Understanding a Term Sheet: Part 1

The term sheet, which denotes an intention to invest by a venture capitalist, is a slim handbook that rarely has more than a dozen pages. But for an entrepreneur, it is often a vindication of the business idea as well as evidence that the startup is a success.It is a core element of the VC-entrepreneur game. The reason we call it a game is because we have a set of players, choices that each player can make and a set of outcome. There are many kinds of games in a business setting.

The VC-entrepreneur game is similar to splitting a pie, which is also a kind of game. Two individuals come together with a set of ingredients to make a pie and at the end of the process they need to split the pie between themselves. For this we have zero sum approach, where one person’s victory means other person’s loss.

There is also a non-zero sum way of cutting a pie and that is by discussing with each other. The two individuals may discover that one of them is interested in crust and other only in stuffing. And then both of them can get 100% of what they want. In the case of splitting a company ownership we don’t have crust and stuffing, we have economics and control. It turns out that just like two individuals can have different preferences regarding the pie, they can also have different choices with respect to economics and control.

If one of them is not surely interested in the crust or economy or stuffing or control, it can still be carved in the non-zero sum way. It doesn’t have to be a pure preference; you can simply have a mild preference for one over the other and you can end with non-zero results,meaning that you don’t have to give up everything for the other to gain and vice-versa. Understanding the preferences of the entrepreneur vs. the VC is very important.

Entrepreneurs typically are looking for the right amount of funding with the least equity sharing, loss of control, may be help with customers, some help with legitimacy and may be some advice. VCs on the other hand are looking to pay the right amount for their shares, maximize the returns on investments with the lowest amount of risks and want to exit on schedule.

So the preferences of entrepreneurs and VCs are really different and that is a good thing because that means we can end up with a non-zero sum result. The importance of creativity is highlighted because when you are cutting a pie down the middle that doesn’t require a lot of creativity, it is a zero sum approach but to cut through the inner way where one person gets the crust and the other stuffing takes more skills and creativity.

In the next part we will talk about the terms found in a term sheet like tag along rights, drag along rights, preemptive rights and so on.

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