As a founder, it can be a daunting experience to go through the process of raising capital for the first time. A great amount of time and energy is spent on getting a pitch deck ready and presenting it to investors, but an equally, if not more important part of the process is the term sheet that is signed once investors are ready to invest. Before you can start negotiating the terms of the term sheet, you need to know what you are negotiating.
As a starting point, let’s consider what a term sheet is and where it comes into play in the capital raising process:
- After investors make a verbal commitment to invest, a term sheet is drawn up as the first formal, but non-binding, document between the founders of a business and potential investors.
- The purpose of the document is to lay out the terms and conditions for investment from potential investors.
- It is used to negotiate the final terms between the founders and investors, which is then written up in a formal contract.
Naturally, founders tend to be on the backfoot when the negotiation of a term sheet starts, as this is often the first time founders encounter a term sheet in their life. On the other hand, Venture Capital (“VC”) investors see term sheets daily, know what to expect, and are au fait with the legal verbiage contained in a term sheet. It is therefore of paramount importance that founders seek legal advice before agreeing the final terms in a term sheet with investors.
In this blog post, we will look at what elements a ‘good’ term sheet should include, what these elements mean, and also which elements every founder should be sure to avoid.
What does a ‘good’ term sheet look like?
By way of an example, we will walk through a one-page term sheet template which Y Combinator has put together, specifically designed for a Series A raise, but which can be used for any investment round:
1. Valuation and Investment Amounts
The biggest point of negotiation when raising capital for a startup, generally, is the valuation of the business. It can be very challenging to determine the value of an early-stage startup, as a valuation is as much art as it is science. The science tends to be the easy part – researching what comparable companies are valued at, pulling comparable earnings multiples, and even constructing discounted cash flow models. The art, on the other hand, is more challenging – how strong is the founding team and management? How innovative is the technology? And how probable is the pipeline and growth plans of the business?
There is a lot of reading material on the internet providing real-life examples of how startups have been valued, and we recommend in-depth research before engaging in negotiations with investors. It can also be useful to get expert advice on how to value your business but be cognisant of the fact that your business is ultimately only worth as much as the market is willing to invest / pay for your business.
Once a valuation is agreed with investors, both the pre-money and post-money valuation tend to be included in the term sheet. The pre-money valuation is what the business is valued at before the new investment is received, whereas post-money is that valuation plus the new investment received.
Together with this, the amount that is being invested by new investors is also always indicated on the term sheet, and is typically split between the ‘Lead Investor’ (which is the investor taking up the biggest chunk) and ‘Other Investors’ who are participating in the investment round alongside the Lead Investor.
2. Option Pool
An option pool is easily explained by thinking of a bucket which is put aside with a certain number (or %) of unallocated shares which is currently not owned by anyone. This bucket of shares is put aside and reserved for current or future employees of the business (as a remuneration tool in future). On the term sheet, you may need to create an option pool or expand on the existing one. What you are effectively also doing is, you are laying down the terms for how the shares of founders and investors will be diluted as the new shares are issued to employees.
Generally, what we see is that pre-money option pools (ones that exist prior to the new investment) tend to favour the investors, and not the founders, as they call for all future dilution to fall on the founders. However, a more founder-friendly option pool can certainly be negotiated which is then calculated post-money and would include all investors in future dilution. This is an important element to be aware of.
3. Liquidation Preference
Simply put, liquidation preference is the order in which shareholders are entitled to receive payment in the event of a liquidation of the business (i.e. if the business gets sold). It serves as a safety net for investors who are getting preferred shares, as it allows preference shareholders to receive cash before ordinary shareholders do. This is an important clause for investors as it provides investors with a certain degree of security to the risk of their investment. The general guidance to founders is that the Liquidation Preference should not be more than 1.0x. Anything higher than this number means that preference shareholders are entitled to receive more cash than their initial investment, before the ordinary shareholders will have any entitlement.
In layman’s terms, dividends are a distribution of the company’s net profit to the shareholders of the business. Dividends can be paid either in cash or in shares (additional shares in the company). It is commonly also another “sweetener” for preference shareholders as they have entitlement to dividends before ordinary shareholders do. This is what makes the shares “preferred”.
There are two main types of dividends to understand: (a) Cumulative, and (b) Non-Cumulative
(a) Cumulative: cumulative dividends accrue to the holders of preference shares on an annual basis, based on the original issue price. That means that even in a year where no dividends are paid, the dividends that preference shareholders are entitled to still accrue and are carried forward to the next year. This is very favourable to investors holding preferred shares and disfavour the founders as the preference dividends are akin to interest that accumulate on a loan and need to be paid eventually.
(b) Non-Cumulative: with non-cumulative dividends the Board of Directors have to declare a dividend in the financial year in order for it to accrue to the preference shareholders. In the event that no dividends are declared, preference shareholders forego the right to dividends in that financial year and will have no future claim to dividends not declared. This is a much better scenario for founders as the company will have no contractual obligation to pay dividends to preference shareholders if the company is not in a financial position to do so.
It is important to note that in both scenarios outlined above, dividends for ordinary shareholders may never be declared if dividends for preference shareholders are not also declared. In other words, the company will not be able to declare dividends to ordinary shareholders if the company does not also declare dividends to preference shareholders. However, the inverse is possible: the company may only declare dividends for preference shareholders and not any for ordinary shareholders.
5. Conversion to common stock
Common practice is that preference shares automatically convert to common shares in the event of an IPO or sale. Seed and Series A investors typically also have the right to convert their preference shares into common stock at any time (at the election of a preference shareholder). The reasoning behind this is that it allows a preference shareholder to convert to common shares should he determine in a liquidation event that he is better off getting paid pro rata with all common shareholders rather than accepting the liquidation preference and participation amount.
6. Voting Rights
On a term sheet, the voting rights simply state the voting rights of the investor. Generally, investors will receive the same number of votes as the number of common shares they could convert to at any given time. In addition to this, the term sheet may also define certain events which require the approval of the majority of preference shareholders (examples include to change the authorised number of shares, declaring or paying dividends, or to change the rights, preferences, and privileges of the preference shareholders). The most important veto rights that an investor usually receives are the veto of financing and the veto of a sale of the company.
Drag-Along is defined by the Morgan Lewis law firm as, “Drag along is the right to obligate other shareholders to sell their securities along with securities sold by the investor.”
This element essentially provides investors with the confidence that founders and minority shareholders will not block the sale of the company in the future. Drag-along rights are also good for the minority shareholder, as they ensure that the same deal is offered to all shareholders.
Minority shareholders are often protected even further by including tag-along rights. Tag-along rights provide minority shareholders with the right, but not the obligation, to participate in any action along with the majority shareholders (i.e. in a scenario where the majority shareholders are looking to sell their shares to a new investor, the tag-along rights will force the new investor to offer the same purchase terms to the minority shareholders and give them the option to participate in the sale or not). This clause is included as majority shareholders are often more capable of finding favourable deals which minority shareholders would be excluded from without this provision).
8. Anti-Dilution Rights
Anti-dilution rights protect investors in the case of a down round in future. A down round is a situation where a subsequent investment round takes place at a lower valuation than the current investment round. If anti-dilution rights are in place, the company is usually contractually obliged to issue additional shares to preference shareholders in the future when a down round takes place to ensure that the preference shareholders are not diluted to any extent. The most common anti-dilution rights are ‘weighted average anti-dilution rights’ which means that both the price and the number of shares in the down round are taken into account in order to determine how many new shares need to be issued to preference shareholders. However, ‘full-ratchet anti-dilution rights’ also exist and founders should be weary of agreeing to these rights, as it effectively disregards the number of new shares that are issued in the down round, and automatically allows for the conversion price of the preference shares to be set at the price at which the new shares have been issued.
9. Board of Directors
Due to the early-stage nature of a startup, the idea of having a board of directors is usually a foreign concept. However, a term sheet will always include a section on this, due to the importance of the board of directors as and when the company grows.
The general guidance is that the board of directors should include at least one member from the founders and existing shareholders, as well as one member from the investors. We often also see a third, independent member included, which can be someone with industry experience. But this is not critical and is open for negotiation with investors.
Linking with the option pool explained above under point 2, the term sheet typically also includes the period over which unallocated shares (in the option pool) will vest to the founders and/or other employees. This period is the amount of time that the founder and/or employee needs to remain in employment of the company before all of the shares that have been earmarked for that person ‘vests. Shares typically vest over time, and as and when shares vest to an employee, that person takes ownership of the shares and is then legally entitled to sell the shares. The ‘1-year cliff’ referred to in our term sheet example below means that an employee will have shares vest to him/her monthly for a four-year period. However, all shares that have vested to the employee will fall away if that employee leaves the company before the end of their first year of employment. The 1-year mark is thus a cliff where, if the employee leaves before it, that employee will lose all shares that have vested. But if the employee leaves after the 1-year mark, the employee will retain ownership of the shares that have vested up to the point of leaving.
The purpose of the no-shop clause is to provide investors with a specified time frame within which they have security that the founders will not ‘shop around’ for other investment proposals from other parties.
This provides the investors with leverage as it prevents the founders from finding and negotiating better terms with a different investor.
Even though the no-shop clause is common practice, it is important for founders to be weary of the duration of the no-shop clause. You certainly do not want a too long no-shop clause as it could allow for the investor to spend an unreasonably long time performing due diligence and then pull out at the last minute (as mentioned earlier, never forget that the term sheet is non-binding).
In addition to the above, there are many other terms that may be included in the term sheet, but we believe the above to be the most important ones.
Example term sheet from Y Combinator:
Lastly, below are a few key items every founder should try to avoid in a term sheet:
- Redemption Rights
Redemption rights are designed to provide investors with the right to ask for their investment back. This typically does not come into play when the business succeeds or fails, as investors automatically get their investment back if the business succeeds, and they lose their investment when the business fails. But, where this does become problematic, is when the business is going through shaky waters and is struggling. Investors will then have the right to ask for their money back which could put significant cash flow pressure on the business and lead to it going under.
2. Milestone-Based Financing
Milestone-based financing is a concept where investors agree to pay an initial amount of investment upfront (the initial tranche), with subsequent rounds of investment being paid as and when the business hits certain milestones. In certain instances, if the business does not meet the predefined milestones, investors will also have the right to change the terms of the deal. Milestone-based financing is not common practice anymore and founders should feel empowered to push back if investors want to include it in the term sheet.
3. Unnecessary fees
We have seen instances where investors include “board fees” or “monitoring fees” in the term sheet. In essence, what this is, is a fee that the company has to pay the investors for their presence at board meetings or for the task of monitoring their investment. These fees are unnecessary and unfair, and will most likely upset future investors, so we highly recommend pushing back on these fees.
Note: this blog post does not constitute legal advice and we encourage founders to consult with their own legal counsel while reviewing term sheets and before signing such.
Author: Daniel Swiegers | Head of Investee Company Experience @ simple.Capital()