After you’ve done your due diligence and finally start investing in startups, you’ll have to review the term sheet.
If you’re lucky, you will be working from a standard term sheet like the one that Y Combinator publishes on its website. Not only does this help keep the legal costs down, but you could instead be looking at an 8 to 10 page document so complex that only your lawyer would understand it.
Let's review the most important items on a term sheet and what they mean so that you are better prepared for any legal issues that may arise.
1. Valuation
It is common to see the valuation of the startup as a "pre-money" valu ation. That gives the value of the company before the investors in the round participate. Investing pre-money versus post-money can make a big difference in your equity stake.
Let's say you are going to invest $1 million in a startup and the pre-money valuation is $10 million. If you invest pre-money, the new valuation of the company is $11 million and your equity would be 9.1%. If you invest at $10 million post-money, the valuation is $10 million after your investment and your equity is 10%.
A .9% difference might not seem like a lot, but if it was an investment in LinkedIn, which was just valued at $8.9 billion, a small percent of equity can equal big money.
2. Liquidation Preference
This is what is used to determine how the money is shared once the liquidity event happens. The preferred shares might have a liquidation preference of 1x the common shares. That means that when the company is sold, the preferred shares w ill be paid first and then the...
