For a founder, it's crucial to be familiar with the various clauses of a term sheet before negotiating and signing up for a funding deal.
What is a Term Sheet?
A term sheet is a non-binding agreement between two parties (founder/startup and investor/s) during a deal negotiation. It lays out the proposed key terms of a potential transaction outlining the basic terms and conditions of an investment and serves as a foundation for negotiating and drafting final legal documents. The term sheet is akin to a letter of intent.
21 Clauses of a Term Sheet, and Their Implications
Usually, most investors prefer to create a win-win scenario that is balanced towards the founders, and best to get them a good return on capital. However, in some cases the founders unknowingly ended up losing control over their own business they built, and thus it is vital for them to understand the potential consequences of key terms covered in their term sheet. While term sheets can vary depending on the specific deal and investor, here are some key clauses that you should be aware of:
A. Economics and Control Rights
1. Valuation (Pre-money and Post-money)
A pre-money valuation refers to "the value of your startup before it receives funding" whereas post-money valuation is the estimated value of your startup after receiving the funding/investment. Pre-money valuation is adjudged by the Investors before the funding.
Pre-money + Investment = Post-money valuation (e.g. $5M + $1M = $6M at 20% equity stake)
In the case of startups, the valuation is usually decided based on the pre-money valuation of similar/comparable companies in the industry, or by using other valuation methods. The founder would love to increase the pre-money valuation, so as to lower dilution. Investor/s would like to decrease the pre-money valuation, resulting in a higher stake in the startup. Thus, founders must negotiate to have a reasonable pre-money valuation.
Clause: The term sheet should specify the pre-money valuation of the startup (their worth before they raise funding), which determines the equity stake the investor/s will receive in exchange for their funding.
Implication: It's important to understand how the pre-money valuation has been calculated, and how it may impact your ownership percentage (or equity dilution).
2. Investment Amount and Type
Assuming the pre-money valuation is $1 Mn, the investment of $200 K by the investors would lead to 20% preferred stock (equity) of the startup.
At the early stage (primarily the pre-revenue stage) many investors opt for convertible notes/CCPS/SAFE.
Equity: Shares can be broadly categorized into common stocks (founders, employees) and preference stocks (investors often prefer to use preference shares to get them special rights that are covered in the term sheets.)
2a. Conversion Rights
It gives the investors the ability to convert shares of preferred stock into shares of common stock. There are two main types of conversion rights:
Optional conversion rights: Typically non-negotiable, it allows an investor to convert shares of preferred stock into common stock on a one-to-one basis.
Mandatory conversion rights: Are negotiable, it allows an investor to automatically convert shares of preferred stock into common stock.
The investor’s interest in liquidation preference (covered below) guides this process.
A Convertible Note is a form of short-term interest-bearing loan/debt that converts into equity (preferred shares) during a future equity funding event. In effect, instead of a return in the form of principal plus interest, the investor would receive equity in the company. The future conversion of the note into preferred shares will be based on the valuation in a future financing event. The convertible note can/will have a set valuation cap that limits the amount that the convertible note holder must pay for the preferred shares. Also, the notes generally allow for a discount on the preferred share purchase price paid by future investors.
Investors are getting comfortable with Convertible Notes, where the valuation has been pre-determined.
SAFE (Simple Agreement for Future Equity) notes introduced by Y Combinator in late 2013, it has been used by almost all YC startups and countless non-YC (global) startups as a very attractive alternative instrument for early-stage fundraising. SAFE gives investors the right to buy equity in a startup at a future date when the startup has another round of fundraising. Unlike Convertible notes, SAFE notes carry "No interest rate", and "No maturity date."
But they do have a valuation cap that’s negotiated between the investors and the founder.
A common example would be to have a SAFE note at a $5 Mn valuation cap, while the next funding round (Series A) may come in at a $20 Mn valuation. Thus the seed and angel investors who invested in that SAFE note get more ownership for the money they put in because their valuation cap was set much lower.
Clause: The term sheet should specify the amount of funding the investor is committing to, as well as the type of funding (i.e. equity, convertible note, SAFE, etc.)
Implication: You should understand the implications of the type of funding on your startup's capital structure and future fundraising efforts.
3. Liquidation Preference
A liquidation preference determines the order (after secured debt, trade creditors, and other company obligations), and represents the amount the company must pay at exit to the preferred investors first.
A 1X liquidation preference means that investors are guaranteed to get 1X of their investment back. So if your investors put $10 Mn into your company, and the company gets sold for $15 Mn, then the investors will receive their entire $10 Mn back before anyone else. A 2X preference would raise this hurdle to $20 Mn, leaving no money for the founders or employees.
Ideal (market practice): 1X Non-participating Liquidation Preference is a win-win for both founders as well as investors.
Download the full primer - Liquidation Preferences in Startup Financing.
Clause: This clause outlines the priority and amount of proceeds that the investor will receive in case of a liquidation event, such as a sale or merger of the startup or in the event the startup fails.
Implication: It is critical to understand the scenarios around who gets paid, in what order, and with what multiple when you exit. It's crucial to understand the liquidation preference terms, as they can significantly impact the distribution of proceeds among shareholders.
4. Option Pool
The size of a stock option (ESOPs) pool set aside (reserved) to reward employees and attract future talent/advisors should be carefully thought through. The ESOPs in most cases is taken from the founders’ stock.
In a typical Series A term sheet, the investor will specify a 10% (max.) option (ESOPs) pool for future employees. This makes life easier for all stakeholders — founders don’t have to get shareholder consent every time they make a new hire, and the VCs don’t see their ownership get diluted by every hire.
Clause: These clauses outline the ESOPs (option) pool available to the founders to attract future talent (new hires).
Implication: A larger option pool will further dilute the founders’ ownership share, though it also depends on the startup’s valuation and investors’ equity stake.
5. Dividend Rights
A dividend is a payment made up of a distribution of profits from a company to
its shareholders. Startups generally tend to recycle any cash flow back into the business. Thus, rarely do investment rounds involve dividends.
Clause: The term sheet may specify the investor's rights to receive dividends, if any, and the terms under which dividends may be paid out.
Implication: It's important to understand the dividend rights (if any), as it may impact the startup's ability to distribute profits to shareholders.
B. Investors Rights and Protection
6. Anti-Dilution Protection
Anti-dilution protects the early-stage investors from a risk of loss in their stake in case of a "down round" i.e. when the startup raises future rounds at a lower pre-money valuation than the current round. These provisions can be devastating for founders.
Anti-Dilution Provisions: Overview, Types, How It Works?
Clause: This clause protects the investor from dilution of their ownership stake in case of future fundraising rounds at a lower valuation.
Implication: There are different types of anti-dilution provisions, such as full-ratchet and weighted-average, which can have different impacts on your ownership percentage.
6a. Pre-emptive/Pro-rata Rights
This creates a provision for the existing investors to invest in future rounds at the same terms and conditions offered to future investors, thereby helping the existing investors to maintain (not to dilute) their shareholding. Pro-rata rights are essential to early-stage rounds and are generally positive factors in term sheets.
7. Rights of First Refusal and Co-Sale
The Rights of First Refusal (ROFR) gives the investor/s the first right (to buy equity stake) on any potential share sale to match (at the same rate) any third-party offer on the shares of other investors. Investors often use this right to retain or increase control of the startup.
Tag-Along (Co-Sale/ROFO) Rights allow the investors a right to participate in the sale of shares (sell part/full equity stake) of the company by other shareholders (investors, founders, employees) to any third party on the same rate/terms and conditions. It gives the existing investors a potential exit opportunity if other investors are exiting.
Drag Along Rights (“DAR”) entitles an Investor proposing to sell his shareholding in the company to any third party to necessitate the Founders to also sell shareholding held by them.
The combination of rights of first refusal and co-sale rights gives further protection to the investors, they can choose to either increase their control or take an exit in the case of an acquisition.
Clause: These clauses outline the rights of the investor to participate in future sales of startup stock.
Implication: It may restrict your ability to sell shares to other parties without first offering them to your existing investor/s.
8. Exclusivity and No-Shop
Exclusivity is not to engage with other investors. The time span is usually 45-60 days for early-stage startups, although it can extend to 90 days based on mutual agreement.
Clause: This clause may impose restrictions on the startup's ability to negotiate or enter into discussions with other potential investors for a certain period of time, giving the investor an exclusive opportunity to invest in the startup.
Implication: It's important to understand the exclusivity and no-shop provisions and their implications on your fundraising efforts.
9. Founder Vesting
Founders ought to build the business on a long-term basis, hence every quarter a certain percentage of shares get vested with them.
Series A and later term sheets usually include founder vesting clauses, where the founders' shares are earned/vested over time. Vesting incentivizes the founders to stick around for at least 3-4 years. The idea is to help startups retain key people (founders), or if a founder does leave, the shares can potentially be re-issued to new hires.
Clause: The term sheet may include provisions related to founder vesting, which outline how much ownership of the startup the founders will have over time.
Implication: This is important to understand, as it may affect your ability to retain ownership and control over the startup.
10. Confidentiality and Non-Compete
Founders are expected to exclusively invest their time to work for the venture and invest their time or associate with competing businesses (as an advisor/shareholder.)
Clause: The term sheet may include clauses related to confidentiality and non-compete agreements.
Implication: These may impose restrictions on the founders' ability to disclose information or compete with the startup in the future.
C. Governance Management and Control
11. Board Seat and Control
Controlling the board means controlling the corporation. The composition of the Board is an important and sensitive issue to founders, as we’ve all heard the horror stories of founders being “fired” from the startup they founded.
Founders most often lose control at the Series A with a 2-2-1 board structure, i.e. 2 founders, 2 investors, and an independent board member.
Investors prefer to have a "board seat" with affirmative voting rights, whereas some seed and angel investors ask for an "Observer Right".
Clause: The term sheet may outline the composition of the startup's board of directors, including the number of board seats the investor will receive and any control rights they may have.
Implication: Understanding the investor's level of influence on startup decisions is important.
12. Information Rights
An information rights provision in a term sheet outlines the detailed information (financial, management, etc.,) a company must deliver to the investors at periodical intervals. The information rights allow them to monitor their investments as well as satisfy their reporting obligations to their investors (limited partners).
Clause: This clause outlines the investor's rights to access startup information and financials, and may specify the frequency and level of detail of such reporting.
Implication: It's important to understand the reporting requirements and obligations to provide information to the investor.
13. Founder Rights and Restrictions
Clause: The term sheet may specify certain rights or restrictions on the founders, such as non-compete agreements, non-solicitation agreements, or employment agreements.
Implication: Understanding these provisions and their potential impact on your role and involvement with the startup is essential.
14. Conditions Precedent
Clause: The term sheet may include conditions that need to be met before the investment is finalized, such as due diligence, legal documentation, or regulatory approvals.
Implication: Understanding these conditions and their potential impact on the timeline and completion of the deal is important.
15. Intellectual Property
Clause: This clause may outline the ownership and rights to intellectual property developed by the startup, and may include restrictions or requirements related to the protection and transfer of intellectual property.
Implication: Understanding the intellectual property provisions is important for safeguarding the startup's valuable assets.
16. Escrow and Conditions to Closing
Clause: The term sheet may include provisions related to the escrow of funds and conditions that need to be met for the investment to close, such as obtaining regulatory approvals, shareholder approvals, or other contingencies.
Implication: Understanding the escrow and closing conditions is crucial for ensuring that the investment is completed as expected.
17. Representations and Warranties
Warranties and indemnities provision protects investors against the commercial breach or legal claims that could arise because of the founders/management of the company. In case of any breach, investors usually ask for a refund of investments.
Clause: The term sheet may include representations and warranties that the startup and founders need to make to the investor, such as representations related to the startup's financials, operations, and legal compliance.
Implication: Understanding the representations and warranties is important for ensuring that you are making accurate and truthful statements about the startup.
18. Amendments and Waivers
Clause: The term sheet may specify the process for amending or waiving certain provisions, and may require mutual consent or other requirements for making changes to the term sheet.
Implication: Understanding the process for amendments and waivers is important for understanding the flexibility and potential changes to the terms of the deal.
19. Governing Law and Dispute Resolution
Clause: The term sheet may specify the governing law and the method for dispute resolution in case of any disagreements between the parties.
Implication: It's important to understand these provisions and their implications in case of disputes.
D. Exits and Liquidity
20. Exit Rights
Exit rights are sought by investors to give them a route to sell their shares in a startup if the startup hasn't got to a liquidity event (i.e. IPO, strategic/trade/third party sale, or buy-back/drag sale) within a set period (usually 5-7 years.)
Clause: The term sheet may outline the investor's rights to participate in a future exit event, such as an initial public offering (IPO) or a sale of the startup, and may include provisions related to drag-along rights, tag-along rights, or other exit-related terms.
Implication: Understanding these provisions is important for planning for the long-term potential outcomes of the investment.
21. Termination Rights
Clause: This clause may outline the circumstances under which the term sheet may be terminated by either party, such as if certain conditions are not met or if there is a breach of the terms.
Implication: Understanding the termination rights and their implications is crucial for understanding the enforceability and flexibility of the term sheet.
It's important to remember that a term sheet is typically non-binding and serves as a starting point for negotiations. The final terms and conditions of the investment will be documented in legally binding agreements, such as shareholder agreements.
It's crucial to seek legal advice from an experienced lawyer who specializes in venture capital and startup funding to thoroughly review and understand the term sheet and its implications before signing any funding deal.
Summary
Term sheets are complex documents, and understanding the various clauses is essential for protecting your interests as a founder. Keep an eye on the terms, as you may have to live with these terms for the next 7-10 years. Look beyond the valuation, and ask about the terms. Bad ones can crush your returns, and may even get you out of your own company.
Please share in the comments, if anything has been missed in this post.