An Introduction to Term Sheets
Demystifying term sheets for founders
Securing venture capital (“VC”) funding for a startup can be an exhilarating experience for new entrepreneurs. This injection of capital marks the beginning of a new stage in the young venture’s life. Product development, scaling, and hiring may be put into high gear, but founders should be cautious when they receive their first term sheet. Term sheets are a non-binding document designed to lay out the framework for negotiations between founders and investors. There are many nuances to the different terms and knowing which ones to focus on is critical to the founder’s ability to be satisfied with the deal in the medium and long run. One thing founders should keep in mind before taking an investment from a VC is whether or not they will be able to work with them effectively on an ongoing basis. VC funds typically last ten years and on average are equity holders in startups for about eight years. Finding the right fit is just as important as any other factor in this new relationship. In this post I’ll walk you through the key features of common terms and at the end I’ll construct a simplified term sheet.
The terms of funding may impact many aspects of the start-up company:
Economics of the returns the founders will realize if the company is successful
Control of critical corporate decisions
Consequences of falling short of expectations
Investment size (“Offering Amount”):
This lists the amount of the proposed investment by the VC firm. Large investments will dilute the founders more than smaller investments, but larger investment also provides additional funding that the company can use to extend its runway. Investment should give enough capital to allow the startups to successfully hit all the milestones needed in order to achieve an upround with the next series of financing. Typically, seed to series A rounds should afford the company 18 to 24 months of runway.
Example:
Amount of Investment: $5.0 million
Type of Security:
Venture capital investors typically require convertible preferred stock. Preferred stock has certain rights that common stock does not have. Some of these rights may include accruing dividends and senior priority in the waterfall of proceeds from a liquidation or sale of the company. Typically, convertible preferred converts to common stock if the company has an IPO.
Example:
Type of Security: Shares of the Company’s Series A Preferred Stock (“Preferred”), convertible into shares of the Company’s Common Stock (“Common”).
Valuation and Ownership Share:
Pre-money value is the valuation immediately before the funding round. It’s calculated as follows:
Pre-money Value = Post Money Value – New Investment
Pre-money Value = Total Number of Old Shares * New Share price
Post-money value is the valuation immediately after the funding round. It’s calculated as follows:
Post Money Value = Pre Money Value + Investment
Post Money Value = Investment / Percent Ownership Acquired
Post Money Value = Total Shares (includes old and new) * Share Price
Share Price = Investment / Number of new shares issued
Example:
Post-Money Valuation: The price per share of Series Series A Preferred (the “Purchase Price”) will be based on a fully-diluted post-money valuation of $15,000,000.
Employee Option Pool:
Seasoned VCs will typically require a number of shares to be set aside for employee incentive compensation in the form of stock options. Understanding the effects of option pools on both founders and VCs, and how these effects differ between pre-money and post-money setups, is critical when negotiating the terms of a funding round.
If the option pool is carved out pre-money, then the founders take all the dilution from the carve-out. This effectively lowers the company’s pre-money valuation because it increases the number of shares outstanding before the investment.
If the option pool is carved our post-money, then the investors and founders share in the dilution. This means the pool is created from the equity pool that includes the investment, effectively sharing the dilution from the option pool more equitably between the founders and new investors.
Founders should not be so quick to bulk at the sight of an employee option pool as this should be considered as a way to invest in the startup’s human capital and help maintain it in the future. Startups can’t typically compete with large corporations in terms of salary, so they need other ways to compensate their employees.
Example:
Option Pool: Immediately prior to the Initial Closing, the Company will amend its current stock option plan (the “Plan”) to increase the number of shares of the Company’s Common Stock (“Common Stock”) reserved for grant pursuant to the Plan so that six percent (5%) of the Company’s fully diluted capital stock following the Closings will be available for future issuance.
Price Per Share:
This section of the term sheet lists the price per share the investors will pay for the stock of the startup.
Example:
Price Per Share: $1.00 (“Series A Original Issue Price”)
Dividends:
Dividends are a way for investors to juice up returns at the time of harvesting. They are typically paid back at liquidation and function similarly to the interest on a loan as a percentage of the investment. There are two types of dividends; cumulative and non-cumulative.
Cumulative Dividends:
Cumulative dividends are calculated annually and if the Board of Directors does not elect to pay out the dividend each year the amount owed is carried over to the next year and the cumulative total will grow until paid in full. For this reason, cumulative dividends are considered not to be founder-friendly, in fact in a recent survey by Gompers, Gornall, Kaplan, and Strebulaev (2020) (GGKS) only 17% of VCs said they used cumulative dividends.
Non-Cumulative Dividends:
For non-cumulative dividends If the issuing company misses a dividend payment, the company can resume preferred dividend payments at any time with disregard to past. Of course, these are considered more founder friendly.
Example:
Dividends: The holders of Series A Preferred will be entitled to receive cumulative dividends in preference to any Common Stock, at the rate of 8% per annum.
Liquidation Preference:
The liquidation preference ensures investors are paid back their original investment plus any cumulated dividends before common stockholders see any proceeds from a harvesting event. This is one of the most important terms to pay attention to as this can significantly increase the investors’ returns on behalf of the founders. Some investors will add a multiple liquidation preference which is a provision that gives preferred stockholders the right to receive a multiple of their original investment (e.g. 2X, 3X, or even 6X). The investor still has the option to convert to common stock if the company is doing well, and it provides a higher return. As of July 2020, less than 10% of deals had multiple liquidation preferences GGKS (2020).
Example:
Liquidation Preference: In the event of a sale of all or substantially all of the assets, merger, consolidation, liquidation, dissolution, or winding up the company (a “Liquidation Event”), the holders of Series A Preferred (the “Preferred Stock”) will be entitled to receive, in preference to the holders of Common Stock, an amount equal to the respective original issue price for each series of Preferred Stock held by such holders plus declared but unpaid dividends (the “Preferred Liquidation Preference”). After payment in full of the Preferred Liquidation Preference the remain process shall be distributed to the holders of Common Stock.
Exhibit 1)
Now assuming a 2x liquidation preference we get the following waterfall:
Exhibit 2)
As we can see from the graphical example, the multiple on liquidation preferences can have an adverse effect on the founder’s proceeds during a mediocre liquidation event. In some cases, multiple liquidation preferences have been known to get as high as 10x.
Founders also needs to consider if the preferred stock includes a participation term. This term means that once the amount invested, unpaid dividends, and the multiple agreed upon have been paid the owners then begin to participate in their pro-rata share of the proceeds. In other words, preferred shareholders get to enjoy the proceeds of the common stock on a as converted basis without converting. Many entrepreneurs consider this as “double dipping” since the preferred shareholder gets the benefits of both preferred and common stock. Under this senior preferred shareholders will never convert to common since they will always be strictly better off. The only time preferred shareholders will convert is under an automatic conversion event, i.e. an IPO. In 2020 participation was utilized about 53% of the time in terms sheets GGKS (2020).
Example:
Liquidation Preference: In the event of a sale of all or substantially all of the assets, merger, consolidation, liquidation, dissolution, or winding up the company (a “Liquidation Event”), the holders of Series A Preferred (the “Preferred Stock”) will be entitled to receive, in preference to the holders of Common Stock, an amount equal to the respective original issue price for each series of Preferred Stock held by such holders plus declared but unpaid dividends (the “Preferred Liquidation Preference”). Thereafter, Series A Preferred participates with Common Stock pro rata on an as-converted basis.
Using Exhibit 2 and adding participation to the preferred stock we get the following waterfall:
Exhibit 3)
As we can see from the example above there is no inflection point where the preferred shareholders will choose to convert to common stock. They will always be strictly better off not to convert.
A way of mitigating participation is to apply a cap. This essentially limits the return preferred to let’s say 2.5x. Caps help to make participating preferred more founder friendly by induction a conversion threshold where investors are strictly better off to convert to common stock.
Conversion / Automatic Conversion:
The conversion clause states that the holders of preferred stock have the right to convert to common stock at an agreed-upon conversion rate (typically 1:1).
Term sheets will also contain a term for automatic conversion, which converts all shares of the common stock during the event of an IPO. This allows for easier marketing and share price establishment. This term is important for founders as it sizes up the minimum offering and enterprise value the VC needs in order to allow the company to go public. The lower these two numbers the more flexibility the founders have when going public.
Example:
Conversion: Initially, Series A Preferred will be convertible to Common Stock at a conversion rate of one-to-one subject to any adjustments below (referring to anti-dilution).
Automatic Conversion: Each series of Preferred Stock shall be automatically converted into Common Stock upon: (i) in the event of an underwritten public offering of shares of Common Stock at an aggregate offering price of $30,000,000 with a pre-offering valuation of not less than $250,000,000 (“Qualifying IPO”) or (ii) the date upon which the Company obtains the vote of the majority of Preferred Shareholders to such conversion.
Anti-Dilution:
Dilution occurs when an investor’s ownership percentage is reduced by the issuance of new share. The anti-dilution provision protects preferred shareholders if the company is forced to accept a down round of financing. There are three common methods for calculating dilution during down rounds which are no anti-dilution protection, full ratchet, and weighted average.
No Anti-Dilution:
No anti-dilution protection simply means that during a down round the investors will receive their pro-rata share in whatever dilution takes place.
Full Ratchet:
Full ratchet provisions state that if there is a down round and the issued stock price is lower than the price per share of existing preferred stock then the conversation price of the existing preferred stock is ratcheted downward to the new stock price. This protects the preferred shareholder’s investment by automatically increasing the number of shares they own. This is considered the harshish of the anti-dilution provisions since the ratchet comes at the cost of any shareholder who does not also have full ratchet protection. In 2020 full ratchet provsions were utilized about 20% of the time in terms sheets GGKS (2020).
Weighted Average:
Weighted average anti-dilution provisions are considered more company-friendly, as they are less dilutive to the founders. This provision adjusts the investor’s price downward based on the number of shares in the new round of financing. In other words, the dilution is shared between prior investors and founders, but the investors don’t take as much of a hit as they would there were no anti-dilution provision in the term sheet.
The typical formula for calculating the conversion price is:
New Conversion Price = [(A+B)/ (A+C)] * Old Conversion Price
Where:
A = number of shares outstanding before the dilutive issue
B = number of shares that would have been issued at the old conversion price for the investment in the dilutive round
C = number of shares actually issued in the dilutive round
Example:
Anti-dilution Provisions: In the event that the company issues additional securities at a purchase price less than the current Series A Preferred conversion price, such conversion price will be adjusted in accordance with the following formula:
CP2 = [(A+B)/ (A+C)] * CP1
CP2 = Series A Conversion Price in effect immediately after new issue
CP1 = Series A Conversion Price in effect immediately prior to new issue
A = Number of shares outstanding before the dilutive issue
B = Number of shares that would have been issued at the old conversion price for the investment in the dilutive round
C = Number of shares actually issued in the dilutive round
Pay-to-Play:
Pay-to-play (Play or Pay) provisions are intended to require an investor to participate (their pro-rata share) in down rounds in order to receive the benefits of their anti-dilution provision. Failure to participate results in forced conversion from preferred to common or loss of anti-dilution protection.
Example:
Pay-to-Play: On any subsequent down round all Investors are required to purchase their pro rata share of the securities set aside by the Board for purchase by the Investors. All shares of Series A Preferred of any Investor failing to do so will automatically convert to Common Stock and lose the right to a Board set if applicable.
Voting Rights:
Voting rights address how the preferred shareholders control the company in order to add value and how they exercise control when things go wrong.
Key voting right items include:
Changes to the articles of incorporation
Changes to the size of the board of directors
Employee salary levels
Raising additional capital or debt
Liquidation or dissolution of the company
Example:
Voting Rights: Expect with respect to election of directors, a holder of Preferred Stock will vote on an as-converted to Common Stock basis at the time the shares are voted. Election of the direction will be described under “Board Representation” below.
Protective Provisions:
Protective provisions give investors the right to veto certain corporate actions that might affect the preferred shareholder’s investment. This provision outlines several conditions under which the founders must get approval from preferred shareholders. The purpose of these provisions is the protect the investors from the decisions of the common stockholders who typically have the majority of ownership.
Here’s a list of common protective provisions:
A merger, sale, or other liquidation event of the company
Change the certificate of incorporation or bylaws
Any change in the total number of authorized shares, preferred or common stock
Issuance of stock of any equity security having seniority or being equal to the stock held by preferred shareholders
Pay or declare dividends
Any change in the authorized composition or size of the board of directors
Taking on debt obligations
Buying back any common stock
Example:
Protective Provisions: The consent of the Preferred Majority will be required for any action that:
(i) Amend or repeal any provision of, or add any provision to, the Company’s Articles of Incorporation or Bylaws to change the rights of the Preferred or increase or the number of authorized shares of Preferred;
(ii) Liquidates, dissolves or winds-ups the Company or is a Liquidation Event;
(iii) Creates any new series or class or shares having preference or priority as to dividends or asses superior to on parity with that of Preferred;
(iv) Authorizes or issues any debt, if the aggregate indebtness of the Company would exceed $100,000 unless such debt is approved by the Board of Directors, including the approval of a majority of the Preferred Directors;
(v) Increase or decreases the number of authorized directors on the board.
Participation Rights (Pre-emptive Rights):
Participation rights ensure that if the company sells more shares to raise money then the existing preferred shareholders have the right to buy the new shares first. In other words, the existing preferred holders are the first call placed when a company is ready to offer additional shares.
Example:
Participation Rights: Major Purchases (at least 20% equity on a fully diluted basis) of Series A Preferred Shall have the right to participate on a pro rata basis in subsequent issues of equity securities.
Co-Sale Rights:
The co-sale rights clauses states that if a founder sells their shares, then the preferred shareholders have the right to purchase those founders shares first.
Example:
Right of Co-Sale: Investors will have a right of first refusal with respect to any shares of capital stock of the Company proposed to be transferred by the Founders, with a right of oversubscription for Investors of shares unsubscribed by the other Investors. Before any such person may sell Common Stock, he will give Investors an opportunity to participate in such sale on a pro-rata basis to the amount of securities held by the seller and those held by the participating Investors.
Pro-Rata Rights:
Pro-rata rights give VCs the option to invest their pro-rata amount in subsequent financing rounds. This allows investors to maintain their ownership position in the Company.
Example:
Each Major Investor shall have a pro rata right, based on their percentage equity ownership in the Company (assuming the conversion of all outstanding Preferred Stock and the exercise of all options outstanding), to participate in subsequent issuances of equity securities of the Company. In addition, should any Major Investor choose not to purchase its full pro rata share, the remaining Major Investors shall have the right to purchase the remaining pro rata shares.
Information Rights:
Information rights require that the company provide status reports and financial performance information to investors several times per year.
Example:
Information Rights: Each Investor that holds at least $1,000,000 worth of Preferred Stock (each a “Major Investor” and collectively, the “Major Investors”) will be granted access to the Company’s facilities and personnel during normal business hours and with reasonable advance notification. The Company will deliver to each Major Investor (i) annual and quarterly financial statements (balance sheet, cash flow statement and income statement) and other information as determined by the Board; (ii) thirty days prior to the end of each fiscal year, a comprehensive operating budget forecasting the Company’s revenues, expenses, and cash position on a month-to-month basis for the upcoming fiscal year; (iii) promptly following the end of each quarter an up-to-date capitalization table; and (iv) such other information relating to the financial condition, business, or corporate affairs of the Company as any Major Investor may from time to time request.
Registration Rights:
Registration rights require that if the company has an IPO then the firm must also register the investors stock shares and pay for the legal fees that come with it. This term helps make it easier and cheaper for investors to liquidate their position during a public offering. Typically, venture capital firms are required to participate in a blackout period of 180 days before they can sale their stock. This is a standard requirement from most investment banks during an IPO.
Example:
Registration Rights: The holders of Series A Preferred will have standard registration rights.
Stock Vesting:
The stock vesting term states how the managers and employees earn ownership of common stock after a predetermined period of time or after achieving milestones. Vesting is intended to motivate employees to stay with the company “taking away” or “earning back” shares over the vesting schedule. If the employee leaves the company before their shares vest then the Company gets them back and can use them to attract other talent.
Example:
Stock Vesting: The founder of the Company and all other holders of Common who are employees of the Company shall have 36 months vesting from the purchase of Preferred or date of first employment, whichever is later. Full accretion upon “Double Trigger.”
Board Representation:
The board representation clause gives investors the ability to control part of the board of directors by electing a percentage of the board members. The purpose of this clause is to influence decision-making and to protect their investment. If board representation is not possible due to a syndicated deal, then often times VC firms will require a board observer. Board observers monitor the company and influence decisions by their presence at the board meeting.
Example:
Board of Directors: The Company’s board of directors shall have three (3) members. Series A investor shall be entitled to designate one (1) representative. Common shareholders will be entitled to designate two (2) representative, with one (1) representative being the CEO of the Company and (1) representative being mutually agreed upon by both Series A investor and the Company.
Legal Fees and Expenses:
The legal fees and expenses associated with the round closing are typically up to the company to cover. This also includes a predetermined amount of legal fees and expenses for the investor. In other words, companies can expect to receive an investment wire amount net of fees.
Example:
Legal Fees and Expenses: Company shall bear its own fees and expenses and shall pay up to $30,000 in legal fees incurred by Series A Investor related to this transaction (the “Legal Fees”). At the Closing, Series A Investor will wire the final amount of the Legal Fees to XYX Legal Co and shall subtract such amount from the total purchase price owed by Series A Investor to the Company at the Initial Closing.
Other Matters:
No Shop/Exclusivity: This section is intended to prevent the Company from seeking to find other investors to provide funding for some period of time, typically 30 days.
Example:
Upon reaching an agreement on this Summary of Proposed Terms and Conditions, neither the Company nor any of the Company’s directors, officers, employees, agents, or representatives will solicit, encourage, or entrain other investors or consider any other investment or acquisition proposals for a period of 30 days without the prior approval of Series A investor.
Confidentiality: This section is designed to keep all information about the deal terms and negotiation private.
Example:
The Summary of Proposed Terms and Conditions, and the fact that any negotiations may be on going with the Investors, are strictly confidential and are not to be disclosed to any party, other than the Company’s legal and financial advisors, without the prior approval of Series A investor.
Expiration: This is simply the date in which the term sheet expires.
Example:
This Term Sheet expires at 5:00 p.m. PT on April 28, 2024 if not accepted by the Company by that date.
Final Thoughts:
Receiving a term sheet can mark the next step in a startup’s life. Founders need to understand the trade-offs and long-term implications before they sign a term sheet. It’s advisable that they get lawyers involved right away. They should also have an idea of which terms are most important to them before negotiating with a VC firm. At the end of the day, what matters most is not how the pie is sliced up, but rather how big the pie gets. The main objective of the founders should be to find a VC firm that will help them increase the probability of a great outcome.