Startup Guide: Investor Term Sheet

What is a term sheet?

A term sheet is a summary of the proposed key terms of an investment in your
startup. The terms outline the conditions between your company and your
investors.

The term sheet serves as a blueprint for the formal legal paperwork later drafted
by lawyers. Typically, you agree to confidentiality and not to enter into
negotiations with other investors at the same time.

What you need to know are the key terms, how they affect you, and the best ways
to negotiate them for your startup.

Understanding a term sheet’s key terms

A term sheet dictates who gets what financially and who gets to take legal action
in any specific future situation. Among the key terms is a description of the
valuation of the company, the price per share, and the economic rights of the new
shares.

Usually, term sheets aren’t full of aggressive terms against the startup because
most investors realize that creating a win-win situation is best for getting a good
return on capital. But there are some cases where certain terms can result in a
founder unwittingly giving up more control of their business than desired. This is
why being aware of the potential consequences of specific terminology is vital.
Key terms and clauses: What you need to know
Shares in a company can be broadly categorized as common or preferred stock.
Common stock is usually the form of equity given to founders and employees.
Preferred stock gives certain investors special rights that are negotiable and
included in your term sheet.

Economics and control

Economics and control refer to the percentage of the company the new investors
will own based on the company’s valuation and the amount of money invested.
This is a critical part of the term sheet because it lays out who owns what and
how much each shareholder gets if the company sells. It also sets a foundation
for future term sheet valuations.

When it comes to valuation some critical terms to understand include:

1. Pre-money and post-money valuation

A pre-money valuation refers to what the value of your company is before

receiving funding. The post-money valuation is the estimated value of your
company after receiving venture capital investment.

Here’s an example of how a pre-money and post-money valuation is calculated:

As a founder, you’ll need to aim for a valuation that is not too high or too low. If a
valuation is too low, it can result in the unnecessary dilution of founder shares. If
a valuation is too high, it can increase the pressure to perform and the difficulties
of raising a subsequent round in the future.
The valuation is usually determined by many factors such as industry
comparables, growth rate and traction, startup location, market, and the strength
of the team. Experienced advisors will often encourage early-stage founders to
choose the right investors offering a lower valuation over the wrong investors
with a high valuation.

2. Liquidation preference

A liquidation preference is commonly considered one of the most important

terms to look out for in the term sheet for preferred stock. When a VC investor is
issued shares of preferred stock it grants specific rights, including the liquidation
preference, which makes it more valuable than common stock. In the event of a
liquidation, the preferred stock will have priority over common stock in receiving
the distribution of assets.

● Straight (or non-participating) preferred

[Favors company] When the company is sold, the preferred stockholders
can choose a liquidation preference with a liquidation multiple. This means
that preferred stockholders are entitled to get paid back their entire
investment (plus dividends) and to a multiple amount of their original
investment (e.g., “2X multiple,” 3X multiple”, etc.) before the distribution of
any proceeds to those with common stock.
Or the preferred stockholders can choose to convert their preferred stock
to common stock and to be treated the same as the common stockholders
(allowing them to share ratably in the proceeds).

● Participating preferred (double-dip)

[Favors investor] The preferred stockholders are entitled to the return of
their entire investment (plus dividends) before the common stockholders
get paid. However, the preferred stockholders will still be treated like
common stockholders and share ratably in the remaining proceeds —
effectively being paid twice.
For instance, if an investor invests $1 million in a company at a post-money
valuation of $5 million, this gives him 20% ownership of the company. The
company later sells for $10 million. The investor will initially get paid $2
 million, and then 20% of the remaining $8 million for a total of $2m +
$1.6m = $3.6 million.

● Capped (or partially) participating preferred

The preferred stockholders have the same rights as participating preferred,
but their aggregate return is capped. Once they receive the capped amount
they cannot share in the remaining proceeds with the other common
stockholders. This is often seen as a compromise.
If your company is a runaway hit, liquidation preferences will matter less as
your company valuation is far greater than the original amount the investor
put in. In a more modest exit, the liquidation preference can greatly
diminish the number of proceeds given to founders and employees. So,
this is a term that should be carefully negotiated.

3. Conversion rights

The ability to convert shares of preferred stock into shares of common stock is
called a conversion right. There are two main types of conversion rights including
optional and mandatory rights.

Optional conversion rights are typically non-negotiable and allow an investor to

convert shares of preferred stock into common stock, typically on a one-to-one
basis. The investor’s interest in liquidation preference guides this process. This
allows the investor to choose between getting their liquidation preference or
participating in the proportional share of the proceeds.

Mandatory conversion rights are negotiable and require the investor to

automatically convert shares of preferred stock into common stock through a
process called “automatic conversion”.

4. Option pool size

An option pool is made up of shares of stocks reserved especially for employees.

Usually called Employee Stock Option Pools (“ESOPs”) they help companies
attract top talent to a startup and if the company goes public, employees are
rewarded with stock.
In a term sheet, the ESOP is specified as a percentage of the post-money
valuation. As a result, this often means that the founders are shouldering all of
the dilution. The ESOP is taken from the founders’ stock. For example, the
investor has 25% of the company’s shares and stipulates a 20% ESOP on the
post-money valuation, so the founders are left with 55% of the company’s shares.

If your company is sold, all the unissued and unvested options would be
canceled. Investors would share the additional sale proceeds proportionally with
founders — even though those options were from the founders.

Typically ESOPs are about 10-25%, with different norms depending on your
location. When creating an option pool, you don’t want to develop a massive one.
This can reduce the chance of unallocated equity. Top-ups can occur later if
needed at future rounds.

5. Dividends

A dividend is a payment made up of a distribution of profits from a corporation to

its shareholders. A cumulative dividend is a right connected to certain preferred
shares. It is calculated annually and carried forward to the next year if the
company can’t pay. Non-cumulative dividends don’t have unpaid dividends
carried over from past years which makes them the best for founders. Not all
investment rounds involve dividends.

Investor rights and protections

Investor rights and protections refer to clauses that are used to protect an
investor’s investment, such as:

1. Anti-dilution rights

Anti-dilution rights shield preferred investors in the event of a down round (lower
valuation than what they invested in). When a company’s valuation decreases
from different rounds of financing preferred shareholders are protected by giving
them additional shares. These provisions can be devastating to the founders.

There are typically two types of adjustments:

● Full ratchet
This is rare as this type of adjustment is extremely disadvantageous to the
founders and other common stockholders. The adjustment brings down
the conversion price to the lowest price at which the stock is issued after
the issuance of the investor’s preferred stock, regardless of the number of
shares.

● Weighted average
This takes into account both the lower price and the actual number of
shares issued in the down round via a formula. There are two types of
weighted-average formulas: broad-based (takes into account fully diluted
capital stock including all issued and unissued stock such as options) or
narrow-based (only outstanding capital stock). A broad-based approach is
typically a smaller percentage of a larger amount, which is more favorable
to founders.

2. Pro-rata rights

A pro-rata clause gives an investor the option to participate in future financing

rounds to keep their percentage ownership in the company that would otherwise
be diluted. Pro-rata rights are essential to early-stage rounds and are generally
positive factors in term sheets.

Pro-rata rights are typically given to larger investors in rounds and aren’t always
enforced. Investors can choose to take up their pro-rata rights in later rounds
depending on their strategy.

3. Right of first refusal (ROFR) and approval of the sale

Having a right of first refusal clause requires that all current shareholders are
notified and have the right to buy stock from an investor who is selling. Along
with approval of sale clause, this prevents secretive transfers of stock from
occurring, such as an investor selling your stock to a competitor.

4. No-shop clause

A no-shop agreement is typically part of the final term sheet once you’ve chosen
your lead investor among your available options. Part of the process of
negotiating the final term sheet with this investor is agreeing to commit to getting
a deal done.

Founders may want to bind the no-shop clause to a time of around 30-60 days to
make the commitment mutual. The founder agrees not to shop the deal while the
VC investor agrees to get things done within a reasonable period.

Governance management and control

Governance management and control set the rules concerning who’s in control of
the company along with voting rights, board rights, information rights, and
founder vesting.

1. Voting rights

Voting rights consist of the shareholder’s right to vote on company policy. This
term sheet clause divides voting rights across various instruments (A, B,
Preferred) and sets out for which corporate action a majority vote is needed.

Depending on how the majority votes, it gives the holder of the instrument the
ability to block certain actions such as liquidation of the company, payout of
dividends, revisions to the number of board members, annual spending budgets,
and amendments to the charter or bylaws.

2. Protective rights
These are provisions that protect investors by giving them the right to block or
veto certain actions, even those authorized by the Board of Directors. The
consent of a percentage of the preferred stockholders is required before moving
forward. This helps protect investors from the majority stockholders.

● Standard protective provisions

These provisions are viewed as standard and can include a sale of the
company or a similar liquidation event, amendments to the company’s
Certificate of Incorporation or bylaws to change the rights of preferred
stock, increases or decreases in the shares of preferred or common stock,
the issuance of any equity security having a preference over preferred
stock, redeeming or purchasing preferred or common stock, payment of
dividends from shares of any stock, and any revision in the number of
directors of the company.

● Non-standard protective provisions

Some investors may desire extra items beyond the standard provisions.
These non-standard provisions may include acquiring debt of more than
$100K, hiring, firing, or changing the compensation of executive officers,
entering into a transaction with a director, executive, or employee of a
company, changes to the principal business model, and purchases of
assets of another entity.
If you have strong enough leverage, founders can negotiate to push back
or knock out most of the non-standard provisions.

3. Board rights

The Board of Directors is a group of people who are selected to represent the
shareholders’ interests in the company. The board typically establishes corporate
management policies and enacts major decisions.

After a funding round, typically there is a “balance” in which neither the investor
nor the founders control the board. In a five-member board, two directors will be
appointed by the investors and two by the founders. The remaining director
would be independent. However, founders in “hot” startups can more easily
negotiate to retain control.
The company’s bylaws can set the structure of the board and the number of
meetings, which some investors might try to adjust to take more control over the
board. Be aware of this risk because if you lose control over the board, you can
also lose control of your company.

4. Information rights

Information rights demand that you share the company’s financial status
regularly with investors. Quarterly management reports and detailed annual
financials are usually required after the end of the fiscal year.

5. Founder vesting

Founder share vesting makes it difficult for a founder to abandon a company by

placing shares at risk. If the shares are returned this gives the company the
chance to find a suitable replacement. Founders should negotiate a vesting
program that works in their interest, such as excluding part of their holding from
the agreement.

Exits and liquidity

The terms that govern exits and liquidity describe what happens in the event of a
sale and shareholder rights during the process. Terms to look for include:

1. Drag-along and tag-along rights

If a sale of the company happens, drag-along rights prevent minority

shareholders from blocking the occurrence if it was approved by the majority
shareholder or by a collective majority. This can be helpful to the minority
shareholder as well because it ensures that the same deal is offered to all
parties.
Tag-along rights protect the minority shareholder further by giving them the right
to join in any action with the majority shareholder. Often majority shareholders
uncover more favorable deals from which the minority shareholder would be
denied if it weren’t for this provision.

2. Redemption rights

The redemption clause can have a potentially negative impact that can create a
liquidity crisis for startups. Using the clause, investors can demand redemption
of stock within a certain amount of time.

Management may be forced to quickly sell the company to redeem the funds or
petition shareholders to provide the funding in a rushed financing round. This is
often resolved by the company paying the redeeming party the greater of fair
market value and the original purchase price plus interest.

Term sheets and valuations: How to be a smart negotiator

For startup founders, the term sheet negotiation is about raising capital from VC
investors while maintaining as much control as possible and limiting risks.
Depending on what rights they push for or don’t, you can get a good feel for who
your investor is and where they stand.

Surprises should be unlikely if your startup raises a round from a well-known

venture capital fund. There may be more legal issues to straighten out if you’re
dealing with a late-stage private equity investor or a new corporate investor.

Remember that your investor will have a fundamental role in the development of
your company, so do more research than just uncovering how much funding they
can invest. Think of the process of negotiation as a two-way due diligence
operation.
Top red flags to look for in a term sheet
Certain terms have implications that may not be founder-friendly. It pays to get
objective advice from a lawyer with a background in this area. Your investors’
recommendations don’t necessarily have to dictate who you hire. Ensure you get
a lawyer that can catch provisions that could have negative unintended
consequences for your startup.

Meanwhile, here are some important not-so-founder-friendly terms to look out

for:

● Protective provisions – These provisions can limit how much debt you can
have without the consent of VCs, place restrictions on increasing
authorized shares to take on new funding or give to employees, and
additional revisions to the certificate of incorporation.
● Full ratchet anti-dilution – This protection can wipe out common
shareholders in a down round. A down round is when a company’s
valuation decreases in consecutive funding rounds. A broad-based
weighted average is the most founder-friendly form of anti-dilution
followed by a narrow-based weighted average.
● Cumulative and PIK dividends – Cumulative dividends essentially
guarantee investors a certain level of return, which is not standard for
early-stage deals. Payment-in-Kind (PIK) dividends increase the liquidation
preference for preferred stock and dilute the founder’s control over time.
When it comes to dividends, the word “noncumulative” is the most
founder-friendly language to look for.
● Participating preferred stock – This type of stock is not considered the
standard so founders can make a case against it in negotiations. These
participation rights heavily favor preferred stockholders.
● Anything above a 1x liquidation preference – If the preferred stock has a
2x liquidation preference, this guarantees that investors get double their
money back before common classes of stock can receive anything.
Why some deals fail after a term sheet is signed

Many types of deals can miss the mark at any stage of the process. Never
assume that a great valuation equals a great term sheet. You can create a
win-win situation for both VCs and founders by keeping your request in line with
your industry and your company’s stage of development. Even if VC investors are
willing to throw funding at a product until it meets expectations, it’s up to the
company to not fall short of its promises.

Where to find a sample term sheet template

There are numerous sources online for viewing sample term sheet templates.
The National Venture Capital Association (NVCA) is a public policy advocate for
entrepreneurs and the venture community and is a leading resource for venture
capital data and education. This may be a good place to start for finding a
general term sheet template depending on your particular situation.

If you’re looking for a Series A term sheet template, Y Combinator offers a

one-page term sheet that covers everything and shortens the legalese to be more
user-friendly. This became common over the last ten years as investors sought to
standardize the process to make it easier, faster, and friendlier.

Source: Digify