The Term Sheet: An Overview of Investor Rights and Controls in VC Investments

Understanding the Structure of a Venture Capital Deal

A venture capital term sheet is a document that outlines the important aspects of a venture capital deal. A venture capital fund is a professionally managed pool of capital raised from public and private pension funds, endowments, foundations, banks, insurance companies, corporations, wealthy families, and wealthy individuals.

Venture capitalists (VCs) generally invest in companies with a high growth potential and the realistic probability that they will be able to withdraw their investment and realize a significant return within five to seven years.

Typical Contents of a VC Term Sheet 

A typical VC investment structure includes rights and protections designed to allow the fund to gain liquidity and maximize returns.

The term sheet, the working outline for every finalized agreement, outlines these three most important aspects:

• Liquidation rights
• Management participation and control
• Exit rights

Liquidation Rights 

Most venture capital investments are structured as convertible preferred stock with dividend and liquidation preferences.

Preferred Stock

The preferred stock often will bear a fixed-rate dividend that, due to the cash constraints of early-stage companies, is not payable currently but is cumulative. These cumulative dividend rights provide a priority minimum rate of return.

The liquidation preference generally equals the purchase price, or a multiple thereof, plus accrued and unpaid dividends. This ensures that if the company is sold or liquidated, the VCs get their money back before the holders of the common stock, like founders, management, and employees.

Participation Rights

Most VCs insist on participation rights so that they share equally with common stockholders in any remaining proceeds after the payment of their liquidation preference. These liquidation rights and the right to convert the preferred stock into common stock allow the VCs to share in the upside if the company is successfully sold.

Valuation

An essential consideration for VCs in the case of liquidation is the percentage of the company they own on a fully diluted basis.

‘Fully diluted’ basis is calculated by adding the total number of common stock shares currently issued to the shares of common stock that would be issued if all outstanding options, warrants, convertible preferred stock, and convertible debt were exercised. This percentage is a function of the company’s ‘pre-money’ valuation, which is generally agreed upon by VCs and the company. IT takes into account the risks to the company and the future dilution to the initial investors from anticipated investments.

Protection

VCs protect their ownership percentages in three ways:

• Pre-emptive Rights: These allow investors to maintain their percentage ownership in the company by purchasing a pro-rata share of stock in future financing rounds.
• Anti-dilution Protection: This adjusts investor ownership percentages if the company executes a stock split, stock dividend, or recapitalization.
• Price Protection: This adjusts the price at which preferred stock can be converted into common stock in situations where the company issues common stock or stock convertible into common stock at a price below the current conversion price. Price protection is a hedge against a pre-money valuation that may have been too high. Within price protection, there are two common approaches:
  • Full ratchet: This adjusts the conversion price to the lowest price at which the company subsequently sells its stock, regardless of the number of shares the company issues at that price.
  • Weighted average ratchet: This adjusts the conversion price according to a formula that considers the lower issue price and the number of shares the company issues at that price.

Management Participation and Control 

Many VCs state that they invest in management rather than technology.  While this philosophy generally equates to a great degree of autonomy for company leadership and staff, it does not mean VCs are entirely removed from management.

Most investment structures provide for VC participation in management in the following ways:

• Representation on the board of directors
• Stock transfer restrictions
• Affirmative and negative covenants
• Protective provisions

Typical protective provisions include rights regarding critical business elements like bylaw amendments, stock issuance, dividend payments, extrabudgetary expenses, debt, and the sale of the company.

Most VCs permit management to operate the business without substantial participation, except at the board level, as long as the company is achieving its business goals and not violating any of the protective provisions. VCs generally require that management’s stock be subject to vesting and buy-back rights.

VCs may always negotiate the right to take control of the board of directors under certain conditions. For instance, if the company materially fails to achieve its business plan, meet certain milestones, or violates any of the protective provisions within the VC term sheet.

Exit Rights

Most VC investments have a limited life of 10 years and are structured to provide liquidity within five to seven years. In the end, VCs must achieve liquidity to provide their investors with the requisite rate of return.

The primary liquidity events for VCs are:

• Sale of the company
• Initial public offering (IPO) of the company’s stock
• Redemption or repurchase of VC stock by the company

Sale of the Company

Generally, VCs do not have a contractual right to force the company to be sold. However, the sale will be subject to the VCs’ approval, and depending upon the composition of the board of directors, the VCs may be in a position to direct sales efforts.

IPO

VCs typically have demand registration rights, which theoretically give them the right to force the company to go public and register their shares. VCs will generally also have ‘piggyback registration rights,’ which give them the right to include their stock in future company registrations.

Redemption

VCs may insist on ‘put,’ or redemption rights, to achieve liquidity if it is not available through a sale or public offering. When exercised, these rights require the company to repurchase VC stock after a period of generally four to seven years.

The purchase price of the VCs’ stock may be based upon the liquidation preference, i.e., the purchase price plus accrued and unpaid dividends, the fair market value of the stock as determined by an appraiser, or the value of the stock based on a multiple of the company’s earnings. An early-stage company, particularly one that is struggling, may not be able to finance an investor’s buyout. In these cases, the redemption right may not be a practical way to gain liquidity.

Redemption rights give VCs tremendous leverage to force management to address their need for an exit, which can result in a forced sale of the company. If the VCs trigger their redemption right and the company breaches its payment obligations, they may be able to take over control of the board of directors.

Other Exit Rights 

Additional exit rights VCs may require are:

• Tag-along: The right to include their stock in any sale of stock by management.
• Drag-along: The right to force management to sell their stock in any sale of stock by the investors.

Get to Know the VC Term Sheet

A VC investment term sheet can sometimes seem onerous and complex to entrepreneurs. However, fund managers must intimately understand the terms and structure of the deal and its many variations. As an investor in a VC fund, you don’t need to be as conversant with the terms and structures as entrepreneurs and fund managers. Still, it helps to know the general outline of a deal when evaluating your fund manager’s performance.

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

• The Start-Up/Small Business Advisor Series 
• Valuation Series 
• Raising Capital: Negotiating with Potential Investors

This is an updated version of an article originally published on February 2, 2013 and updated on December 2, 2019.]

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