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  • Barsha Singh

Early-Stage Investment and Term Sheet Analysis

The strengthening of the angel and early-stage investment ecosystem has been one of the greatest themes in the financing surge during the pandemic.

Many company entrepreneurs, like Flipkart's Sachin Bansal and Binny Bansal (not related), would struggle to attract investor money back in the day. Many people might even wait a few of years before receiving their first pay check.

In the year 2021, investors have flocked to early-stage businesses in droves. Over $13.6 billion has been invested in 3,479 early-stage projects since the beginning of the year.

Early-stage funding is required before a start-up can get off the ground. This is the very first investment that must be made before anything else can begin.

Several sorts of persons are engaged at this stage of the investment process. These are the folks that offer the first capital that new businesses need to get off the ground.

Early stage funding is required before a start-up can get off the ground. This is the very first investment that must be made before anything else can begin.





Several sorts of persons are engaged at this stage of the investment process. These are the folks that offer the first capital that new businesses need to get off the ground.

Angel investors (or groups of angel investors), venture capitalists, and high-net-worth individuals are examples of these people. Early-stage funding might also include bank loans and money from friends and family. Typically, these investors will invest between $25,000 and $500,000 in the company, but they may contribute more.

It's not just about the money when it comes to early-stage investing. These investors often have particular industry expertise, experience, and relationships that the start-up might benefit from. Furthermore, many of these investors may take seats in the start-up or serve on the board of directors, offering advice.

Speculators make up the majority of these early investors. They are essentially gambling and investing in the hopes that the firm will be sustainable and successful. New start-ups often take a long time to get off the ground, and investors may have to wait years to see a return on their investment. The majority of start-ups fail, implying that these investors are taking a significant risk.

This is why having a solid business strategy is essential for attracting early-stage funding. In order to acquire appropriate money from early-stage investors, you must have a solid blueprint that defines your company strategy.


The first three phases of a company's development are funded through early-stage funding. There are three different sources of funding:

• Seed investment (seed capital) is money given to an entrepreneur to help them launch a firm.

• Start-up capital—money to assist a business in developing and promoting its goods.

• Funding for early-stage businesses—money to assist start and develop production and sales.

Early-stage investors recognize that starting a firm requires time and continual support, therefore they anticipate making several investments in a single company as it grows.

Because there is greater risk connected with fledgling firms that have yet to establish a market presence, not all investors are willing to invest in them. When a business is just getting started, it may be difficult to know what to expect.

When a start-up evolves into a late-stage business, it might seek capital from late-stage investors.





Term sheet and investors

If you consider your continuous connection with an investor to be a marriage, the term sheet may be seen as the prenuptial agreement, whether the term sheet is with an angel investor or a venture capital investment (VC).

A term sheet is a non-binding document that specifies the fundamental terms of an investment. Equity term sheets are most often associated with start-ups, although they may be an important aspect of wooing venture capitalists.

A term sheet's "terms" establish the "conditions" for an investment and specify particular factors such as the agreed-upon firm value, the investment price per share, the economic rights of new shares, and so on. Term sheets may be written in such a way that they are not legally binding. In such instance, its primary function is to serve as a model for the more formal, legally enforceable contract that will be created. In most circumstances, each participant undertakes to maintain secrecy and not engage in concurrent talks with other investors. Term sheets for both equity investments and convertible securities may be encountered while raising funds (such as KISS docs, SAFE docs, convertible debt, etc). We'll concentrate on equity term sheets in this essay. If you want to understand more about convertible debt, we recommend reading our page on the subject.


A Quick Guide to Term Sheet Negotiations: How to Reach an Agreement on a Term Sheet

When you get a term sheet from a venture capitalist, the variety and depth of terminology may be complicated, complex, and even difficult to comprehend. Even though the agreement isn't legally enforceable, investors will almost certainly expect you to follow the terms. As a result, it's critical to learn how to negotiate the terms of a term sheet before signing it. You can better grasp whether it's in your best interest to collaborate with particular investors and whether their aims and ambitions align with yours by learning how term sheets operate and what to look for.


Several significant components are often included on a final term sheet:


Estimation (and percentage ownership)

The proportion of the firm that new investors will possess is determined by the company's value and the amount of money invested. Because it frequently has the greatest direct influence on who owns what and how much cash each shareholder gets when the firm sells, this may be one of the most important components of the term sheet.

Pre-money and post-money values are used to convey valuation. The pre-money valuation is the value of a firm before it receives a fresh investment. The post-money value is just the pre-money value multiplied by the new investment amount. The primary goal of a founder is generally to maximize capital investment while limiting dilution. It's possible that you won't be able to close the sale if you don't have a clear idea of the value. However, a positive value may not always balance negative conditions elsewhere on the term sheet, therefore it's a good idea to take a holistic approach to the term sheet.


Pool of Alternative

Before the purchase closes, many term sheets may mandate the formation of an option pool or the enlargement of an existing one to put away shares for future employees. "Prior to the close," note the statement. This suggests that the investors want a portion of the cap table left aside for future awards, but that current shareholders should absorb all of the dilution. Calculating the option pool post-money and forcing new investors to join in the dilution would be the most founder-friendly strategy. However, as shown in the example above, the practice for most term sheets is to compute it pre-money. Because some founders may not grasp how VCs think about value, the option pool is a typical source of information asymmetry.

The handling of the option pool may have a big influence on your company's worth. It has a significant influence on dilution and may have an economic consequence.


Liquidation preference

The term "liquidation preference" relates to preferred stock's downside protection. Investors often desire to see a firm prosper so that their original investment in the company is worth more. A liquidation preference, on the other hand, protects the firm against possible damages if it doesn't succeed.

The most typical liquidation preference is 1x invested capital, which indicates that when the firm is sold, preferred shareholders will get an amount equal to their investment before more junior stockholders receive anything. Alternatively, preferred shareholders may convert their shares to ordinary stock and get cash in proportion to their ownership percentage in the firm.





Dividends

Dividends, which are commonly represented as a percentage (e.g., 8%), reward favored owners with an extra return over time. If preferred stock receives dividends, the liquidation preference may grow. Dividends are used to designate who gets paid first and how much they are paid (for example, 1x or 2x their initial investments). One of the most prevalent contingencies in term sheets is dividends.

You may come across the term "cumulative" or the abbreviation "PIK," which stands for "paid in kind," as you go through the document's wording. Cumulative dividends provide investors with a guaranteed rate of return, which is uncommon in early-stage investments. The value of the dividend is given to the investor in the form of extra preferred shares in a PIK dividend. This may raise the preferred stock's liquidation value, as well as diminish the founders' ownership interest over time.


Anti-dilution

Another typical characteristic of preferred stock and term sheets is anti-dilution. In the case of a down round, it prevents investors from being diluted. Anti-dilution is available in a variety of ways, which we discuss in depth in our Dilution 101 essay series.


Members of the Board of Directors

A company's board of directors is an important governing body, and term sheets generally contain provisions for how it will be organized and who will have influence over vital board votes. In many respects, the board of directors of a typical VC-backed firm might be the most essential control mechanism. There are more founder-friendly alternatives and fewer founder-friendly ones, just as there are more and less founder-friendly possibilities for other words. The stage of a firm may have a big impact on whether or not a founder can keep control of it. Early-stage firms' boards of directors are often under the control of its founders. If they keep raising money, however, the investors (as a group) frequently have greater power than the founders.

Even for later-stage firms, some investors believe that the ideal board structure includes an equal number of VC-friendly and founder-friendly members, as well as a "independent" board member. The independent member is generally a well-known businessperson who is well-liked by the rest of the board.

Founders' major goal is often to guarantee that VCs and founders/common shareholders have equal board participation. Both sides have equal voting power in these cases. Both parties would need to use the independent member to secure a decisive vote in their favor in a case where they disagree.


Percentage of Share Classes Owned

Some firm decisions are decided by shareholders rather than the board of directors. When it comes to these choices, voting power is generally determined by percentage ownership. Founder-friendly shareholders or VC-friendly shareholders may possess the majority of the firm.

Issuing extra shares to new investors or workers may need the consent of a majority of each share class, including common and preferred stock, when similar stock splits or dilutive issuances occur. In these situations, the more shares possessed by each class, the more voting powr they have.





Investor Protections

Before agreeing to invest, most investors want specific privileges known as "protective clauses." Investors may have unique jurisdiction over certain corporate acts under these special provisions. Limits on how much debt may be taken on without VC approval, limitations on raising authorized shares to take on more finance or gift to workers, and revisions to the certificate of incorporation are all examples of special requirements. Some provisions are more frequent, while others are more uncommon and rigorous.


Important Points to Remember

• First, make sure you're dealing with the correct investor; secondly, look at all of the conditions, not just the price.

• Make sure you're aware of important details such as liquidation preferences, pool choices, and board seats.

• Venture capitalists are seasoned negotiators. Work with a qualified lawyer to figure out when to dig in and when to give up.


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