A term sheet can be used in a number of transactions, such as the acquisition of a company or a partnership agreement, to establish the terms of a deal between two or more parties.
In the context of this article, we are going to focus on the term sheets commonly exchanged between investors and entrepreneurs in a Series A or equivalent funding round.
We attempt to simplify and clarify the actual terms that are common in a standard term sheet and some cautionary clauses to be aware of before agreeing to the terms.
What is a Term Sheet?
A term sheet is an agreement between investors and entrepreneurs to exchange equity in the form of preferred stock for working capital.
A more appropriate question is actually, “what is in a term sheet?” Unfortunately, the answer can vary significantly because the terms are variables that must be negotiated during the process of discovery, diligence, and deal-making.
Ultimately, the term sheet outlines the changes to two very important elements of a business: finance and control.
From a general finance perspective, the term sheet answers how much funding will be provided and at what price, who owns what percentages of the equity, and how much equity is leftover to incentivize employees. It also helps establish a contingency plan for distributions should the business fail or get acquired.
The focal point of the term sheet for both investors and entrepreneurs is the price, or valuation, of the company. Most investors want to pay the lowest possible price, for the most amount of equity, while most entrepreneurs want the highest possible price, and to sell the least amount of equity.
Price is the biggest factor in the return on investment for investors, but can also be a huge factor for entrepreneurs raising future financing, because down rounds (future investments at lower prices) can dilute existing owners, zap morale, and more.
Often, the term sheet will include a clause regarding the post-money valuation to be fully-diluted. This sets the investor off on the best possible footing to avoid the dilution of their position in the company. This includes the allocation of a sizable employee option pool and can include the stipulation that existing investors will be converted to achieve aggregate proceeds.
This is the clause that establishes the total amount being invested and the percentage of equity in the business the investors will receive in return.
It is also common for investors to include a provision that any previous convertible note investors will convert in this round. Because convertible notes are debt instruments, they are senior to equity in the event of a liquidation, which equity investors want to curtail.
After price, liquidation preference is the second most important financial aspect of a term sheet. If a company decides to wind down operations, any remaining assets (the pie) are divided among shareholders. Liquidation preference determines the order in which the metaphorical pie is served out, typically favoring investors with preferred shares over common shareholders.
Preferred stockholders have the benefit of being guaranteed their dividend payment if one is declared. The company can decide to suspend dividend payments if in financial trouble, but these dividends will go into arrears and are ultimately due to holders of preferred stock.
Some term sheets will include a clause about the preference being a fixed return multiple for investors. While this is typically 1x, meaning the investors will receive their money back before junior investors see any return, there have been term sheets in the past with a 10x preference.
If the entire pie is served to debt and preferred stockholders before reaching the holders of common stock, the common shareholders are essentially left with the dirty dishes but nothing else.
Investors want to be sure there will be shares reserved for future team members to aid in recruiting top talent, but also to ensure the team will have incentive to remain with the company and maximize shareholder value.
As we mentioned already, investors typically specify their investment will be made on a fully-diluted basis, which includes the allocation of this option pool before the investment is made.
Employee stock options are typically granted on a vesting schedule and combined represent 10-15% of the business.
In some cases, preferred stockholders may wish to voluntarily convert their shares to common stock — hence the conversion clause. Conversion gives the investors the right at any time to convert initially at a 1:1 basis, but can be adjusted to increase this ratio.
Once converted, there is no provision for reversing back to preferred shares, which is why this conversion typically happens automatically. An automatic conversion will occur when the company is in the IPO process because investment bankers prefer to have only one class of common stock. It’s not impossible for a company to go public with multiple classes of common stock, but it is uncommon.
Venture capitalists are making high-risk investments on startups and in some cases may have mispriced the round (i.e. overpaid on valuation). When mispricings occur, realized in a down round, anti-dilution provisions can help them offset their losses and prevent dilution.
We discuss specific provisions later, but the thought process is quite simple, when the company raises a down round (lower valuation than the previous round) the anti-dilution provision kicks in and either fully or partially offsets the difference in price by diluting common shareholders.
Governance Terms of a Term Sheet
The first section of this guide to the term sheet was about the money and now we will turn to the power. A one-time term sheet in an early fundraising round can have long-term implications for control and governance.
From power plays in the boardroom to ousting the founder from a leadership position, investors have the potential to disrupt operations and make substantial changes. You will want to firmly understand the governance terms before you enter into an agreement with investors.
Board of Directors
Composition of the board is outlined in the term sheet and entrepreneurs will often advocate for a board composed of people with the interests of common shareholders in mind, because ultimately, the board has the authority to hire and fire the CEO (often the entrepreneur).
Investors will want a seat on the board, if not more than one, and most boards have neutral third-party representation as well. In most funding rounds, there will be a number of investors participating in the round, with one lead investor who usually invests the lion’s share of the deal and will take the board seat.
Let’s assume a hypothetical three-person board of directors: the lead investor representing the interests of preferred shareholders, the CEO representing common shareholders, and a neutral third party agreed upon by the other board members.
It’s worth noting that term sheets usually specify the board seat to be held by the current CEO, which means if the founder/CEO is ousted from their role, they will not retain control over the board.
When a VC makes a sizable investment, they want to make sure that they have influence over high-level decisions that will impact the company’s future; this is where protective provisions are important.
In our board of directors example above, you might intuitively assume that each board member has an equal vote. Protective provisions in a term sheet could shift the scales slightly, giving the preferred shareholders additional voting rights.
Common decisions that are up for a board vote — and are of great interest to investors — include hiring and firing the CEO, mergers, acquisitions or another form of liquidation, issuing new shares, and other corporate actions.
Pro rata is the right, but not the obligation, to participate in a future funding round which would prevent the investor’s subsequent dilution.
The term sheet usually specifies pro rata rights will be upheld for investors of a certain investment threshold. The reason for a minimum investment pro rata becomes clear when a company has filled their round with many investors of small individual check sizes; it can be cumbersome to postpone a financing while investors decide whether or not to participate and invoke their pro rata rights.
When a large shareholder wants to sell their stock in the company, stock restriction can serve a few purposes:
- Prevent the founders from liquidating their shares and with it their incentive to build shareholder value.
- Prevent power and control from being acquired by unknown or unappealing characters (i.e. hostile takeovers).
Stock restriction can take two forms, which are complete opposites of each other: the right of first refusal (ROFR) and co-sale agreements. ROFR is in place so the company or existing shareholders have priority to purchase (or not) any shares offered for sale by other existing shareholders before a third-party.
A co-sale agreement means that if any shareholder is liquidating their shares, the other shareholders have the equal right to sell their shares. This typically means that the original seller is unable to offload their desired holding because the buyer won’t likely have the appetite or money to buy everyone’s shares.
This clause essentially prevents a small investor from blocking a transaction, such as an acquisition, that has been deemed desirable by a majority of larger shareholders, board members, and founders.
Drag along is usually invoked in three steps:
- The board of directors votes to approve
- A majority of common shareholders approve
- A majority of preferred shareholders approve
The minority shareholders that oppose the deal are literally dragged along.
While not as common, these terms could be included in a term sheet so you should be aware of them.
- Participating: Terms where the investor can receive their liquidation preference and convert preferred shares to common, benefiting from any subsequent appreciation.
- Senior: This would place new investors ahead of earlier-stage investors to receive a return of capital. Opposed to Pari Passu, Latin for side-by-side or on equal footing, where the liquidation preferences of all investors is the same.
Anti Dilution Rights
- Full Ratchet: In the event of a down round, the initial investor essentially receives additional shares to completely offset their mispricing, diluting existing shareholders such as the founders and employees.
- BBWA: Broad-based weighted average lowers the VCs cost basis, but does not fully offset the mispricing.
- One-Year Cliff Vest: Founders or employees release their shares if they depart the company before their one-year anniversary, after which they receive a percentage of their shares and regular equity installments over a specified period, typically four years.
- The ability for the VC to essentially return their shares of stock in the company in exchange for their money back. Most state laws restrict redemption if the business is in distress, which is good for the entrepreneurs.
Convertible Note Term Sheets
We won’t delve too deeply into the term sheets of convertible notes, but since they have grown in popularity over the past few years, we will touch on them briefly.
A convertible note is initially a debt instrument that usually carries an interest rate and has a maturity date for when the debt should be repaid or converted into equity. This can be advantageous to quickly raise money from investors without agreeing on a valuation, and essentially deferring the price negotiations to the Series A investors.
There are risks of raising too much or too many convertible notes. Many entrepreneurs have raised multiple investments via convertible notes, finding them a harmless vehicle for fitting more people into a round and prolonging the need to raise a formal round.
The downside becomes clear when the Series A sets the valuation, the notes convert, and the founders are diluted more than they anticipated. There is one clause of a convertible note term sheet that we think is very important for you to be aware of: capped and uncapped.
Uncapped vs. Capped Convertible Notes
Capped notes place an upper bounds on the valuation the investor is willing to pay. Uncapped notes simply mean the debt will convert to equity at the same price as the future investors. Uncapped notes do not compensate early-stage investors for the risk they are taking on the investment.
The easiest way to explain how capped convertible notes work is to go through an example. Let’s assume the company raised $500,000 in convertible debt with a $5 million cap on the note. When a priced round (i.e. Series A) is raised, let’s compare two term sheets on the table, and explain how each will impact the convertible note:
Term sheet #1: $4 million post-money valuation
The $500,000 note converts to equity at a lower valuation than the cap, which gives the investors the benefit of paying a lower valuation, therefore receiving 12.5% in equity. Had the priced round converted at the cap, they would have received only 10% in equity.
Term sheet #2: $10 million post-money valuation
The $500,000 converts to equity at the $5 million valuation cap which benefits the note holders with a discount compared to the later-stage investors who are investing at the $10 million valuation.
Term Sheet Tenacity
As an entrepreneur, it can be easy to become blinded by a high price without assessing the true cost of closing a deal with disagreeable terms. It’s important to consider the long-term ramifications of the various terms and contingencies, should the various scenarios play out.
As an investor, it can be easy to maximize upside potential and minimize downside risk by taking advantage of a naive, first-time fundraiser. More importantly, negotiating terms that are clear and comfortable for both sides of the table will almost always produce far greater outcomes.
The relationship established between investors and entrepreneurs is commonly compared to marriage. In this analogy, the term sheet would be the prenuptial agreement. Whether you are raising capital or investing in startups, you must be able to see past the honeymoon stage and understand the importance and long-lasting impact of the agreed upon term sheet.
EquityNet provides a platform for entrepreneurs and investors to connect and build value together on their own terms. Our pricing model of charging a flat-fee, versus gouging deals on a percentage basis, showcases our dedication to equitable terms.