Getting your first term sheet from an investor can be exhilarating. It is the first tangible step that says someone is really interested in funding your business. Of course many term sheets never lead to a completed deal but most do.
But that first term sheet can also be daunting. The standard “NVCA Term Sheet” that many venture firms use these days can include as many as 40 different terms.
The best advice I can give is to make sure you have an attorney representing you with lots of experience negotiating venture deals. This is a very specialized area so don’t leave it to your family lawyer. And if you can’t find someone in your part of the country (or world) there are hundreds in the active investing areas of the US coasts and most deals are done by phone and email anyway.
This discussion assumes a “priced round” of preferred stock. I wrote about convertible notes in an earlier post. And “Series A” generally refers to the first of what is often several rounds of financing. Some angel financings will be referred to as “Series Seed” to retain the “A” designation for the first venture round.
The first thing to understand about preferred stock is that it includes “preferences” that grant holders rights not available to holders of common shares. The most important among these rights, from an economic standpoint, is the liquidation preference. This means the holder of a preferred share gets her money back before the holder of common shares. If, on liquidation of the company, there is not enough money to pay all preferred shareholders, the common holders get zip.
There are two principal types of preferred stock used in early-stage financings: “non-participating” (also known as “convertible”) and “participating”. With the former, a preferred shareholder can either get their liquidation preference—typically the money they invested—or convert to common and get their pro rata share of the liquidation proceeds but not both. This is virtually always done in connection with a “liquidation event”, typically a sale or IPO (which requires conversion of preferred shares) so the lawyers will normally do the math and suggest the proper choice.
With participating preferred, the holder receives the liquidation preference and then shares pro rata in the remainder with the holders of common shares. In earlier days, some of us called this “piggy preferred.” This structure is a better deal for the investor because it provides a return of the initial investment plus a share of the upside.
That’s probably enough for this first post. I’ll discuss valuation and dilution in Part 2.