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.

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.

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