Exclusive: Why venture capital terms sheets can be fatal for any scaleup

The moment an entrepreneur gets that email from a prospective VC with a term sheet – when a business moves into the next growth stage – excitement kicks in. 

However, many founders make one crucial mistake, namely not to interrogate their terms sheet in a lot more detail than they were expecting to. 

For many first time founders going through this process, getting your head around what to expect from a term sheet, the desired outcome and understanding key language and definitions in the actual document often prove to be a key challenge.

Now a big caveat is that you should always have a legal representative handle your term sheet negotiations so that you can ensure that you are getting the best possible for you as a founder and for your business to succeed without agreeing to terms that may hinder your progress later down the line. 

A recent report published by  Mountside Ventures focuses on  “Demystifying Venture Capital Term Sheets” in partnership with Landscape and Beauhurst which surveyed over 200 plus funders to produce some insightful data as part of their mission to reduce the opacity of the term sheet and help founders understand both the ecosystem and the process a little more. 

Managing partner and previously Head of the Raise and Scale programs at PwC Jonathan Hollis explains “Our objective in publishing this guide is to increase transparency in the early-stage fundraising ecosystem by demystifying the world of term sheets for founders.”

“We’re on a mission to optimise the fundraising process and this initiative is all about increasing transparency in the early-stage fundraising ecosystem by demystifying the world of term sheets”

Jonathan Hollis

Reem Mobassaleh Wyndham, a Founding Partner at Pact VC, explained to Morning Wire today that  “as both an angel and an institutional VC I’ve seen founders be pressured into some onerous terms that might make sense to investors in the short-term, but ones that don’t align incentives with founders and could ultimately limit the potential of the company in the long-term.”

The report centres around the four key pillars of the term sheet and seeks to help  founders understand this crucial stage that really does define how the investment unfolds and what the deal structure a startup can expect to receive. 

When your term sheet is signed it will normally trigger a period of binding exclusivity and then going forward is the template solicitors will use to draw together a more robust and detailed investment agreement. Hollis and his team outline that term sheets will usually focus on four key pillars which the report identifies as: 

The Valuation  apart from the obvious this can also include key investment terms and rights which are attached to the shares being issued to the incoming investor.

Deal Conditions which can include any due diligence expectations in terms of information that will be required to be disclosed by the your startup

Control pertaining to founder vesting and minority protection and consents

Binding terms which highlight to a founder any exclusivity period, broad scope of confidentiality and associated fees with the investment.

In addition to the above as a founder some other important facts that could be worth reading through as they are always hot topics of discussion in the VC onboarding process include:  

Time to close On average over 50% of funds believe that it can take between eight to twelve weeks from the first meeting to go through due diligence and for all parties to finalise the investment and equity agreements to be agreed. So closing the deal within two to three weeks is possible but startups need to be “investor ready” to try and expedite the process. 

Share structures: 80% of investors that responded to the report expect to be issued with preference shares which means these rank higher than ordinary shares. What in reality the preference actually means can be up for debate but usually in a VC context will be how the return of capital will happen upon the company winding up or liquidating..

Fees: within the context of institutional capital fall into two types; deal fees which highlight that 70% of funders surveyed recharge fees to the startup they are funding. Typically these fall under legal and due diligence fees as a result of using a third party outsourced provider. Management fees can come in varying forms depending on the type of investor you are working with. Here the data shows of the 200 plus companies that partnered on the report there is a massive differential on how the fees are charged and to whom. 

Founder Vesting this is to ensure that the management team remains highly motivated to help the startup succeed. If a founder leaves before the vesting period is over they lose the shares and then the company can deploy the “unvested” shares to attract new talent into the business. 

Employee Share Options: As a first time founder VC’s will want to know what employee share schemes look like for the business and that a decent amount of equity has been ring fenced for future talent to be brought into the business. 

Chris Smith Playfair Capital Managing Partner, said: “Ensuring that founders and investors are on the same page when it comes to current market investment terms and terminology really helps transactions run smoothly and enables a quick close so that we can get on with the business of building great companies.”

“Any initiative that gives founders a clear understanding of what to expect when they receive an offer from an investor is to be welcomed.”

Chris Smith Playfair Capital Managing Partner

The report highlights the importance of first time founders learning the intricacies of VC investment and having a significant network of talent within the business to be able to get the highest possible return for the money they are taking in.

Because while your legal team who has experience dealing with early stage companies should preside over the entire process, the right team of advisors like Mountside Ventures will be able to help with term sheet negotiations to ensure founders are getting the best possible terms and can talk startups through the long term impact of the investment on the business.