You reached this stage, GREAT. This means you are on the right track.
Be careful however as the next step is trickier than you think. Although the investor agreed to back you up, you both still have to take the legal route and sign on the term sheet.
In the world of entrepreneurs, getting to the term sheet stage is already a reason to party, but the tough challenge now is to ensure that what is in this term sheet won’t hurt your company on the short and long run.
Note: term sheet is the agreement that you will sign on with the investors and it has all the terms and conditions you both have to agree on. NO it’s not another software agreement you can skip, this could be the most critical document you will sign in your life (I have to be dramatic here to get your attention).
Anyways, here are few steps you must do to ensure protection of your rights, company, and future:
- Don’t get over excited and sign immediately. Trust is great and all, but this is business and trust has just a small place in it.
- Read the agreement once, twice, 10 times, until you personally feel comfortable with the terms. Don’t jump to the excuse that you are not a “legal” expert. These agreements are not written in gibberish, which means you can actually read them and understand them. Let’s not put the legal experience as a barrier and let’s read every word.
- Now that you got a bit comfortable with the agreement (and if not, put some comments and questions on it for later discussions with the investor), run it by a legal expert or a lawyer. These people read between the lines and might alert you to tricky terms that could make you vulnerable. Having said that, be careful as they take things way too strictly and might hinder you from signing with the investor.
- Combine your comments with the legal experts’ comments and share it with the investor. Keep the balance that makes sense to you and your plans. Don’t be too nice with the investor, and in the same time don’t be too rigid to the point where it makes you lose the deal. You are the only one who can decide on the right level of compromise.
From my humble experience and interactions with investors, here are few critical points you have to understand in your term sheet:
- Shares distribution: make sure that the term share states the shares distribution between you and the investor exactly as you agreed on (both percentage wise (%) and number of shares)
- Board of directors (BoD) formation: some investors like to control the board and some don’t. Be sure to check the terms that breaks down the number of board members, who they are, and who appoints them. Also be comfortable with the chairman of the board mentioned in the term sheet
- Board decisions vs CEO decisions: This is one of the most important terms to check. The last thing you want is to be an operational CEO with little impact on the company’s strategy. Review the rights of the board and the rights of the CEO VERY CAREFULLY before you sign
- Voting in the board: Control is key, especially in the early stages of your startup. If you give control away, then you almost turned into just an employee of your startup. Voting for key decisions during board meetings could take the company to vastly different directions. I would recommend that you (and your co-founders) keep the voting rights to your side. This term could be very complicated and tricky, so get some help from a lawyer if you feel stuck.
- Terms that might affect future fund series: some investors inject terms that protect them in the future fund raising rounds. Some of these terms might represent a disadvantage to the future investors and hence could reduce your chances of getting more fund. However, given that the current investor backed you up early on, it’s fair to give them some protection. For such terms, think of the right balance and seek the help from seasoned entrepreneurs as they have been through it and could help you greatly. Some key words here to pay attention to (just to name a few) : “preferred shares”, “IP rights”, “anti-dilution”, “pro-rata rights”, “control rights” and the very important one: “Right of first refusal“
Now, trust me, i didn’t write the above to scare you or make it sound like a nightmare. But considering how important the first fund/incubation is to your company, you really have to give the proper needed time for this agreement and sign on it when you are 100% comfortable.
The bright side though, you found someone who believes in your startup and willing to invest in it!!
(p.s: invite me to the party if any).