In the startup world, understanding your contract and term sheets can make or break your deal. A term sheet is the first formal (non-binding) document between a startup founder and an investor and lays out the terms for investment. A good term sheet aligns the interests of the investor and the founder. It makes it clear what has been agreed and allows the lawyers to draft contracts that reflect this agreement. The eventual contracts are legally binding documents between founders and investors. They are supposed to capture the agreement expressed in the term sheet in legally solid language. Educating yourself and making sure you fully understand these documents is part of your responsibility as a founder.

This blog, which forms part of our Startup Survival blog series, gives an overview of the most common mistakes you could make and shares some practical advice.

What to keep in mind

• The market rules. To find out what kind of financial terms could be expected: research online and check with as many people as you can. It may sound strange but it’s generally best to have ‘market standard’ financial terms for your deal. If you think you are getting much better/worse than the market standard then your deal will likely be a disappointment for one of the two sides eventually. And you want both sides to feel comfortable throughout, ideally.
• A term sheet is non-binding. The parties agree on something, but it’s not a binding contract. The contract should be the same content-wise, but it often reads more complex because it’s been rewritten by lawyers to make it legally binding. It’s quite possible that the final contracts will be slightly different from the term sheet. So if you have something signed in the term sheet, check it again in the contract.
• Consider yourself a beginner. When it comes to the contract, make sure you’ve read and fully understood it. If you don’t understand something, start asking questions until you do understand it. You can write your own contract, but it’s like doing your own electrical wiring. It might go right, but if it goes wrong you may only find out when it is too late.
• A lawyer makes it legal, not smart. If a lawyer looks at a contract and says it’s legal, it doesn’t mean it’s smart to use. It might contain clauses that are perfectly legal but will actively hinder the growth of your company or future rounds at a later date. Unfortunately, there aren’t a lot of lawyers that have sufficient startup experience. And those often like to do the bigger funding rounds. So in the beginning you should consider using standard contracts, provided you are sure they are actively being used, like the Leapfunder contracts.
• Boring contracts are cool. Having a boring standard contract is actually better. That’s because future investors will understand the structure easily, which builds trust. Having a ‘clever’ structure in place to beat the system is usually only harmful.
• If you have several investors: standardise. If you’re talking to an investor, it’s preferable that you have the contract ready on your end. Because if you’re talking to five investors and you don’t keep control of the process, you’ll get five contracts from five different investors. Juggling these different contracts can be very challenging. It’s better to have your standard contract ready and have your investors align to it.
• You can often fix contracts later if there is trust. If all parties sign up for an amendment, you can just tear the old contract up and make a new one. But that requires everyone to be cooperative, and for there to be trust. It’s often smart to be radically transparent with the investor and show them a clear proposal for a repair. A good amendment usually makes your contracts more standard and therefore easier to understand. Startups that use Leapfunder can call us to give a hand.

Some common silly mistakes

• When you state the valuation of the company you need to make clear whether that valuation is ‘pre-money” or “post-money’. It also needs to be clear whether the valuation is ‘fully diluted’ or not, especially if it includes the “ESOP” or “VSOP”. If you don’t know what those terms mean you need to do more reading.
• When you download a contract from the U.S. or somewhere else abroad: please be aware that this contract may simply be void in your jurisdiction. Best to keep it local.
• Sometimes an investor will promise to release cash later based on reaching pre-defined milestones. In practice, the company will often evolve making the agreed milestones irrelevant. And, in practice, startups rarely meet any of their targets. In other words: if you sign a milestone-based deal you should assume that the milestones will not be met. If it’s still a good deal under that assumption you can sign.  But if the deal becomes awful without the milestones, well then it’s likely awful.
• A convertible note has a qualifying event. Having bad qualifying event definitions can be a major problem. Mistakes that we have seen included letting the expiration date of the convertible count as a qualifying event, without defining adequately how the valuation will be set at that time. Another mistake that we have seen is allowing a small funding round, or even an in-kind/non-cash investment, to count as a qualifying event. That means that when you enter an accelerator and give up some shares in return for a service and some cash: you will be faced with your convertibles converting into shares on those terms, which could be weird and even harmful.
• Small shareholders should go into an investor pool, so they act as one shareholder. Smaller shareholders have very little power in the general shareholders’ meeting. For that reason, it’s better for them to be pooled into a stronger collective block. At the same time, it’s better for the startup because having too many voices at the table in a shareholders’ meeting will likely decrease the quality of those meetings. Small shareholders are just as much work, and sometimes more work, than bigger ones, so you’re draining resources. That’s why you ought to set up a Special Purpose Vehicle, which groups smaller investors. At Leapfunder, we have standard pooling vehicles available for our startups. Those have stood the test of time, and will keep your startup safe and investable for later investors.

Does all of this sound too complicated? Don’t worry, get in touch with Leapfunder and we’ll take care of that headache for you.

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