A term sheet is a non-binding agreement between the founder(s) of a company and an investor or group of investors. It defines the key components or parameters of the potential business agreement for an investor to fund a business.
VC term sheets typically include the amount of money being raised, the types of securities involved, the company’s valuation before and after the investment, the investor’s liquidation preferences, voting rights, board representation, and so much more.
Once the term sheet is signed, it’s used as a template to create a legally binding, detailed set of documents. As a founder, it is one of the most important documents you will ever sign. Knowing what the term sheet’s conditions mean for you and your business is essential.
While term sheets can vary in content and length, many investors have started shortening their term sheets over the past decade in order to make them more “user friendly” to founders. Rather than overburden founders with the complicated legalities of an investment, investors are using single page term sheets to make closing a deal easier, more standardized, and faster.
In this article, we will cover the most important terms and conditions included in a typical venture capital (VC) term sheet, as well as what each term means.
It’s important to note that not all term sheets are the same. To keep things simple, however, we will use a sample “Series A VC term sheet” as an example in this article. It typically includes, but is not limited to:
You will come across most of these terms when reviewing term sheets. They are considered the terms that matter most to both the founder and investor. Let’s take a look at the not-so obvious items listed above. Some other terms to keep in mind and research include:
The term sheet includes the type of securities the investor is considering purchasing. This includes preferred shares, common shares, stock options, warrants, debt securities, partnership and membership interests, and any other security types being considered. Sometimes a term sheet includes a combination of securities. However, preferred shares are the most common type of securities early-stage investors opt for. For that reason, we’ll focus on preferred shares.
Preferred shares are a different class of equity than common shares. It has higher payment priority than common shareholders (i.e. founders) and allows investors to attach exclusive clauses to them. These clauses can include the rights, preferences, restrictions, conversion rights, voting rights and other special or relative rights of the preferred shares.
Ultimately, preferred shares have more claim to the company’s assets than common shares. And in the event of liquidation, this can be extremely significant.
This section specifies the total investment amount raised in the financing round, breaking it down by lead and non-lead investors. It also includes the percentages of the company each investor will own on a post-closing, fully-diluted basis after all convertible securities, options, warrants, and other rights have been converted or exercised.
Remember that each investor’s fully-diluted ownership is essential in any venture capital deal. Investors care about the percentage of the company they own because it affects each investor’s ability to control the company’s fate. Further, an investor can experience a reduced reward upon their exit from the company if the shares are diluted in a subsequent raise.
The percent of the company each investor owns is such an important factor that many investment deals will include anti-dilution terms in the agreement. Anti-dilution terms are parts of the contract that give rights and privileges to an investor suffering from dilution—the reduction in percent ownership or expected reward through events outside the investor’s control—and preserve the balance of control among the investors.
For example, an investor may purchase a certain percentage of the company on a post-money, fully-diluted basis. But a later capital raise offers completely new shares at a lower price. Offering shares at a lower price, compared to a prior raise, sometimes happens if the company was over-valued in the past or the overall economic prospects of the company are more modest than first assumed.
In this scenario, two dilutive effects take place; offering new shares the early investors did not anticipate and offering those shares at a lower price.
Offering additional shares dilutes the early investors because the total count of shares increases, meaning every existing shareholder now owns a smaller slice of the company. Offering late-round shares at a lower price than early-round shares further dilutes the early investors by re-pricing all the shares to the lower price.
Regardless of the reasons, when a capital raise is offered at a lower per-share price than the prior raise, the early investors can see their economic gain curtailed. After all, they are now holding shares that the marketplace has proved to be worth less than expected.
To correct this loss, some investors will require one of the two common anti-dilution methods: “full ratchet” or “weighted average.”
Full Ratchet anti-dilution is the transfer of shares to an early investor at risk of dilution to give that early investor the same dollar-value equity stake in the company the investor originally held. If an investor buys X million dollars of equity, the full ratchet method makes sure that the investor always holds X million dollars of equity even if the company, even if the company has to give away shares to that person.
Weighted Average anti-dilution is less drastic and seeks a middle ground to protect the founders and the early investors. It uses a formula to re-price the cost of an early investor converting shares between classes. It lowers the price for an early investor to top-up their equity position to hold the same position in the company. The lower price is a measure of comfort to the diluted shareholder.
In all cases, anti-dilution clauses protect investors and protect investors and discourage later capital raises at a lower share price, discouraging later capital raises at lower share prices than early rounds.
Valuation is one of the most important parts of the term sheet to understand, and is perhaps the most negotiated element. It has an effect on your percentage of shares, the value of your shares, and the percentage of equity the investor will own. Your company’s valuation is seen two different ways: pre-money and post-money.
Simply put, pre-money valuation is the value of a company prior to the investment(s) and excluding any outside financing. Post-money valuation, on the other hand, is the valuation of the company before the investment(s) plus the total dollar amount raised in the financing round or any outside financing.
Company valuation is used to:
Your company’s pre-money valuation, divided by the number of outstanding shares prior to the investment, determines the price of each share issued. The number of shares issued is sometimes a subject of negotiation between the founder and investor. Some corporations will have shares that are authorized but not issued, and the investor will want to understand the plans for those shares.
However, price per share is where things can get complicated for founders without a lot of knowledge of finance. It is best to speak with your financial advisor when determining the agreed upon price per share and number of outstanding or “fully diluted” shares.
That being said, explaining the effects of pre-money vs. post-money valuation can be simplified. Here is a basic example of how pre- and post-money valuation affects a founder’s shares in the company:
Say your company is being valued at $2M, and you want to raise an additional $500k. It matters if the $2M valuation is pre-money or post-money. If the pre-money valuation is $2M, after you receive the $500K investment, you will hold 80% of the company’s shares. However, if $2M is the post-money valuation, then you will only hold ~67% of the company’s shares.
Consider reading up on pre-money vs. post-money valuation in greater detail.
Liquidation preference indicates whether the investor will get paid before other shareholders if the company closes, is acquired, or goes through a dramatic change in equity structure. It also defines how much preference the investor will receive. This section is most commonly used by venture capital (VC) firms planning to invest in a startup.
One of the primary features of liquidation preference is the multiple. It determines the amount the investor must be paid back before the common shareholders start receiving any remaining proceeds. For example, a 1x multiple would guarantee the investor receive their investment back in full, while a 2x multiple would guarantee the investor be paid twice what they invested.
Another primary feature of the liquidation preference is whether the preference is “non-participating” or “participating”. This feature establishes whether an investor can receive additional proceeds after their liquidation preference has been fulfilled. It essentially allows an investor to benefit as a regular shareholder after the liquidation preferences are satisfied.
In the case of non-participating preferred shares, the investor has to either exercise their liquidation preference (typically the amount paid for the shares), or convert their preferred shares to common.
Upon receiving accrued and/or unpaid dividends, the remaining proceeds are distributed exclusively to the common stockholders. Non-participation is the most founder-friendly option as it forces the investor to choose between its liquidation preference or its pro-rata share of the business.
In the case of participating preferred shares, the investor is entitled to receive their preference amount first in a liquidation event plus accrued and unpaid dividends. The percentage of participation is generally based on the ownership percentage represented by the investor’s preferred shares.
The remaining proceeds are divided among holders of common and preferred shares on an “as converted” basis, which simply means that the preferred stock a shareholder owns is assumed to have been converted to some number of common stock. You can think of participating preferred shares as a form of “double-dipping.”
Furthermore, participating preferred shares can be capped in order to protect the founders. Placing a cap on participation simply means that once a preferred shareholder receives a certain amount or given percentage of proceeds, participation stops.
Also referred to as “pro-rata”, these rights specify whether or not the initial investor can participate in future rounds in proportion to their current ownership percentage, maintaining that percentage and effectively “doubling down” on a proven company. It is important to investors that desire a certain level of control over a company and do not wish to see their ownership percentages reduced by future capital raises.
Dividends are available to preferred shareholder investors. One way investors can guarantee a return is to ask for a dividend. That amount will be clearly specified here, as will the type of dividend. It can either be considered a cumulative dividend or a noncumulative dividend, or regular dividend. The type determines the basis upon which the accrued dividends are paid out.
Cumulative dividends accrue and must be paid out even if the company does not increase its earnings or profitability. Noncumulative dividends, or regular dividends, only accrue—and become payable—if the company declares them by an act of its Board of Directors. In the case of most startups, investors will opt to receive a dividend cumulatively. By opting for this, investors ensure they receive a minimum return on their investment in the company. This can make cumulative dividends unfavorable for the company and its founder(s).
However, investors don’t always anticipate or collect cumulative dividends, instead focusing on the effect it has on the overall stockholder equity (also referred to as shareholder equity). When preferred shares convert, the cumulative dividends will convert into additional common shares, increasing the percentage of ownership the investor has in the company.
In the case of cumulative dividends, one way to provide flexibility to yourself as a founder is to agree on a method the board of directors or the preferred holders can use to waive cumulative dividends. The most founder-friendly option is when the company decides if it pays out a dividend.
These rights refer to the investor’s ability to convert preferred shares into common shares. Conversion rights are significant because they affect the calculation of other rights of shareholders. Most calculations use the number of outstanding shares on an as-converted basis. This means that the total number of shares is calculated by including the shares into which preferred shares would convert. Conversion rights come in two forms:
Investors rarely make use of Conversion rights, as preferred shares generally have more value than common shares at the time of liquidation.
When a company issues new stock at a cheaper price than the investor paid for in a previous equity financing round, equity dilution can occur. Anti-dilution provisions are included in the term sheet to ensure the investors who bought stock in an earlier round have a buffer against dilution due to an increase in total amount of shares outstanding.
By including the anti-dilution provision, also referred to as an anti-dilution clause, the investor(s) shields their investment from losing value and protects their ownership percentage from becoming diluted as new shares are issued.
It’s possible for equity dilution to occur if a company employee or shareholder, specifically one that holds a stock option or other optionable security, exercises their option.
The two most common types of anti-dilution clauses include full ratchet and weighted average provisions.
This provision, simply put, adjusts the conversion price of an investor’s existing preferred shares to reflect the price of new shares issued in a later round. By adjusting the conversion price downward, the investor can protect their original investment, converting the existing preferred shares to common at the new share price, doubling the number of shares they hold, and protecting their ownership stake from dilution by the new stock offering.
Without the full ratchet anti-dilution provision, the investor would have to buy additional shares to maintain their percent ownership position. Furthermore, if a new round offers shares at an increased price than the round the investor participated in, then their ownership position is protected without needing to buy additional stock.
When used, the weighted average provision (also called broad-based anti-dilution) adjusts the value of existing preferred shares using a weighted average calculation, ensuring that dilution is fairly shared among all shareholders. The calculation accounts for all equity previously issued and currently undergoing issuing, including convertible securities.
An investor may require a weighted average provision before investing in order to protect their ownership stake should the company seek additional rounds of funding.
This section specifies the voting rights of an investor based on the shares they own. However, depending on the class of stock issued, the investor may or may not have any voting rights at all. When they do have voting rights, it’s typically due to the fact that they negotiated to attach those rights to the preferred shares. Preferred shareholders with voting rights can vote together as a single class on matters of corporate policy, regardless if they have majority board representation (discussed in the next section).
Investors will typically negotiate for veto rights (known as protective provisions, approval rights or negative covenants) over certain company actions. Furthermore, investors may negotiate for the right to approve:
In the founder’s case, it’s preferable to have investors participate in a class vote, rather than a series vote. In a class vote, Investors from both the Series A and B rounds would vote on matters of policy together because they own the same kinds of shares.
The Board of Directors oversees the strategic planning of your company and makes certain critical decisions. It appoints the officers of the company—the CEO, CFO, CSO, etc—approves the budget, and sets the company’s direction. As a startup, your board should be people who add value to your efforts to launch and grow your company.
You should think critically about what each member brings to the table and how they will work together. However, when seeking investors, some will likely stipulate that they receive board representation in exchange for funding.
As a type of “control term”, this section designates the number of directors the lead investor and other investors (generally speaking) may elect to the Board. It also sets the number of investors the founders can elect, as well as who might serve as an independent director (one who is not employed by the company).
This example is a fairly average representation, where the investors and founders are represented by two directors each, while a fifth director acts as an independent member. This type of arrangement ensures that all parties are fairly heard and that there is an independent, third-party to resolve disputes or issues.
Startups often use Employee Stock Option Pools (ESOPs) to incentivize and reward employees. Besides compensating for a lower employee salary (this is a startup we’re talking about), ESOPs ensure that a company and its employees’ interests are aligned, and that they’ll stick around to build the company.
The terms surrounding employee stock options are often an important part of negotiation. This section specifies the size of the employee stock pool and whether it is based on the pre-money or post-money valuation of the company.
An ESOP issued on a pre-money valuation means the founders and investors fund the creation of the pool before the investment takes place. On the other hand, if it’s issued post-money (i.e. after the investment takes place), then the dilution affects both the new and old shareholders.
Also referred to as a no-shop agreement or no-shop clause, this confidentiality agreement prevents a founder from using an investor’s term sheet to solicit other offers from investors. It is typically one of the only “binding” provisions included in a term sheet. Including the no-shop agreement means investors don’t want you using the terms of their deal to gain leverage with another firm. Agreeing to it will let the investor who presented the term sheet know you’re pursuing the deal in good faith.
It’s important that founders find as many potential investors as possible before signing a term sheet, as this will increase the likelihood of:
Term sheets almost always include a non-shop provision. Before signing, make sure the investor has the commitment, the money, and everything else you are looking for in a business partner. Make sure they are serious before getting too far with negotiations or signing off on the term sheet.
Furthermore, whatever is really important to you in this deal—board control, how your founder shares will be vested, what veto rights the investors will have, etc.—should be spelled out in the term sheet rather than left to the definitive agreements.
This provision, when included, requires that the minority shareholders join in the sale of the company if it occurs at the will of the majority shareholder. The majority shareholders can “drag along” the minority owners. In doing so, the majority owners are required to offer the same terms, conditions, and price as any other seller.
Furthermore, drag-along rights make share offerings, mergers, acquisitions, or takeovers less complicated. With the majority shareholder effectively in charge, it leaves more control to the sellers and buyers. Ultimately, the drag-along provision prevents a minority shareholder from undermining a sale that the majority shareholder arranges.
In addition to understanding drag-along rights, it’s important to understand the various share classes of ownership and voting shares that your company offers. These conditions can have an impact on majority vs. minority control (specifically, when a company is sold).
Drag-along rights can benefit minority owners too. It requires that the price, terms, and conditions of a share sale be the same across the board, which means that the minority shareholders are in a more favorable position. In other words, they may benefit from sales terms that would have been unattainable without these rights.
The typical term sheet is full of conditions that can be confusing to a first-time founder. Knowing what a term sheet generally includes is the first step in arming yourself with the knowledge needed to determine what a “good” term sheet looks like, and whether or not a potential investor will be a good business partner going forward.
Furthermore, the term sheet will not only determine the terms and conditions you use in future funding rounds, but it will also partner you with an investor or group of investors for quite a long time. That’s why this point in financing has such an impact on yourself and your company
If you’re headed into a term sheet negotiation, having an experienced lawyer by your side can be extremely helpful. In fact, it’s highly recommended.
This article is informative, and is not meant to represent legal advice. It is best practice to speak with a lawyer or financial advisor, preferably one that is familiar with startup and venture capital deals.