisable to get acquainted with some of the important terms used in the term sheet. Feel free to take the help of a legal and financial expert in case of need.

Some important glossary of terms are mentioned below for you to understand and be aware of.

•  Voting Rights: When it comes to matters related to voting rights, preferred shareholders are constituted as one class, and common shareholders are administrated as another group as defined in the term sheet.
•  Pre-money valuation: It determines your company valuation before any investors invest in your company. Investors who believe your company is worth Rs 10 crores before investing money are referring to pre-money.
• Post-money valuation: It determines the implied value of your company after investors inject funds into your business. For example, a Rs 1 crore fund invested for a 10% stake denotes a valuation of Rs 10 crores.
• Pro Rata Rights: These rights ensure the ability to maintain the investor’s ownership percentage giving them an opportunity to participate in future funding rounds.
• Anti-Dilution Provision: These provisions prevent and protect from dilution resulting from the further issue of shares at a much lower price versus what investors paid initially.
• Redemption Rights: The redemption rights allow an investor to redeem or the company to repurchase its shares later.

What Objectives or Purpose does the Term Sheet Serve?

Before you prepare the term sheet draft and present it to your potential investors, you need to know the objectives of the term sheet and what purpose it serves to you and your investors. Here are some of the most important objectives of a term sheet

• Listing and laying the terms: In the term sheet, you need to include the investment amount, the name of the investors, and the funds they agreed to park. You should also include the nature of the deal, all cash or stock deals, and the type of stocks involved, which could be Class A, B, C, and preferred shares.
• Summarizing the deal: Another objective of the term sheet is to summarize the deal in a manner that could be easily understood by the parties involved. You should include the target company and potential investors, clearly stating the deal’s target date and other important aspects.
• Accepting the deal by signing: You must ensure that the nomenclature, terms, and conditions are easily understandable, avoiding any conflict of interest and confusion. The term sheet must be read and then signed by the intended parties to the agreement.

What is a Venture Capital Agreement?

Venture capital funds, and angel investors, are becoming increasingly popular in Southeast Asia and India over the years. The Indian subcontinent has become a home for some of the amazing Startups in the past decade. Many foreign VC funds are eyeing India as an investment destination giving rise to cross-border regulations and other legal aspects.

Thus a need arose for a well-defined agreement. The Venture Capital Agreement thus provides a well-written and standardized set of documents used in Pre-Seed, Seed and early stage financing rounds.

The Venture Capital Agreement constitutes the following important documents needed when you reach out to potential investors.

•   Series A Term Sheet
•   Series A Subscription Agreement
•   Non-Disclosure Agreement
•   Pre-Series A Term Sheet

Irrespective of the industry or sector your Startup serves, you need to have these documents prepared, updated, and then present them to your investors when raising funds for your venture.

How to Evaluate the Venture Capital Term Sheet?

When you successfully convince many potential venture capital firms and wealthy investors that your Startup company is an attractive investment proposition, you offer detailed terms and structure of the investment. Although sorting out the term sheet can be daunting, you need to evaluate the venture capital term sheet.

You need to understand and evaluate the terms and structure of the investment or the fundraising round. You need to know and evaluate the payout structure for your investors and what it is that you will earn when liquidating your company. You also need to know the impact of dilution in case of future investment rounds and determine the control mechanism when a board of directors is constituted for all major decisions.

In matters where you require hand-holding and advice, TykeInvest bridges the gap between entrepreneurs and the community, thereby helping you build, network, and grow your venture leaps and bounds.