Innovis insights - Mastering the Term Sheet

In this edition of our newsletter, we’re excited to share an insightful excerpt from Venture Deals, one of the most trusted guides to venture capital, written by Brad Feld and Jason Mendelson (2012). Being a young, motivated VC student initiative, we were lucky to stumble upon this read which led us to vastly insightful learnings relative to our early careers. Nonetheless, this book is an oddity since each chapter can be read independently, offering diverse perspectives from entrepreneurs as well as professionals, all backed by the authors’ experience as devoted veterans of the startup field.

The following excerpt focuses on the importance of a term sheet in venture capital and breaks down its key components – one of the key parts of this 368-page book. “The term sheet is critical”, a quote which is emphasized and heavily underlined to never be underestimated since it’s not a simple “letter of intent” but rather a backbone of the investor – entrepreneur relationship (Feld & Mendelson, 2012, p. 31).

"The term sheet is one of the most important documents in a venture capital financing. It lays out the key terms of the investment, including the valuation of the company, the rights of investors, and the governance structure of the startup moving forward. The primary components of a term sheet typically include the price per share, liquidation preferences, anti-dilution provisions, and voting rights. Understanding these terms is critical for any entrepreneur seeking to raise venture capital, as they will have long-term implications for both the founders and the investors" (Feld & Mendelson, 2012, p. 72).

Now, let’s delve deeper into some key concepts we found most eye-opening in Venture Deals and understand why they are crucial for structuring a successful venture capital deal, thereby understanding how we can become truly smarter than our lawyer and a venture capitalist.

Read more : Venture Capital : definition, remunerations and recruitement

Constraining behavior and aligning incentives

In venture capital, aligning incentives ensures that both founders and investors are working toward the same goals. Terms like vesting schedules and liquidation preferences help ensure this alignment, keeping founders committed and protecting investors (Feld & Mendelson, 2012). This alignment reduces potential conflicts and keeps everyone involved focused on growing the business.
 

Transaction costs

Transaction costs refer to the time, effort, and legal resources spent negotiating and closing a deal. Feld and Mendelson emphasize that a well-structured term sheet can significantly reduce these costs by setting clear expectations early in the negotiation process. As Feld and Mendelson (2012) explain, lowering transaction costs streamlines the process and allows startups to focus on scaling and move forward efficiently.
 

Agency costs and information asymmetry

One challenge that often arises between founders and investors is a misalignment of interests, usually due to information asymmetry. Agency costs arise primarily due to information asymmetry, where founders typically have more information about the company than investors. Feld and Mendelson (2012) suggest using mechanisms like board seats and regular reporting to ensure transparency and keep everyone aligned. This concept highlights the importance of open communication.
 

Reputation constraints

In the venture capital world reputation matters. Both investors and founders depend heavily on their reputations to secure future deals and partnerships. According to Feld and Mendelson (2012), maintaining ethical behavior and building strong relationships is essential for long-term success within the venture ecosystem. However, this was simply a small extract from this vast book, which offers unique takes in each of its paragraphs.

Read more : How do you turn a financial analysis into a convincing presentation ?
 

As Feld and Mendelson (2012) put it, "In the end, the best deals are those where both sides feel they have won something" (p. 155). Understanding and negotiating the listed key components such as transaction costs, aligning incentives as well as agency costs ensures a balanced relationship between founders and investors, which ultimately leads to a more sustainable success. Resonating with various readers from the industry and having heavily positive reviews, this book is written by authors with years of experience collected as investors, venture capitalists and entrepreneurs which made this read especially valuable for us. Based on their practical knowledge, the writers offer precious insights to help the reader understand critical elements of successful venture capital deals which many surely can benefit from.
 

Author: Innovis VC e.V. Editorial Team
 

References :
 

Feld, B., & Mendelson, J. (2012). Venture deals: Be smarter than your lawyer and venture capitalist (3rd ed.). John Wiley & Sons.

Interested ? Read more : https://www.venturedeals.com/