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Reading a term sheet: the valuation is the least useful number on the page

A term sheet has arrived and the eye goes straight to the valuation. It is the figure repeated to a co-founder, to a partner, to anyone who asks how the raise went. It is also the item on the page that tells you least about what you will personally end up with.

A term sheet describes how a company will be governed, and the order in which people are paid when there is finally something to pay out. The valuation fixes a starting proportion of the shares, and nearly everything else on the page determines whether that proportion is worth what the founder assumes.

Founders read the document as an opening offer to be accepted or improved upon. The investor reads it as the settled shape of the transaction, because for them it generally is. The long form documents that follow, the subscription agreement, the shareholders' agreement and the new articles, are drafted from the term sheet by people who treat each line in it as decided.

That asymmetry does more damage than any single clause, because the founder goes on treating the document as a proposal for some time after the investor has stopped.

What the headline number conceals

The percentage a founder calculates from the valuation is rarely the percentage they hold once the round completes, because the arithmetic is performed on a share count that has not yet absorbed everything due to be added to it.

• An enlarged option pool is frequently created out of the valuation rather than after it, which means the shares reserved for future employees are paid for by the people who already hold shares, and by nobody else.
• Money raised earlier on convertible loan notes or advance subscription agreements converts as part of the same event, usually at a discount or against a ceiling agreed when the company was worth considerably less.
• Warrants, adviser shares and promises made informally to early supporters all land in the same column, and they tend to be remembered only when a lawyer asks for a complete list.

The size of the option pool is where founders are most often relieved of value while believing they are discussing administration. It is sized against a hiring plan written optimistically, and the founder is diluted today for people who may never be recruited. It is also the point at which a founder can most easily be shown to be arguing about the wrong thing, because conceding on the pool preserves the valuation, and the valuation is the number they will be asked about.

The preference decides what a founder actually receives

Investors normally take shares carrying a right to be repaid ahead of ordinary shareholders on a sale or a winding up. The preference may be limited to the amount invested or set at a multiple of it. It may stop once that sum has been returned, or allow the investor to take their sum and then share in what remains alongside everybody else. Successive rounds create a queue, and later money commonly stands ahead of earlier money in it.

None of this matters in a spectacular outcome, where there is enough for everyone, and none of it matters in a failure, where there is nothing. It decides the middling result, and that is the outcome founders are least likely to have modelled. A sale that the whole market describes as a success can return very little to the founders and almost nothing to the employees holding options, and the moment this becomes apparent is normally the moment the waterfall is modelled properly for the first time, which is to say when the sale is already agreed.

There is a further complication particular to England and Wales. The tax reliefs many early investors rely on require shares that carry no preferential right to the company's assets on a winding up, so how a preference is expressed, and where it is expressed, is not a matter of taste. A provision lifted from a document written for another market can quietly remove the relief the investor was counting on, and that is discovered by the founder, not by the person who drafted it.

Control does not follow ownership

Founders regularly skim the clause listing the matters that require investor consent, and it does more to determine how the company is run than the valuation does. A holder of a modest proportion of the shares can, through it, hold a veto over decisions that a majority shareholder would otherwise take alone. Alongside it sit the composition of the board, who appoints its members, and how a deadlock resolves.

The dramatic consents attract attention: selling the company, changing what it does, taking on substantial borrowing. The ones that shape daily life are duller. Approving the annual budget, committing capital beyond an agreed level, senior hires and their packages, and, above all, issuing further shares. That last consent means the ability to raise the next round sits with an existing investor, and it is exercised at precisely the point when the company has the least room to argue.

In practice these consents are more often left unanswered than refused. They are handled by whoever at the fund holds the file at the time, and a request that is urgent to the company can look minor from there. A founder discovers which consents were expensive on the day a decision needs to be made quickly and cannot be.

Non-binding does not mean inconsequential

Term sheets state that they create no obligation to invest, and then carve out the provisions that do bind: confidentiality, who bears costs if the deal collapses, and exclusivity. Exclusivity is the one with teeth. It stops the founder speaking to anyone else while the investor conducts diligence, and the company's outgoings do not pause while that happens.

The remainder binds in a different way. A position agreed in principle is not reopened without a reason, and any reason a founder gives sounds like second thoughts rather than late comprehension. Under the law of England and Wales the document may impose no obligation to proceed on those terms, but the practical cost of departing from them is real, and it is paid in the investor's willingness to be generous on everything still genuinely open.

There is also the exposure created by signing at all. A founder who takes a term sheet has almost always told the other interested parties that the round is done, because that is the polite thing to do. If the deal then fails during diligence, they return to a market that has noticed, and the remaining investors will want to know what the first one found. The answer is frequently nothing of substance, and that is a difficult answer to make convincing.

Leverage runs opposite to need

Every one of these terms is negotiable, and how negotiable it is depends almost entirely on one thing: whether the founder can credibly do without this particular investor. A company with another party in genuine conversation moves terms. A company approaching the end of its cash does not, and cannot conceal the fact, because the financial information handed over during diligence states it plainly.

This is why the negotiation is substantially decided before the term sheet is written. By the time a founder is reading one, their position is whatever their alternatives make it, and alternatives are not built quickly. The founder who raises when the accounts still look comfortable is negotiating from a different document to the founder raising because payroll is in question, even where the two term sheets appear identical.

Founders also spend what leverage they have in the wrong place. Goodwill in a negotiation is finite, and it is routinely exhausted on the valuation, because that is the term with social consequences. The preference, the consent list and the leaver provisions attract no interest from anyone the founder will ever discuss the round with, and so they are conceded to protect a number that will not determine the outcome.

What is not worth fighting

A good deal of what a founder finds objectionable on first reading is standard for the stage, and the investor could not depart from it even if they wished to, because their own fund documents constrain what they may accept. Attacking every unfamiliar clause achieves nothing except establishing that the founder has not done this before, which itself weakens them on the terms that were open.

Some rounds do not justify sustained negotiation at all. Where the sum is small, the documents are the investor's usual ones and the economics are modest, a line by line renegotiation consumes money the company raised the round to spend, and the terms achieved will not repay it. There is a version of diligence about your own investors that is similarly disproportionate, and knowing which situation you are in is the whole exercise.

The harder honesty is that sometimes the answer is not to take the money. A round raised to fund a plan the founder does not privately believe in is not improved by better terms, and it postpones the same conversation until more people are entitled to be part of it. The judgement worth paying for concerns which of these provisions will still be operating when the company looks nothing like it does today, and what they will do to a founder at that point. That requires having watched a number of these agreements reach their conclusion, which is not knowledge a founder raising for the first time can be expected to have.

This guide is general information about how these matters usually run. It is not advice, and nothing becomes advice until terms are agreed in writing. Brandleys Legal Ltd delivers reserved legal activities alongside regulated partners.