Decoding The Term Sheet For Entrepreneurs

Term Sheets – a series of legalese that most entrepreneurs don’t understand. However, to optimize any investment, they need know what they are signing-up for.

A few tips for entrepreneurs before they sign a term sheet with an angel or a VC.

Investors, who enter into long-term partnerships with start-ups, intend to protect entrepreneur interest so that the benefits are mutual. At YourNest, entrepreneurs are advised to keep following in mind while negotiating a term sheet.

1. Board Control: As the business grows over time the entrepreneur’s equity stake dilutes significantly. This should not translate into a passive role in decision-making. The entrepreneur should retain the Board Control with majority board members. Promoters of many listed entities exercise control despite having less than say 26% beneficial interest.

2. Drag Along: The investors would like to have a clear right to Exit at any time. They also seek Drag Along rights to protect their interest. This clause would work in the entrepreneur’s interest when the Drag Along is accepted with multiple times (say 10x-25x) return to the entrepreneur.

3. Right to en-cash partly for Self & family: An entrepreneur has to survive with minimal salary during the initial stages of the business. They must retain aright to be able to sell a part of their personal equity (say up to 20% of promoter equity) to generate some cash for self and family.

4. Right to Buy-Back: A VC normally has a holding period of 5-7 years for their investments. At the end of this period, VC looks at various ways of exit. An entrepreneur at that stage may retain the right to buy-back VC stake over a short window of a few months. While providing an exit option to the investor it would enhance entrepreneur’s equity stake.

5. Investor Breach: Investors normally have a remedy for any breach of terms by the entrepreneur. Similarly the entrepreneur should also have a remedy for breach by investors e.g., ensure timely investment as per term sheet so that there is some certainty of disbursement of tranches.

6. ESOPs Pool: The pre-money valuation normal allocates part of the equity to be set aside for attracting talent in the venture. Sometimes this ESOP pool is not fully utilized at the end of the investment-holding period. For that scenario, entrepreneur can retain the right to subscribe to the invested ESOPs so that the value remains with the entrepreneur.

[This post was originally appeared on Yournest blog. Yournest is an early stage venture capital fund, investing in businesses built on vibrant and new ideas enabled by path-breaking use of technology.]

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