Understanding Term Sheets

Understanding Term Sheets: Key Terms and Their Meanings

Raising venture capital (VC) is a significant milestone for any startup. However, the process can be daunting, especially when faced with a term sheet full of legal and financial jargon. If you're a startup founder looking to understand the basics of a VC term sheet, this guide is for you. We'll break down the key terms you need to know to navigate your first preferred stock financing.

What is a Term Sheet?

A term sheet in a non-binding written document that acts as a blueprint for future investment deals between startups and investors. It outlines the important terms and conditions proposed by both parties to assist in streamlining the negotiation process. After pitching to investors, this document will be crucial in clarifying expectations for both parties and ensuring there are no misunderstandings prior to executing any legal agreements. Term sheets discuss the valuation of the company, the investment amount, equity allocation, investors rights and more. 

Valuation Terms

The valuation of your company is one of the main components in a term sheet. These terms play an important role in the investment amount, the option pool size, and other terms of the financing. Establishing the valuation in the term sheet allows both parties to have a clear understanding of the value of the company and the investor’s stake. A pre-money valuation is the value of the company before the investment is made. The post-money valuation is the estimated value of the company following the investment. 

Board Composition

Term sheets specify the board composition, detailing how many board seats investors can fill. This ensures they have representation and can influence key company decisions. Typically, the lead investor of the seed round is given a seat on the company’s board of directors. Any additional seats at subsequent preferred financings are negotiated on a case-by-case basis.

Investors' Rights and Control Provisions 

Investors' rights and control provisions significantly impact investors’ control over the company, including the number of board members the investor is allowed to appoint and voting rights, such as veto rights and drag-along rights. These provisions lay out the balance of control between the founders and the investors and are crucial in determining the influence and decision-making powers between the parties.

Common types of control provisions: 

• Right of First Refusal: Investors often get a right of first refusal on future financing rounds. This means they can choose to invest in subsequent rounds to maintain their ownership percentage before the company offers shares to new investors.
• Veto Rights: These rights grant stockholders the ability to block specific actions or decisions proposed by the company. These rights are typically granted to preferred stockholders, such as investors, to protect their investment and ensure that they have a say in important decisions pertaining to the company.
• Drag-Along Rights: These rights allow majority stockholders to force the remaining, minority stockholders to vote in favor of the sale of the company. In essence, it allows certain stockholders to “drag” other stockholders to support and cooperate with the sale process of the company if that is what the majority stockholders decide.
• Co-Sale Rights (Tag-Along Rights): Conversely, co-sale rights (or tag-along rights) protect minority stockholders. If a majority stockholder sells their stake, minority stockholders have the right to sell their shares on the same terms.

Liquidation Preferences 

Liquidation preferences protect investors’ interests in different types of exit scenarios, such as a sale, merger, or dissolution of the company. A liquidation preference ensures that investors receive their initial investment back (and possibly more) before common shareholders get anything. This provision is frequently crucial to investors because it allows them to mitigate their risk.

Two main types of liquidation preferences:

• Non-participating liquidation preference: Under a non-participating liquidation preference, investors receive their initial investment amount before distributing any proceeds to common stockholders.
• Participating liquidation preference: Under a participating liquidation preference, investors receive their initial investment amount plus a share of the remaining proceeds alongside common stockholders.

Conversion Rights

Preferred stock often comes with conversion rights, allowing investors to convert their preferred shares into common shares. This can be voluntary (at the investor's discretion) or automatic (typically happening during an IPO or sale of the company).

Anti-Dilution

One of the most significant provisions regarding ownership within the company will be the anti-dilution provision. The anti-dilution provision safeguards the investor’s equity stake in the company in the event of a future fundraising round.

There are two main types of anti-dilution provisions:

• Weighted average: This is the most common type of provision found in term sheets. This mechanism protects investors when new shares are later issued at a lower price than what the investor originally paid. It adjusts the conversion price of the investor’s shares (preferred shares) to a weighted average of the price the investor paid and the new, lower price. There are two types of weighted average anti-dilution provisions: 1) broad-based, which includes all outstanding shares of common stock, options, and convertible securities, which results in a smaller adjustment to the conversion price and 2) narrow-based, which only includes the outstanding common stock, resulting in a larger adjustment to the conversion price.
• Full ratchet: This type is much more rare, and is very disadvantageous to the founders and common stockholders of the company. The full ratchet mechanism decreases the conversion price to the lowest price at which is the stock is issued after the issuance of the investor’s stock, regardless of the number of shares.

Option Pool

An option pool is a block of equity set aside for future employee stock options. This is typically created before the investment, affecting the pre-money valuation. It ensures the company can attract and retain talent. It’s often the case that companies have already established an option pool and issued equity awards thereunder to employees prior to their first preferred financing. In that case, the term sheet will likely include a requirement to “reset” the company’s option pool to a negotiated amount (typically 10% of the company’s authorized shares) to ensure the company can continue to attract quality talent following the financing.

Conclusion

These common terms are a sample of what our clients at @VirtualCounsel typically encounter when negotiating a term sheet before a preferred financing. Understanding the terms in a term sheet is paramount for both startup founders and investors. The term sheet sets the stage for the future relationship between the company and its investors, outlining the rights and obligations of each party. Founders should familiarize themselves with some of these common terms to assist in navigating the negotiation process and secure favorable investment deals that align with the goals of the company. Our team at @VirtualCounsel is experienced in providing expert guidance to review and negotiate term sheets and facilitate venture financings to ensure that your interests are protected and your company is positioned for success.

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