Investor Notes for Founders Ep VI: What Are The Key Terms of a Term Sheet?

What Are the Key Terms on a Term Sheet? 

In the venture capital world, a term sheet is a pivotal document that represents a significant milestone in the fundraising process for a startup. It is typically generated after a series of discussions, due diligence, and negotiations between the startup and potential investors. Getting to the level of a term sheet is a big achievement for a startup and typically follows a specific progression. For a startup to receive a term sheet, it usually goes through the following process. 

Investor Interest: The startup captures the attention and interest of potential investors. This can occur through various channels, such as networking events, pitch competitions, or introductions from mutual connections. Investors who see potential in the startup's business model, technology, or market opportunity express a desire to learn more.

Initial Discussions: The startup engages in preliminary discussions with interested investors. These discussions aim to provide a deeper understanding of the startup's business, its growth potential, and any challenges it may face. The investors may ask questions about the market, competition, team, and financial projections.

Due Diligence: If the initial discussions prove promising, the investors may initiate a due diligence process. This involves a comprehensive examination of the startup's operations, finances, legal matters, intellectual property, and market potential. The investors seek to validate the information provided by the startup and assess any risks associated with the investment.

Negotiations: After completing due diligence and determining their level of interest, the investors and startups enter into negotiations. These negotiations focus on the key terms and conditions of the investment, such as valuation, investment amount, funding structure, governance rights, and potential exit scenarios. The parties aim to reach mutually agreeable terms that balance the interests of both the startup and the investors.

Term sheet Preparation: Once the negotiations progress positively, the investors may decide to present the startup with a term sheet. The term sheet summarizes the key terms and conditions of the investment, providing a framework for further discussions and legal documentation. It is important to note that a term sheet is typically non-binding, allowing both parties to continue refining the details before entering into a binding agreement.

Receiving a term sheet is a significant achievement for a startup, as it indicates that the investors are serious about investing in the company and believe in its potential for success. From this point, the startup and investors can work together to finalize the terms and move towards closing the investment deal, which involves drafting legal agreements, conducting additional legal and financial due diligence, and fulfilling any remaining conditions precedent.

How are term sheets negotiated?

Negotiating term sheets involves a collaborative process between the startup and the potential investor to reach mutually agreeable terms for the investment. The negotiations are not always a linear process and may involve back-and-forth discussions, revisions, and iterations. Both the investor and the startup need to consider their respective bargaining power, market dynamics, and industry standards while negotiating terms. Legal and financial advisors play a crucial role in guiding the negotiation process, ensuring that the startup's interests are protected, and helping both parties find common ground for a successful investment agreement. The negotiation process typically follows these steps:

Initial Proposal: The investor and the startup engage in discussions to understand each other's objectives, expectations, and terms they deem favourable. The investor may provide an initial proposal or term sheet that outlines their preferred terms based on their investment thesis and risk appetite.

Term Discussion: Both parties review the proposed term sheet and engage in discussions to understand each other's perspectives. They may seek clarification, raise questions, and identify areas of agreement or disagreement. These discussions help build a common understanding of the key terms and potential areas for negotiation.

Due Diligence: During the negotiation process, the investor conducts due diligence to assess the startup's business, operations, financials, legal aspects, and market potential. The results of due diligence can influence the terms and valuation proposed in the term sheet.

Term Sheet Markup: The startup, with the support of legal and financial advisors if applicable, reviews the term sheet and prepares a marked-up version that reflects their proposed changes and counter-offers. This process involves careful consideration of the startup's interests, risk tolerance, and alignment with their long-term goals.

Negotiation Discussions: The negotiation process involves multiple rounds of discussions, negotiations, and revisions to the term sheet. Both parties present their arguments, justifications, and concerns for specific terms. They work towards finding mutually beneficial solutions and compromises, aiming to align the interests of both the investor and the startup.

Balancing Interests: Negotiations focus on achieving a fair balance between the investor's risk and return expectations and the startup's need for funding, growth, and operational flexibility. Parties may negotiate on various terms, such as valuation, investment amount, governance rights, liquidation preferences, anti-dilution protection, and other provisions to reach a middle ground.

Legal Documentation: Once the parties reach a consensus on the terms, a binding investment agreement is prepared by legal professionals. The agreement incorporates the negotiated terms and converts them into legally enforceable provisions. The agreement is reviewed and signed by both parties, finalizing the deal.

What are the Key Terms on a Term sheet? 

When discussing the key terms of a term sheet in the venture capital context, there are several important elements to consider. In a term sheet, the terms can generally be categorized into two broad categories: legal terms and economic terms. Let's break down these categories and explain the key terms that fall under each:

The Economic Terms of a Termsheet.

Valuation: The valuation of a startup determines its worth and plays a crucial role in determining the ownership stake that the investor will receive in exchange for their investment. A valuation can be expressed in terms of pre-money valuation (startup's value before the investment) and post-money valuation (startup's value after the investment). A valuation can be determined through various methods, including market comparables, discounted cash flow analysis, or by considering the startup's traction and future potential.

Example: An investor agrees to invest $5 million in a startup at a pre-money valuation of $20 million. After the investment, the post-money valuation of the startup would be $25 million. In our previous newsletter, we did a deep dive into the valuation of startups. You can read it here.

Liquidation Preferences: Liquidation preferences are a crucial aspect of the term sheet that protect the investor's investment in the event of a liquidity event, such as an acquisition or initial public offering (IPO). They determine the order in which the proceeds from the liquidity event will be distributed among the shareholders. Let's dive deep into the different types of liquidation preferences and their implications:

Non-Participating Preferred Stock: In a non-participating liquidation preference, the investor has the right to receive their original investment amount (plus any accrued dividends) before any other shareholders. However, once they receive their investment back, they do not participate further in the distribution of the remaining proceeds.

Example: Suppose an investor holds $5 million in non-participating preferred stock with a 1x liquidation preference and a 10% ownership stake. If there is a liquidity event resulting in $50 million in proceeds, the investor will receive their $5 million back first. The remaining $45 million will be distributed among other shareholders based on their ownership stakes.

Participating Preferred Stock: In a participating liquidation preference, the investor receives their original investment amount (plus any accrued dividends) and also participates pro-rata with the common shareholders in the distribution of the remaining proceeds. Participation can be structured in different ways, such as full participation or capped participation.

Example: Let's consider the same scenario as before, but this time with participating preferred stock. If the investor has a 1x participating liquidation preference and a 10% ownership stake, they would receive their $5 million back first. After that, they would also participate in the distribution of the remaining $45 million based on their 10% ownership stake.

Multiple Liquidation Preference: In certain cases, the investor may negotiate for a multiple liquidation preference. This means they receive a multiple of their original investment amount before other shareholders. For example, a 2x liquidation preference would entitle the investor to receive twice their original investment amount before other shareholders.

Example: Suppose an investor holds $5 million in preferred stock with a 2x liquidation preference. In a liquidity event resulting in $20 million in proceeds, the investor would receive $10 million (2 times their $5 million investment) before any other shareholders. The remaining $10 million would be distributed among other shareholders.

Liquidation preferences can have a significant impact on the distribution of proceeds and the ultimate returns for shareholders. Higher liquidation preferences can provide greater downside protection for investors, but they may also impact the potential returns for common shareholders, including founders and employees. These preferences are often subject to negotiation and depend on factors such as the stage of the company, the investor's level of risk, and the overall investment climate.

Funding Structure: The funding structure refers to the overall plan for providing capital to the startup. It provides a framework for the timing, conditions, and potential subsequent funding rounds for the startup. It plays a vital role in planning the startup's capital needs and aligning the expectations of the investor and the startup. Let's dive deep into the components and implications of the funding structure:

Timing of Funding Rounds: The term sheet may specify the timing of subsequent funding rounds, often referred to as series A, B, or C rounds. These rounds represent subsequent infusions of capital as the startup progresses and reaches specific milestones. The timing of these rounds can be based on predetermined milestones, such as revenue targets, product development achievements, or user growth metrics.

Example: A term sheet might outline that a series A funding round will occur within 12 months of the initial investment, provided the startup achieves a minimum of $1 million in annual recurring revenue.

Conditions for Subsequent Funding: The term sheet may include specific conditions that need to be met for subsequent funding rounds to occur. These conditions can vary based on the investor's requirements and the startup's progress. They may include milestones related to product development, customer acquisition, market expansion, or financial performance.

Example: The term sheet might specify that a series B funding round will be contingent on the startup securing at least three enterprise-level customers and achieving a 20% month-over-month revenue growth rate.

Follow-On Investments: The funding structure may include provisions for follow-on investments from the same investor or the opportunity for additional investors to participate in subsequent funding rounds. These provisions help ensure that the startup has access to the necessary capital to support its growth and development over time.

Example: The term sheet might state that the investor has the option to participate in future funding rounds up to a certain percentage ownership to maintain their ownership stake and prevent dilution.

Investor Commitment is a critical aspect of the term sheet that outlines the financial commitment and obligations of the investor towards the startup. Let's dive deeper into the concept of investor commitment and its implications:

Investment Amount: The term sheet specifies the amount of money that the investor commits to invest in the startup. This investment amount is a crucial factor in determining the startup's funding needs, valuation, and the investor's ownership stake.

Example: An investor commits to investing $2 million in the startup. This means that they are obligated to provide the agreed-upon amount of capital to the startup, subject to fulfilling any conditions or milestones set forth in the term sheet.

Tranches and Milestones: In some cases, the investor commitment may be divided into tranches, with each tranche contingent upon the startup achieving specific milestones or meeting certain conditions. This structure allows the investor to mitigate risks by ensuring that subsequent funding is tied to the startup's progress and performance.

Example: The term sheet may outline that the investment will be made in two tranches of $1 million each, with the second tranche being released upon the startup achieving a certain level of revenue or user growth.

Timing of Investment: The term sheet may specify the timeline within which the investor commits to providing the investment amount. This helps establish expectations and ensures that the startup has access to the necessary capital at the appropriate stages of its growth.

Example: The term sheet might state that the investor commits to providing the investment amount within 30 days of signing the definitive investment agreement.

Anti-Dilutive Provisions: Anti-dilutive provisions are an important aspect of the term sheet that protects the investor's ownership stake in the event of future equity issuances at a lower valuation than the investor's initial investment. These provisions aim to mitigate the potential dilution of the investor's ownership percentage.

Full Ratchet Anti-Dilution: Full ratchet anti-dilution is a common mechanism used to protect investors from dilution. Under this provision, if the startup issues new shares of stock at a price lower than the price at which the investor originally invested, the conversion price of the investor's preferred shares is adjusted downward to reflect the new, lower price.

Example: Suppose an investor purchased 1,000 shares of preferred stock at $10 per share, and later the company issues additional shares at $5 per share. Under full ratchet anti-dilution, the investor's conversion price would be adjusted to $5 per share, allowing them to maintain their ownership percentage.

Weighted Average Anti-Dilution: Weighted average anti-dilution is another common anti-dilution mechanism that takes into account both the price and the number of new shares issued. It provides a more nuanced approach to anti-dilution protection by considering the impact of the new shares on the overall ownership structure.

Example: Let's consider the same scenario as before. Under weighted average anti-dilution, the investor's conversion price would be adjusted based on a formula that factors in the price of the new shares, the number of new shares issued, and the investor's ownership percentage.

Dilution Protection Formula: The term sheet may specify the formula used to calculate the adjustment to the investor's conversion price. This formula determines the extent of protection the investor receives against dilution, and it can vary depending on the specific anti-dilution mechanism used.

Example: The term sheet might state that in the event of an equity issuance at a lower price, the investor's conversion price will be adjusted using a "broad-based weighted average" formula, which takes into account the price, number of new shares issued, and the total number of shares outstanding.

Anti-dilution provisions can have various implications for the company and its existing shareholders. While they offer protection to the investor, they can potentially impact the ownership stakes and dilute the value of other shareholders' equity. Therefore, anti-dilution provisions are often a subject of negotiation between the investor and the company.

It's also worth mentioning that anti-dilution provisions may have certain limitations or exceptions, such as excluding certain issuances, conversions, or adjustments triggered by the actions of the investor. These exceptions are designed to strike a balance between investor protection and maintaining flexibility for the company's future financing activities.

Overall, anti-dilutive provisions in a term sheet serve as a safeguard for the investor's ownership percentage in the event of equity issuance at a lower valuation. The specific type of anti-dilution provision and its impact on the investor's ownership will depend on the negotiated terms and the prevailing market conditions.

The Legal Terms of a Term Sheet. 

Governing Law and Jurisdiction: This term determines the legal framework within which the investment agreement will be interpreted and enforced. It specifies the jurisdiction whose laws will govern any disputes that may arise between the parties. It is important to establish clarity and certainty regarding the applicable legal system to resolve potential conflicts.

Example: The term sheet states that the investment agreement will be governed by and interpreted in accordance with the laws of the State of Delaware, and any disputes will be subject to the exclusive jurisdiction of the courts in Delaware.

Term sheet Binding-ness: It's important to note that while the term sheet outlines the investor's commitment, it is typically a non-binding document. This means that the investor is not legally obligated to follow through with the investment until a binding investment agreement is executed, which will typically contain more detailed provisions and legal protections.

Example: The term sheet specifies that it is non-binding and that the investor's commitment is subject to the satisfactory completion of due diligence, negotiation of final investment terms, and the execution of a definitive investment agreement.

Representations and Warranties: Representations and warranties are statements made by the startup to assure the investor that the information provided is accurate, complete, and reliable. They cover various aspects of the startup's business, financials, intellectual property, legal compliance, and other material aspects. Representations and warranties provide a basis for the investor's decision-making process and help establish a level of transparency and trust between the parties.

Example: The startup represents and warrants that it has all necessary intellectual property rights to operate its business and that it is not infringing upon the intellectual property rights of any third party.

Conditions Precedent: Conditions precedent are specific conditions that must be fulfilled before the investment agreement becomes binding and enforceable. These conditions are typically negotiated to protect the interests of both parties and to ensure that certain requirements are met prior to the completion of the investment.

Example: The term sheet specifies that the investment agreement is subject to the completion of satisfactory due diligence by the investor and the receipt of all necessary regulatory approvals.

Confidentiality and Non-Disclosure: This term ensures the protection of sensitive information shared during the negotiation and due diligence process. It establishes obligations for both parties to maintain the confidentiality of the information and prevents the unauthorized disclosure or use of such information.

Example: The term sheet includes a clause requiring both parties to keep all non-public information exchanged during the negotiation confidential and to use it solely for the purpose of evaluating and negotiating the investment.

Indemnification and Limitation of Liability: Indemnification provisions allocate responsibility and define the parties' obligations in case of breaches of the investment agreement or losses incurred. These provisions outline the circumstances under which a party may seek indemnification and specify the scope and limitations of liability.

Example: The term sheet includes a provision stating that the startup will indemnify and hold harmless the investor against any claims, damages, or losses arising out of misrepresentations or breaches of warranties by the startup.

Board Representation: This term outlines the composition of the board of directors and specifies the number of board seats the investor will have. Board representation allows the investor to have a say in the company's strategic decisions, providing them with a level of governance and influence.

Example: The term sheet stipulates that the investor will have one board seat, giving them the right to participate in board meetings, vote on important matters, and contribute to the startup's strategic direction.

These legal terms in a term sheet are crucial for establishing the legal framework, protecting confidential information, mitigating risks, and setting expectations between the startup and the investor. It is important for both parties to carefully review and negotiate these terms to ensure clarity, protection, and alignment of interests. Legal professionals experienced in venture capital transactions can provide valuable guidance and support throughout this process.