NOTE: This is the second post in our series about standard terms in early stage equity financings. These posts refer to the model Series A Term Sheet put out by the National Venture Capital Association (NVCA) and available for download here.
* * * * * * * * * *
Introductory Paragraph
The introductory paragraph in the NVCA’s model term sheet is important because it makes clear that, for the most part, the term sheet does not create any legally binding obligations. Entrepreneurs must recognize that a term sheet is an agreement to try to reach an agreement, and therefore only a steppingstone (albeit an important one) on the path to financing. However, while the terms of an eventual financing may vary from those outlined in the term sheet, the term sheet is the first place lawyers on both sides will look to when preparing the actual financing documents. Any deviation from the term sheet must be justified; for instance, by a revelation about the company discovered during the investors’ due diligence.
Note that the introductory paragraph excludes the “No Shop/Confidentiality” and “Counsel and Expenses” provisions from the non-binding caveat.
Offering Terms
The “Offering Terms” section of the NVCA’s model term sheet summarizes the key economic provisions of the financing. This section is fairly self-explanatory, so we will limit our discussion to three points.
First, sometimes the investment will be divided into tranches spread across two or more Closing Dates, and later tranches may be subject to the company achieving certain milestones. If milestones are included, it is important that they be clearly defined and, if achievement or failure of a milestone cannot be objectively determined (i.e. is open to interpretation), that the mechanism for determining if/when the milestone is achieved also be clearly defined. Typically, determining if a milestone is achieved will fall to the investors, so it is in the company’s best interest to ensure the milestones are sufficiently well defined to minimize the investors’ discretion.
Second, the employee option pool is typically set at 15-20% of a company’s fully-diluted post-money capitalization at the time of a Series A financing, though it is sometimes set as low as 10% or as high as 25%. The principal factor in determining the size of the pool should be the need to incentivize current and future employees, so a company with a strong core team already in place should not need as large a pool as a company that expects to hire a new CEO in the near future. If the pool seems large, your investors may have a different expectation about the future growth of the company and you should raise your concerns with your invstors. The goal should be to establish a pool that is the right size to meet the company’s needs for the foreseeable future.
Third, it is also important to note how the pre- and post-money valuations of the company are impacted by the employee option pool. The NVCA model term sheet treats the option pool as part of the post-money valuation, but investors will sometimes include the option pool (or a proposed increase in an existing option pool) in the company’s pre-money valuation. This results in an illusory increase in the pre-money valuation, which the guys at Venture Hacks have dubbed the “Option Pool Shuffle.” There is nothing inherently wrong with including an option pool in the pre-money valuation, but it is important for entrepreneurs to understand that doing so has real economic impact. To illustrate, consider a pre-money valuation of $5 million that does not include an option pool and a pre-money valuation of $6 million that includes an option pool equal to 20% of the company’s fully-diluted capital. In the latter case, the option pool accounts for $1.2 million of the valuation, making the effective pre-money valuation only $4.8 million. Check out the Venture Hacks article for a more in-depth discussion of the impacts of the Option Pool Shuffle.