Term Sheets 101: A Guide to Negotiating Your Startup's Future with Venture Capitalists
Understanding the Economics, Control, and Protective Provisions of Term Sheets for Successful Fundraising
Term sheets
Officially
A term sheet is a written agreement outlining the main terms and conditions of a deal between a startup and a venture capitalist.
It is not a binding legal document.
Unofficially
The term sheet serves as a framework for the future relationship between the founder and the investor.
It sets expectations for the negotiation and investment process.
Basically
A term sheet is a simple outline for the financing round, followed by pages of clauses and provisions protecting both parties.
However, not all of these provisions are always enforced.
Fundamentally
A term sheet can be broken down into two main components: economics and control.
Economics refer to the financial terms of the deal, while control refers to the decision-making power and authority over the company.
Economics
Venture returns are based on buying low and selling high
Deal economics encompass the terms that relate to financial returns for investors and founders in different scenarios.
Deal economics is important not just for founders and VCs, but also for future employees and investors.
Some examples of terms that fall under economics include:
Pre-money valuation, which determines the price per share and is a crucial factor in negotiations.
Resize of ESOP, which adjusts the employee stock options pool to reflect the new financing.
Liquidation preference, which determines the seniority of preferred shares in any payouts.
Founder vesting, which ensures that founders continue to have a stake in the company even after new financing rounds.
Anti-dilution provisions, which provide protection in case of a downround, where the company's valuation decreases.
All of these terms must be carefully negotiated to ensure a fair and successful outcome for all parties involved in the deal.
Control
Refers to terms that restrict or affect the founders' ability to make decisions and require the founder to obtain the investor's consent before taking certain actions.
Board of Directors: the body responsible for making major corporate decisions.
Company policies, appointing officers, and how the BOD will function are usually detailed in the board of directors clause in the term sheet.
Early-stage companies will typically have 3-5 board seats occupied by a combination of VC investors, founders, CEOs, outsiders, advisors, and others.
VC investors require board influence to ensure capital is used appropriately.
Startup representatives require board seats to maintain power over the company's decisions.
Typically, the BOD will have an odd number of seats, with one reserved for an outsider to prevent tie votes, which can be detailed in the term sheet.
Protective provisions: clauses that give investors the right to block or veto certain actions, even if the BOD authorizes the action.
Sophisticated VCs will always require protective provisions. Examples are the ability to block a change of terms in stock owned by the investor, change of size and composition of BOD, and sale of the company.
Investor's rights: right of first refusal (pro-rata), giving the investor the right to maintain ownership in the company, and other investor rights that may relate to protective provisions.
Pre-money Valuation
Valuation is a crucial component of the term sheet, especially in the early stages of a company when it is difficult to assess its worth. While valuation at a late stage is more of a science, at an early stage, it is more of an art.
Some of the key factors that impact pre-money valuation include the level of competition in the market, future fundraising needs, the company's location, and the dilution effect on the cap table.
Rounds can dilute the cap table by approximately 20%, while the employee stock option plan (ESOP) typically accounts for 10%-15% of the cap table.
The competitiveness of a deal and the location of the company can also impact pre-money valuation. For example, companies based in first-tier locations such as New York, San Francisco, and Boston may command higher valuations than those based in second-tier locations such as Seattle, Los Angeles, and Austin, or third-tier locations like Chicago.
Seed:
Financial modeling is difficult due to lack of data and highly inaccurate projections
Investors tend to focus more on the founding team, market potential, and overall idea
A "hot" deal in a major market may attract more investment than a less exciting deal in a smaller market
Series A:
More data available for financial modeling, but projections still highly unreliable
Startups may be more well known and have more institutional investors, increasing the potential for highly valued rounds
Track record for key metrics, such as user acquisition and revenue, is important for attracting investment
Series B+:
True going concerns with layers of management, metrics, and growth track records, making financial analysis more valuable Investors may expect more reliable financial projections and analysis from startups at this stage
Growth potential and a proven business model are key factors in attracting investment at this stage
Employee Stock Option Pool (ESOP)
Definition: It is the amount of equity reserved for future hires, and the option pool can significantly impact the valuation of the company.
It represents the percentage of a company reserved for employees.
New companies can create an option pool by setting aside common stock shares and granting them to employees.
The ESOP is created to offer incentives other than money, as the company may have limited capital to offer monetary incentives.
The potential upside awaiting from ESOPs can motivate employees to work harder.
Key points
ESOPs are commonly between 10%-20%.
The amount of ESOP should be based on the company's hiring plan.
The ESOP's placement (pre-money vs. post-money) can significantly impact its effects on dilution.
ESOPs are part of nearly every financing round, and their inclusion ensures that dilution happens. The key is to identify which parties it will affect.
Founder Vesting
Founder vesting is an agreement where founders commit that their stock will vest over a period of time.
Option agreements are traditionally structured with a 4-year term, with a 25% cliff at Year 1 and then monthly vesting over the following 3 years.
Accelerated vesting and/or different triggers can also be used.
The purpose of founder vesting is to prevent "dead weight" on the cap table, which can negatively impact the company and other shareholders.
Founder vesting can be a contentious issue in term sheet negotiations since it requires the founders to re-earn their shares.
Optional Conversion
Allows buyers of preferred stock to convert to common stock if they choose to do so
Conversion is triggered if the liquidation preference and participation have been met
Requires the holder to take an active step to convert their shares
Automatic Conversion
Requires the holder to automatically convert their preferred stock to common stock without any action on their part
Usually happens at a later stage of the company's growth
Can be triggered by a specific event, such as an IPO or a vote by the board of directors
Anti-Dilution
Anti-dilution provisions act as a buffer to protect investors against their equity ownership positions becoming diluted or less valuable.
Adjust price per share to what the preferred holders had already paid.
Two types of anti-dilution:
Broad-based = fully-diluted capitalization, so common + preferred + unexercised options and warrants.
Narrow based = essentially just the outstanding common and preferred stock.
New Conversion Price formula = Old Conversion Price * ((CS + (New $/Old CP))/(CS + New # of shares))
New CP = New Conversion Price
Old CP = Old Conversion Price
New $ = aggregate dollar value of the stock sold in the dilutive issuance
New # of shares = aggregate number of shares issued in the dilutive issuance
Voting Rights
Rights of a shareholder to vote on matters of corporate policy
In VC, voting rights tend to refer to the right of preferred shareholders to participate in voting alongside common shareholders
This is a crucial power as the ability to vote on corporate affairs is often a primary characteristic separating preferred and common shareholders
Fundamentally, voting rights tend toward eliminating the difference in power of share classes, as they look at management decisions through an "as converted" basis (all converting to common)
Most of the time, voting rights are simply an "FYI" section as all heavy rights are contained in other sections such as the protective provisions
The most important application of this is that no separate approval of the preferred shareholders is necessary to approve an increase in the number of authorized common shares as long as the majority of stockholders approve the change.
Share Class vs Preferred vs All holders:
Share Class: a specific group of shares in a company, such as common or preferred
Preferred: a class of shares that has certain rights and privileges over common shares, such as liquidation preference, anti-dilution protection, and voting rights
All holders: includes both common and preferred shareholders, regardless of share class, and can refer to the collective interests of all shareholders in a company.
Protective Provisions
Protective provisions are class voting rights that give preferred stockholders veto power on certain actions by the company
These provisions are hotly negotiated between the company and the investors
Examples of protective provisions include:
Sale or liquidation event
Increase or decrease in the total number of authorized shares
Amendment to the certificate of incorporation to alter powers, preferences, or special rights to the shares of preferred stock
Change in the principal business of the company or entering into a new line of business
Hiring, firing, or change in compensation of any executive officer
Transaction with any director, executive, or employee of the company
Voting rights and protective provisions prevent decisions from being made solely by majority ownership
Redemption Rights
A clause that gives investors the option to require a company to buy back their shares at a predetermined price after a specified period of time has elapsed
Functions like a put option, providing investors with leverage over the company
It is a right and not obligation to sell shares
Company must purchase preferred stock at original purchase price, regardless of the current market value
Typically used by VCs as a way to secure their investment
A 5-7 year trigger is standard for redemption rights
Can also be used during a "sideways situation," where a company is not growing as expected
Seen in about one-third of all financing deals
Redemption rights are not commonly implemented, especially in early-stage companies where the focus is on growth
Management and Information Rights:
Information rights require the company to provide investors with regular financial statements and other company information
Typically included in an investor rights agreement
Management rights allow the investor to attend board meetings and provide advice on the management of the company
Management rights tend to be less negotiable and are typically granted to larger LPs with greater regulatory requirements
Information rights can be more complex and are sometimes only granted to investors above a certain threshold
Information rights are generally expected for most investors, especially in later-stage companies
Registration Rights
Registration rights are an important feature in venture capital transactions that allow investors to register their shares publicly for sale. Here are some key points to consider:
Definition: A right that entitles an investor who owns restricted stock to require the company to list the shares publicly so that the investor can sell them.
Examples:
Demand Rights: Some investors can force the company to register its shares publicly, which is known as demand rights.
Piggyback Rights: The right of smaller investors to "piggyback" or include their shares in any that are being registered.
Timing: Registration rights come into play at a later stage, and the timing, value, and expenses of registration are important considerations.
Number of Registrations: The number of registrations is also an important factor to consider, and this can vary depending on the agreement.
Lock-up: Some registration rights agreements include a lock-up period, which is a time during which investors cannot sell their shares.
"Best Efforts": Companies are required to make "best efforts" to register the shares, but this can sometimes be difficult to define.
Early-Stage: At the early-stage, most term sheets skip this section and have standard registration rights.
D&O/Key Person Insurance
D&O Insurance:
Directs officers (D&O) insurance is an indemnification that protects the board from company decisions made during their tenure.
Protects individuals making decisions on the company’s behalf.
It is designed to protect personal assets in case of a lawsuit.
Key Person Insurance:
Key Person insurance is essentially a term life policy.
It is used with founders who possess something crucial (experience, unique expertise, etc.) and necessary for the company’s future success.
In the event of a key member's death, the insurance provides funds to continue business operations and help cover costs related to finding and training a replacement.
Right of First Refusal (ROFR)
A provision that allows certain existing investors to accept or refuse the purchase of equity shares offered by the company, whether through transfer or new issuance.
Existing investor right to buy new shares in a following round to maintain ownership.
Key points:
Pro-rata, but also extends to "co-sale."
Governed by "Major Investor/Qualified Purchaser" threshold.
Use it or lose it, as it is difficult to maintain ROFR in subsequent rounds.
Super pro-rata = option to buy up ownership in the following round (increase).
Pro-rata is key to ensuring a fund maintains its ownership through the life of a company.
Drag-along vs. Tag-along
These are provisions used in shareholder agreements that provide rights to minority and majority shareholders during a sale or offering of shares:
Drag-along right: This provision gives majority shareholders the ability to force a sale of the company to a third-party without the consent of minority shareholders.
Protects the majority shareholder's ability to sell the company
Minority shareholders receive the same price, terms, and conditions as any other seller
Used in the sale of a company
Tag-along clause: This provision requires the majority shareholder to allow minority shareholders to join in on their sale or offering of shares.
Protects the minority shareholder's interest in the company
Minority shareholders receive the same price, terms, and conditions as any other seller
Used in the sale and offering of shares
Both provisions are used to protect shareholders from unfavorable acquisition terms.
Others
No-shop agreement: This is a confidentiality agreement prohibiting founders from using the term sheet to solicit offers from other potential investors.
Expenses: It is typical for the company to pay legal and administrative costs of the transaction, including VC attorney fees.
Pay-to-play: This requires existing investors to invest on a pro-rata basis in subsequent financing rounds, or else they will lose some or all of their preferential rights (anti-dilution, voting rights).