Term sheets (part 3) – things to watch out for – what’s the exact deal

by Simon Murdoch

I’ve written about term sheets before – the first post was on standard term sheets, and the second on liquidation preference.

One key thing to watch out for is whether the term sheet you have received really defines the deal exactly. I am amazed how many people are not clear about their definition of pre money valuation. The most common moving variable is the top up of the option pool. Many entrepreneurs assume the option pool should be topped up afterwards. All VCs define the pre money valuation including the top up to the option pool.

deal handshake

To a VC, pre money valuation plus the round size should equal the post money valuation. As an early stage VC our aim is to make at least 10x on the deals that work, so we need to believe that you can build a business worth at least 10x the post money valuation and ideally a fair bit more to leave room for further rounds of finance which are very likely to be required.

In our standard term sheet we define the exact terms of the share purchase in two ways. Firstly the section called Structure of Financing includes the pre money valuation but anchors that by defining the unallocated option pool % and the share price per share, plus we state how much we will invest and our expected %.

Secondly in Appendix A we provide a capital table or more often refer to a cap table spreadsheet which we send with the term sheet so there is total clarity about the deal as we see it.

Are you clear about the different definitions of pre money valuation? I’ve put together a Google spreadsheet as an example capital table.

Example capital table

In this example with two founders, we first split the shares by a large multiple e.g. 100,000 in this case (column C). We like to do this as it makes share numbers and option grants easier. With over a million options they can be shared out among many people in due course with much more granularity. Psychologically 100,000 options and a recent share price of £0.15 sounds much better than 1 option with a recent share price of £15,000. Numbers of shares or options should always be integers.

I won’t go through the calculations in detail but you can view them in the Google spreadsheet. The smart cells in this spreadsheet are D16 and E9. The share price is calculated allowing for the 10% option pool. Then the number of options is calculated based on 10% of the post money valuation divided by the share price.

Notice how the VC definition of pre money valuation is £1.75m whereas the alternative way of defining pre money valuation before the option pool is cell C17 and is £1.5m. And as a check, cell F18 has the final number of shares and options times the share price giving the expected answer of £2.5m.

 

If you are still with me on all this, we had a more complicated situation in a recent deal where the company had already received a convertible loan. We talked with the entrepreneurs about four ways of considering the pre money valuation as in the second Google spreadsheet example cap table below:

Example cap table 2

In this particular case, the four possible ways of defining the pre money valuation are in cells G21..G24. The convertible loan had only recently been granted and most of the money was still in the bank. So to an extent that money was part of the round even though those lenders were able to buy their shares at a big discount to our price. So I would argue that the most relevant pre money valuation is £3.35m. If the company had largely used up that cash, then we would have considered the pre money as £3.5m.

So, the key point in raising all this is to check carefully if the term sheet(s) you receive are detailed enough so you know the exact situation post deal. I strongly recommend that every term sheet is linked to a specific cap table spreadsheet which defines the share price and everyone’s stake after the deal.

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