Term Sheet

A term sheet is a non-binding legal document that outlines the basic terms and conditions of an investment transaction between two parties - typically between an investor and a startup seeking funding.

Although not an agreement, a term sheet plays a role in the negotiation process. It allows both sides to establish an understanding of deal points before investing time and resources in detailed legal contracts and due diligence. This initial agreement on the term sheet is often viewed as the step towards a business transaction laying the groundwork for smoother negotiations and reducing the chances of disagreements regarding investment terms.

Key components addressed in a term sheet typically include the funding amount offered, company valuation, and the investor's equity type. Additional important terms may cover investor rights, board positions, preferences during liquidation events, and restrictions on fundraising activities among others.

Usually, the lead investor drafts the term sheet after talking with the startup team. The startup can suggest changes before they all agree on a version. This agreed-upon document then guides lawyers in creating binding contracts to finalize the deal.

Entrepreneurs and new startups looking to secure funding must grasp the importance of term sheets to ensure they don't relinquish control and obtain a favorable agreement. It's advisable to seek guidance from experts when evaluating investment proposals before making any decisions.

Valuation Methods

Valuation holds importance in a term sheet as it dictates the portion of ownership that a startup is willing to offer in return for an investment. There are two valuation measures;

Pre-Money Valuation: This indicates the worth of the company before any funding is secured taking into account factors, like revenue, user base growth, and intellectual assets.

Post-Money Valuation: This is the pre-money valuation plus the amount of investment received. For instance, if a new business has an investment value of $5 million and secures a $2 million investment the post-investment value would be $7 million.

Some common valuation approaches include:

• Venture Capital Method: Uses estimated terminal value to value early-stage companies. Calculates terminal value based on projected revenues or earnings in the future.
• Berkus Method: A simpler method that values startups based on qualitative factors like a core team, IP, prototypes, traction, etc.
• Book Value: Uses assets and liabilities of a business to determine valuation. Not ideal for startups without significant hard assets.
• Comparable Company Analysis: Benchmarks valuation against similar companies in the same domain and growth stage.
• Discounted Cash Flow Analysis: Estimates future cash flows and discounts them to arrive at the present value of the company.

Valuation depends on traction, market potential, team, IP, and other factors. Higher traction and lower perceived risk generally lead to higher valuations. First-time founders often struggle to justify high valuations due to a lack of leverage.

Equity and Ownership Structure

Equity structures define how a company's ownership is divided between founders, investors, employees, and other shareholders. The term sheet outlines this distribution using two types of stock;

Common Stock

• Issued primarily to founders and employees
• Carries voting rights
• Lower priority for dividends and liquidation
• Subject to vesting schedules

Preferred Stock

• Issued to investors
• May carry additional rights and preferences
• Higher priority for dividends and liquidation
• Usually convertible to common stock

For founders, a key consideration is the split between common stock and preferred stock. Investors will want more of the high-priority preferred stock, while founders want to maximize common stock and control.

Founder Shares

Founders' stock ownership typically goes through a vesting period of around 4 years with a one-year cliff. This means that founders won't fully own their shares until they complete this vesting period by remaining with the company.

• Promotes long-term commitment from founders
• Aligns incentives between founders and investors
• Founders may negotiate accelerated vesting

The vesting schedule and structure of founder shares is an important point in term sheet negotiations. Founders will want to maximize ownership while investors want to ensure retention.

Investment Term Sheets and Preferences

Investment terms specify the financial rights, privileges, and protections granted to investors in exchange for their capital infusion into the company. Key investment terms to understand in a term sheet include:

Liquidation Preferences

The liquidation preference establishes the priority for payouts in case of events like acquisitions or asset sales. It specifies how much investors receive before shareholders.

There are two kinds of liquidation preferences: participating and non-participating. In the case of participating liquidation preference, investors receive their investment first before sharing pro rata, with common stockholders in the remaining proceeds. On the other hand, non-participating means that investors only get their investment back first.

Liquidation preferences are usually 1x or 2x+ the original investment amount. Higher preferences provide more downside protection for investors but can significantly dilute founders and employees.

Dividend Rights

Some term sheets give preferred shareholders rights to dividends alongside common stockholders. This guarantees regular income to investors in addition to the potential for capital gains.

Dividends are usually cumulative - unpaid dividends accumulate over time and investors must be paid first before common stock dividends. Convertible preferred stock may also carry a dividend right that converts into common stock upon payment.

Anti-Dilution Provisions

Anti-dilution provisions are in place to protect investors from dilution, in case new shares are issued at a valuation. The weighted average anti-dilution formula is generally viewed as favorable for founders compared to the ratchet formula.

Pay-to-play provisions function as penalties for existing investors who opt out of participating in funding rounds by converting their preferred shares to stock or losing rights.

Board of Directors and Governance

In a term sheet, it will be specified how many board seats investors will receive. Typically venture capital firms leading an investment round would aim for 1 to 2 board seats. The number of seats will vary based on the investment size and the stage of the startup. In the stages, startups might set aside 1 to 2 seats for investors while established companies could allocate additional seats as they secure larger funding rounds.

Board Composition

The term sheet will specify the number of board seats that investors receive. Typically, venture capital firms will want at least 1-2 board seats if they are leading an investment round. The specific number of seats will depend on the size of the investment and the startup's stage. Early-stage startups may reserve 1-2 seats for investors, while later-stage companies may allocate more seats as they raise larger rounds.

Founders will want to maintain control of the board. The term sheet may indicate that founders and management have at least the same number of seats as investors, if not a seat or two more. Independent board members may also be added for specific expertise.

Voting Rights

Along with board seats comes voting power. The term sheet will outline the voting rights held by different directors. Certain key decisions like issuing more stock, hiring/firing executives, or approving budgets may require a majority, supermajority, or unanimous board vote.

Investors will likely ask for protective provisions that require their approval for major decisions. Founders will want to limit these provisions and maintain control over strategic decisions. Negotiating voting requirements helps balance founder and investor rights.

Protective Provisions

Also called veto rights, protective provisions give investors a level of control over specific company actions. These may include veto rights on:

• Issuing more shares
• Changing company bylaws
• Selling major assets
• Making acquisitions
• Filing for IPO

Investors may request broad protective provisions covering much of the company's operations. However, unnecessary veto rights can impede the company's progress. Founders should focus on defining measures and outlining areas of the business that fall solely under their control.

The composition of the board voting procedures and protective measures are governance terms that serve to align interests between founders and investors. Thoughtful negotiation of these terms is essential.

Option Pool

The presence of an option pool is an aspect of a startup's capitalization table and term sheet. The purpose of having an option pool is to reserve a portion of equity for employee stock options.

Typically, investors seek to have around 10 to 20% of money shares allocated for the option pool. This structure incentivizes startups to reward, attract, and retain talent through stock options and grants. The option pool is drawn from the founders' ownership stake.

The option pool shares do not vest immediately. Employees granted options will have a vesting schedule, usually over 4 years with a 1-year cliff. This means they need to stay with the company for a certain period before fully earning their options.

The size of the option pool and the vesting terms are important negotiating points in a term sheet. Investors want to make sure there are enough shares to hire key roles, while founders want to limit dilution. Agreeing on fair vesting terms prevents early employee churn. Getting expert legal advice can help navigate option pool dynamics.

Investor Rights

One key section in the term sheet details the privileges granted to investors as part of the investment agreement. These rights aim to safeguard the interests of investors in the company and ensure their ability to participate in fundraising activities. Key investor rights typically include:

Information Rights

Investors will seek access to data and operational metrics to track the company's performance and overall well-being. The term sheet will specify the information that the company needs to share with investors such as reports, operational budgets, and minutes, from board meetings. This ensures that investors stay updated on the company's progress.

Right of First Refusal

These rights allow investors to take part in fundraising rounds to maintain their ownership stake. If the company looks for funding, investors have the option to buy shares before external investors can do so. This prevents too much dilution of the investor's equity stake.

Registration Rights

Registration rights enable investors to sell their shares at a date through an IPO or sale of the company. The term sheet will detail when investors can request that the company file for an IPO. This gives investors an exit strategy to realize returns. Common registration rights include demand, piggyback, and Form S-3 registration rights.

These provisions enable investors to monitor their investments, maintain their proportional ownership, and access liquidity. Negotiating reasonable information rights, transfer restrictions, and registration rights is important for both entrepreneurs and investors.

Exit Strategy and Liquidation Events

A startup's exit strategy refers to how investors and shareholders can "exit" or liquidate their holdings in the company to realize a return on their investment. Term sheets will often specify the terms around potential liquidation events and exits.

Liquidation Events

The most common liquidation events defined in term sheets are an acquisition or merger and an initial public offering (IPO). This specifies the scenarios in which investors can sell their shares and receive payouts. Term sheets may also include provisions around the sale of major assets or a change in control as liquidity events.

Acquisition and Merger Provisions

In case of an acquisition, where another firm buys out the startup term sheets, often provide investors with a liquidation preference ensuring they recoup their investment ahead of shareholders receiving any proceeds. Founders may negotiate limits on this preference to ensure they also receive meaningful proceeds in an acquisition.

Term sheets also outline the approval process for any potential acquisition. Investors usually require a veto right over mergers to protect their interests. Founders can negotiate the threshold and terms under which investor approval is required.

IPO Terms

An initial public offering (IPO) occurs when a startup offers its shares for sale to the public on a stock exchange. The agreement will detail investors' entitlements if the company decides to go through with an IPO.

This includes registration rights, which are provisions that enable investors to sell their shares publicly. Term sheets also outline any lock-up periods that restrict when investors can sell shares after the IPO. Founders should pay close attention to these terms to understand investor liquidity options.

Legal Considerations

A term sheet involves complex legal and regulatory issues that require careful review by qualified counsel. The National Venture Capital Association offers model legal documents, including term sheets to assist in this legal review process. Here are some key areas to consider: Transitioning from the term sheet to more binding legal documents such as the stock purchase agreement involves detailed clauses on reps & warranties, foreign investment regulatory stipulations, legal counsel designation, VC investment specifics, investor rights, and protection clauses.

Securities Regulations

In cases of securing funding for startups, private securities are common. These transactions are subject to regulatory oversight by securities laws. These regulations encompass guidelines on transparency and verification of investor credentials as limitations on fundraising activities and promotional efforts. Entrepreneurs must verify that their agreement terms align with the securities laws and regulations set forth by the SEC. This becomes crucially significant when considering the issuance of securities to investors who do not meet accredited status requirements.

Intellectual Property and Confidentiality

Term sheets usually contain clauses related to IP ownership, licensing, and confidentiality of proprietary information. Founders need to pay close attention to ensure these clauses don't grant investors overly broad rights to their core IP or restrict their ability to operate. Non-disclosure agreements are commonly put in place around sensitive deal terms during negotiations.

Dispute Resolution

It's best to agree upfront on how potential disputes arising from the deal will be resolved, rather than leaving it ambiguous. Options include arbitration, mediation, litigation, or other alternative resolution methods. The applicable jurisdiction is also important to specify upfront in the term sheet. Founders should aim for dispute resolution processes that are fair and efficient, and keep decision-making control within the company.

Having experienced legal counsel review and negotiate a term sheet is highly recommended before founders sign any binding agreements. This can help surface potential pitfalls, ensure favorable terms, and avoid costly mistakes down the road. Founders should see a term sheet as the start of building an ongoing relationship with investors, not just a one-time transaction.

Negotiation Tips and Best Practices

As a founder raising capital, you’ll need strong negotiation skills to get favorable terms in your term sheet. Here are some tips:

• Understand your bargaining power. As the entrepreneur with the idea, product, and team, you have more leverage than you think. Don’t be afraid to push back on unfavorable terms. Investors want you to succeed.
• Involve experienced advisors. Work with a lawyer to review the term sheet. Lean on mentors who have fundraised before. Their expertise can help you navigate the term sheet negotiation firmly but fairly.
• Focus on building trust. Term sheet negotiations are the start of a long-term relationship with investors. Approach the process in good faith to build trust. Avoid overly aggressive tactics.
• Pick your battles. Don’t get bogged down fighting every single term. Focus your negotiation efforts on the 3-5 terms that matter most, understanding that not all terms are heavily bargained over as parties do not intend to heavily negotiate them. Be willing to compromise on less critical points.
• Use data to support your position. Reference market standards, comparables, and norms to justify your stance. Back up your arguments with evidence.
• Frame requests a win-win. Show how adjustments to terms can align incentives and help the business thrive long-term which benefits both parties.
• Maintain relationships. Negotiations shouldn’t get overly adversarial. Keep communication open and positive. The goal is to set the stage for a productive partnership.

With preparation, prioritization, and relationship management, founders can negotiate win-win term sheets that provide sufficient investor protections while allowing the startup to flourish.