Updated: Sep 8, 2022
A term sheet is a road map for savvy founders to guide a startup in building long-term relationships with its potential investors.
Term Sheets, Letters of Intent, Memorandums of Understanding and Heads of Agreement are similar initial transaction documents (the main difference being style) that set out the main commercial terms of the transaction being discussed or agreed in principle between the parties.
A term sheet is a relatively short document and one of the first legal documents a founder has to go through during the fundraising process.
A term sheet indicates the serious intention of the parties to enter into a definitive transaction agreement based on certain (but preliminary) conditions, and may have moral force, but there is usually no legal requirement for the parties to complete the transaction according to the specified conditions in a term sheet or not at all. Even if a term sheet is signed, it is generally not a legally binding document in itself (unless certain terms, usually involving confidentiality and exclusivity, are expressly stated in the term sheet as binding).
Term sheets are used in a variety of transactions, including business negotiations, mergers and acquisitions, loan arrangements, joint ventures and real estate transactions. In financial transactions, term sheets are often attached to the lender's commitment letter.
The term sheet is also used for private placement, but has a slightly different meaning when used for this purpose. Content varies by offering type and size. For example, if the private placement is for a large number of accredited investors, the term sheet is usually a summary of the terms of the offering and does not address the issuer's business and affairs or securities terms. It is usually attached as a schedule to the engagement letter between the issuer and its underwriters and to the subscription agreement given to investors. In this case, the term sheet is usually a non-binding term sheet for the transaction.
Role of Term Sheets in Venture Capital Investment
The importance of the term sheet is that it serves as a roadmap for investment, and subsequent deviations require careful consideration by all parties.
The term sheet represents the starting point for the startup and its potential investors to engage and negotiate possible investments. Typically, investors submit a draft term sheet containing key economic terms and governance rights to signal their interest in investing in a startup. Depending on the circumstances and bargaining power, the term sheet may be sent in draft form and subject to further negotiation, or (more commonly) in signed form and prepared on a "take it or leave it" basis, sometimes with a deadline for acceptance. Whether (and to what extent) a term sheet is negotiable depends on the specifics and dynamics of the deal. However, as with any contract, a term sheet should only be signed if there is sufficient comfort.
The term sheet can be considered as the outline of the transaction documents to be executed. It sets out the main terms and conditions that will be documented in more detail in the transaction documents. Transaction documents typically required by venture capital investors include subscription agreements and shareholders' agreements.
Legally speaking, there is no requirement to sign a term sheet before negotiating transaction documents. However, it is a useful and practical exercise for both parties to spend enough time and effort on the term sheet to agree on key issues. Doing so will help avoid protracted negotiations (and associated costs) when negotiating transaction documents. Any concerns or disagreements should (if possible) be raised at the term sheet stage. Any subsequent deviation from the term sheet will inevitably raise potentially embarrassing questions from investors as to why the position has changed from what was agreed upon in the term sheet.
Founders should note that the terms of Series A will be the starting point for subsequent funding rounds. Any missteps can be exacerbated in subsequent rounds, which may require founders to sacrifice valuable negotiation chips to correct them.
Important Terms when Negotiating a Term Sheet
First-time entrepreneurs can be intimidated by unfamiliar terms and foreign concepts. However, it is important for them to have a general understanding of the broad concepts and points in the term sheet.
One of the main points is that there is no standard price. While the lead in a Series A round typically wants a 20% stake in the company, the price can flex up or down based on the leverage both parties hold. Price is an important term, but VCs are more concerned with terms of control and structure that founders are less familiar with, and are therefore more prone to confusion and problems.
Here are the key terms to consider:
(a) Preference Shares
First-time founders often ask why investors need preference shares (rather than ordinary shares). Simply put, this is because preferred shares have priority over ordinary shares in certain important situations (dividend distribution, liquidation or sale).
(b) Pre-Money Valuation
The term sheet defines the initial valuation, that is, the initial valuation by pre-investment investors. This is different from a "post-money" valuation, which is the sum of the pre-money valuation and the total investment.
(c) Use of Proceeds
In most cases, the investment amount is usually used for the growth and expansion of the startup and to finance its day-to-day operations. However, if any part of the total investment is used for a specific purpose (for example, opening a new factory or expanding the business into a certain foreign jurisdiction), it may be expressly stated or referred to in an agreed business plan between the parties.
(d) Liability Basis
Typically, a term sheet requires the founder to personally support the startup's obligations under the agreement document. This means that the founder's personal assets are at risk if the startup does not perform the actions agreed in the transaction documents, or if any representations or warranties prove to be untrue.
While understandably uncomfortable for any founder, such terms are common for early-stage fundraising to keep founders "in the game," especially given the startup's lack of assets or track record at that stage. The risk faced by founders can be mitigated by negotiating a limit on the scope of their liability (eg, the fair market value of the shares owned by the founder). If there is more than one founder, the founders should decide whether the liability is "joint and several" (the founders will be liable for the breach of the contract by the joint founders) or "several but not joint".
Term sheets often stipulate that startups reimburse investors for fees associated with their investment, subject to agreed limits. Typically, these reimbursements will be made to the lead investor (who drives the investment and bears most of these costs). Things to consider include agreed limits and whether reimbursement only be made after the deal closes.
Often, early-stage investors don't use dividends as a way to get a return on their investment, because startups may use all their free cash to grow their business and may not report a profit. So, in most cases, one may see the qualification that dividends are paid if and only when declared by the board, rather than startups offering any fixed dividends. That said, the term sheet may state that if a dividend is actually declared and paid, the preference shares will have "dividend priority", meaning that the dividend must be paid first to preference shareholders (at a pre-agreed rate or as per the board of directors), before dividends can be paid to ordinary shareholders.
(g) Liquidation Preference
Liquidation preference gives preference shareholders (i.e. investors) the right to receive payment ahead of ordinary shareholders in a liquidation or liquidity event. This protects the investor's initial investment in bad conditions. It is also used for other defined liquidity events (such as the sale of a start-up company through the sale of shares or the sale of assets). There are two components to consider here.
First, "preference", that is, the right to receive the actual investment amount (or in some cases a multiple of the investment amount) before other shareholders. Example of such term is:
Liquidation preference more than 1x - the investor gets paid more than the invested capital first.
The second is the "participation right", that is, whether the investor will continue to enjoy the right to participate in the distribution with the ordinary shareholders after the payment of the preference amount. Founders may want to consider expected exit scenarios and how different liquidation preferences will affect those scenarios.
(h) Voting Rights
Each preference share will have voting rights assigned to it. Although this means that the control and influence of existing shareholders (including the founders) over the startup will be diluted, the founders usually still retain a majority stake in the startup, at least in the initial funding rounds. Therefore, investors need the right to veto a list of things that are very important to them.
Preferred shares usually require mandatory conversion (subject to anti-dilution rights) so that the preference shares are automatically converted into ordinary shares upon the occurrence of certain specified events. A commonly designated event is the completion of a Qualified Initial Public Offering (“QIPO”). Compulsory conversion rights are intended to facilitate the occurrence of specified events. For example, a QIPO is usually easier to conduct if the startup company has ordinary shares only.
(j) Anti-dilution Provisions
Anti-dilution rights provide investors with some protection if additional shares are issued at a price below the conversion price of the preferred shares. Generally, the conversion price of the preference shares is based on the original purchase price of the preference shares, unless there is a subsequent adjustment. Although there are various anti-dilution mechanisms, the broad weighted average adjustment is the most commonly used in the market today.
(k) Employee Share Option Plan ("ESOP")
Employee Share Option Plans (“ESOPs”) are designed to incentivize current and future employees by allocating shares to them in the startup as part of their overall compensation package. A typical ESOP pool for a startup that receives a Series A investment will include anywhere between 5% and 20% (but more typically 10% to 15%) of fully diluted share capital. The actual size of the ESOP pool will depend on what the parties deem sufficient to meet the startup's recruiting needs until the next funding round.
It is also important to clarify, for the purpose of calculating the startup value (on a per share basis), that whether the creation or any increase in size of the ESOP pool will be considered outstanding in the startup pre-money capitalization. It is common practice for ESOP pools to be considered outstanding (although there are exceptions on a case-by-case basis). This means that the fact that an ESOP pool is created or expanded (regardless of whether the pool is actually adopted or not) will have the effect of diluting existing shareholders, but not new entrants.
(l) Board of Directors
Investors with significant interests often have the power to appoint board members, giving them more access to information and the ability to influence board decisions. Here, founders should keep in mind the dynamics of the board of directors and the balance between founders, new investors, existing directors and later on, independent directors. You also need to make sure the board doesn't get too big—typically, early-stage startups have three or five board members, while late-stage startups can have as many as seven or nine members. In general, it is better to have odd-numbered boards to avoid deadlocks, or the need for a casting vote for the board chair.
The most common way founders lose control in a Series A is a 2-2-1 board structure, which is 2 founders, 2 investors and 1 independent board member. Losing board control is the worst because it means founders can be fired from their own companies.
Whether being fired by the company as an employee also triggers the founder's removal from the board is a separate question, depending on what was negotiated in the financing documents. Sometimes a founder's right to vote his shares to appoint directors will depend on the founder's current employment with the company. Whenever you attach conditions to your right to vote on anything, be sure to let your advisor walk you through the various situations where those conditions are important and how they could hurt you.
Another way the founder loses control is a term not found in the standard example above, which is a separate clause stating that operational decisions require approval from the investor's director, such as setting the annual budget, hiring/firing executives, transforming business, adding new lines of business, etc. When the board of directors is formed to weaken the power of the founders, the extrinsic justification of investors is usually reasons of governance or accountability.
(m) Reserved Matters
Investors need the right to veto a list of things that are very important to them. This is often referred to as the "reserved matters" list. An example of a reserved matter is the sale of almost all of the underlying assets of a startup. Such reserved matters and associated approval thresholds should be carefully considered to ensure they are appropriate. A balance must be struck between the need to protect investors' interests and the administrative burden faced by startups by always having to obtain shareholders' approval.
(n) Pre-Emption Rights over New Issuances
Investors are usually given the pre-emption rights. This refers to the right to subscribe to a portion (usually pro-rata) of any new shares that the start-up wants to issue (such as in a new financing round), with certain exceptions. This gives existing investors an opportunity to retain their existing shareholding percentage in the startup. Founders should consider who to offer the pre-emptive rights — whether to all investors, or only to certain segments (for example, those who hold a minimum number, percentage or class of shares).
(o) Right of First Refusal
A right of first refusal ("ROFR") allows a startup and its shareholders to ensure that any shares to be sold can be purchased by existing shareholders. This ensures that the startup's shareholder base remains the same and prevents shares from being sold to third parties.
Particular attention should be paid to who can use the ROFR (usually investors), and the triggers to exercise those rights (will be negotiated on a case-by-case basis, but usually include the founder). However, in some cases, investors have the right to transfer their shares freely without being bound by the ROFR; in other cases, investor transfers may be subject only to certain other investors and/or founders. Therefore, depending on the specifics of a particular investment, the ROFR may have different variations and styles.
Also, it is important to note that in early-stage companies, the focus of the ROFR may be the transfer of the founder or other common shareholders, in which case one would see such ROFR rights first being granted to the startup company and/or other founders, and only to investors if the ROFR has not been implemented.
However, in some cases, the investor has the right to transfer his shares freely without being bound by the ROFR of other shareholders; in other cases, investor transfers may only be subject to a right of first offer by certain other investors and/or founders. Therefore, depending on the specifics of a particular investment, the ROFR may have different variations and styles.
Also, it is important to note that in early-stage companies, the focus of the ROFR may be the transfer by the founder or other common shareholders, in which case one would see such ROFR rights first being granted to the startup company and/or other founders, and only to investors if the ROFR has not been exercised.
(p) Tag-Along Right
The tag-along rights allow investors to participate in any sale of shares by the founder and, sometimes, other shareholders. The tag-along rights are designed to align the interests of existing shareholders with those of other shareholders by allowing all shareholders to exit the startup company together.
Particular attention should be paid to who can use the tag-along right (usually investors), and the triggers to exercise those rights (will be negotiated on a case-by-case basis, but usually include the founder). However, in some cases, investors have the right to transfer their shares freely without being bound by the tag-along rights of other shareholders; in other cases, investor transfers may be subject only to certain other investors and/or founders. Therefore, depending on the specifics of a particular investment, the tag-along rights may have different variations and styles.
Also, it is important to note that in early-stage companies, the focus of the tag-along rights may be the transfer of the founder or other common shareholders, in which case one would see such ROFR rights first being granted to the startup company and/or other founders, and only to investors if the ROFR has not been implemented.
However, in some cases, the investor has the right to transfer his shares freely without being bound by the tag-along right of other shareholders. Therefore, depending on the specifics of a particular investment, the tag-along rights may have different variations and styles.
(q) Drag-Along Right
Drag-along clauses give a certain group of shareholders the right to force the sale of the entire startup, regardless of the intentions of other shareholders. This right is useful when a potential acquirer wants to buy 100% of the startup, as it ensures that no minority shareholder can stop the process. Negotiations will focus on the appropriate threshold to trigger the right, as neither the founder nor the lead investor wants the other party to have the right to unilaterally force a sale. In most cases, the parties will reach a compromise, and the right to drag can only be triggered if both the lead investor and the founder agree.
(r) Restrictions on Founder Transfers
It is not uncommon for investors to require the founder to comply with a lock-up period or to restrict the transfer of shares owned by the founder. This is because the founder is often the key to the success of the startup, and this constraint ensures that the founder continues to remain invested in the startup, aligning the interests of all parties involved.
(s) Restrictive Covenants on Founders
Early investors can ask the departing founder to accept a reverse vesting, which is the right to buy back their shares for a certain vesting period. Non-compete restrictions are also standard and are used to prevent founders from setting up (or joining) competing businesses after securing funding from investors. Negotiations usually focus on the number of years this lock-in/reverse vesting/non-compete period should be extended.
It is in the interest of all parties to reach a fair and amicable position to avoid any delay in the preparation of final transaction documents and to avoid any lingering misunderstandings or mistrust. Your Series A document is the foundation and precedent for the terms of future rounds. A good foundation makes the next round of term sheets and financing quick and easy, as potential investors only need to enter the same simple terms. Doing otherwise can complicate future fundraising, such as future investors demanding the same structurally burdensome clauses, existing investors refusing to waive clauses that subsequent investors want removed as a precondition for investment, etc. Getting rid of bad terms is difficult and often impossible.
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To optimize the outcome of the negotiation terms, the founder must make sure that he understands the terms that really matter and hire their own advisors early to leverage their experience in the dynamics of the venture capital market.
Even in the early stages, founders should not hesitate to contact and consult with advisors to help them make more informed decisions when negotiating term sheets, especially if they are dealing with more experienced investors. For early-stage founders, Bestar provides a source of useful knowledge and advice, as well as educating them on investment terms and the fundraising process.
Contact us now.