NAVIGATING THE TERM SHEET: A GUIDE FOR FIRST TIME FOUNDERS

If your startup company has moved beyond angel financing, it means there’s a shot you’re about to start courting venture capitalists. This can be incredibly over overwhelming for many first time founders. This article attempts to prepare you for that process by explaining five of the most frequently discussed terms in venture financing term sheets.

The first thing to note is that a term sheet is not a legal promise to invest. The purpose of a term sheet is to set out the major business and structural issues involved in the proposed investment. The final agreements that set out the actual terms of the investment will be negotiated later, based on the term sheet. Therefore, it’s really important that you fully understand the term sheet before signing it because it drives all of the other documents.

1. Valuation

The first term that any founder will want to look at is the price, which can be stated in different ways. The “pre-money” valuation is the value of the company before any new cash is invested, while the “post-money” valuation is simply the pre-money valuation plus the total new investment amount. Valuation can be made more complex by the option pool, which is discussed separately below.

How is pre-money valuation determined? Typically, the parties pick a number within a fairly arbitrary range set by the market consensus on what seems reasonable to pay for a team of people and an idea that hasn’t yet been turned into a money-making business. The exact number within this range depends on the venture capital community’s interest in the company.

2. Option Pool

The option pool represents the pot of stock set aside for existing and future employees and other service providers, to compensate and motivate them. The option pool is typically part of the pre-money valuation of the company, and it dilutes pre-money shares. Typical option pools range from 10-20%. While a large option pool will make it less likely that the company runs out of available options, the size of the pool is taken into account in the valuation of the company, thereby effectively lowering the true pre-money valuation.

3. Type of Security

Usually, companies issue preferred stock to investors, which comes with a series of preferences, including the right to receive the proceeds of an exit before holders of common stock. Preferred shares may or may not have voting rights, and typically have an option to convert to common shares.

4. Liquidation Preference

Liquidation preference provides downside protection to investors and reduces the total amount available to the founders (as holders of common stock) upon a liquidity event. Basically, it means that money used to buy preferred stock gets returned first, at a particular ratio if a liquidation event occurs. The term sheet will specify what counts as a liquidation event, but in general it’s an event equivalent to the company going away – getting acquired, merging or selling most of its assets. Preferences usually range from 1x to 3x (1x is typical), which means that an investor with a 1x preference gets his/her original investment back before the founders get anything.

5. Protective Provisions

Investors normally require an approval right over company actions that would be adverse to them or their economic position. Protective provisions are effectively veto rights that investors have on certain actions by the company, thereby protecting the investors. In other words, in order for the company to take certain actions, the company must obtain the approval vote of the holders of a majority of the shares of preferred stock, voting separately as a class and not together with the holders of the common stock (the founders). The protective provisions provide investors greater control over the company, even if they don’t own a majority of the stock.

Conclusion

This article provided a brief overview of five key provisions in venture financing term sheets. Term sheets will include many other provisions that you’ll want to understand before signing one. There are many great sources of information about venture capital term sheets online. The Term Sheet Series by Brad Feld is widely known and respected, and is a good source of information on the topic [provide a link to Brad Felds].

It’s always a good idea to hire legal counsel to assist in drafting and negotiating a term sheet and the resulting agreements between the company and investors. And when it comes to choosing a lawyer for your startup, bigger isn’t always better. Being large often makes you slower, more bureaucratic and inefficient. Thompson Burton is run with a startup mentality – we’re cloud based, efficient and lean, focusing constantly on ways to improve our clients’ experiences with us.

BIO

Allison Finkelmeyer is an experienced corporate attorney and startup lawyer at Thompson Burton. Her practice focuses on corporate transactions and securities offerings, including the representation of early-stage companies and entrepreneurs. Allison practiced corporate and securities law for five years at a large, international law firm based in Atlanta before becoming in-house counsel at Nissan North America. She missed private practice and joined Thompson Burton in January 2014.

Tennessee LLCs: Top Five Most Common Mistakes when forming a Tennessee LLC

Forming a Tennessee limited liability company (TN LLC) may seem like a simple task, but there is more to it than filing Articles of Organization with the Secretary of State.  The following is a list of five things that are commonly overlooked when forming a TN LLC.

  • Although an Operating Agreement is not required by TN statute, all LLCs should have one, especially multi-member LLCs.  The Operating Agreement is a contract between/among the members of the LLC that lays out the rights and obligations of the members with respect to the LLC.  The Operating Agreement structures the LLC’s financial and functional decisions, and governs the internal operations of the LLC in a way that suits the specific needs of the business owners.  Without an Operating Agreement, the LLC will be governed solely by the provisions of the TN Revised LLC Act, which may not be desirable to the members in certain circumstances.  Multi-member LLC Operating Agreements are complicated legal documents that require the attention of an attorney who is experienced in TN LLC formation.
  • The LLC’s Articles of Organization must be filed with the Register of Deeds in the county in which the LLC’s principal office is located, if the principal office is located in TN.  This requirement is not common in most states and is easily overlooked if the LLC is formed by someone who is not experienced in TN LLC formation.
  • The LLC must have an EIN to open a bank account, to pay taxes and for other business purposes.  EIN stands for Employer Identification Number (also known as a Federal Tax Identification Number) and is the corporate equivalent of a social security number for individuals.  The LLC may obtain an EIN by completing an application on the IRS website.
  • All TN LLCs must register with the TN Department of Revenue.  The TN Department of Revenue recently started cracking down on business registrations. The LLC may register online with the TN Department of Revenue for any of the following taxes which it may be subject to: City and County Business Tax, Franchise and Excise Taxes, Sales and Use Tax, and other taxes that apply only to specific industries.  An LLC that has not registered with the TN Department of Revenue will not be able to obtain a Certificate of Good Standing from the TN Secretary of State and may be subject to administrative dissolution.
  • All TN LLCs (except those satisfying one of the limited exemptions set forth in T.C.A. Section 67-4-2008) are subject to TN Franchise and Excise Taxes.  Historically Franchise and Excise Taxes only applied to corporations, but in 1999 they were extended to other entity types including LLCs.  The Franchise Tax is an annual tax required to be paid upon the value of the assets of the LLC, and the minimum amount payable each year is $100.  The Excise Tax is basically an income tax of 6.5% on what would be the LLC’s net earnings for federal income tax purposes.  An attorney who is experienced in TN LLC law can help you minimize your TN Franchise and Excise Tax obligations.