Mastering Term Sheets: A Comprehensive Handbook for Indian Startups on Securing Funding Deals

Introduction to Term Sheets

A term sheet is a non-binding agreement that outlines the basic terms and conditions under which an investor will make a proposed investment into a company. It serves as a basis for legal documents if the investment proceeds.

The main purpose of a term sheet is to provide a summary of the key commercial and legal terms of the proposed investment. This allows both parties to agree on major deal points upfront before spending time and money on full legal agreements.

Some key terms and clauses covered in a typical term sheet include:

• Investment amount, valuation, and equity percentage
• Liquidation preference - priority payout to investors
• Founder vesting - multi-year vesting schedule for founder shares
• Anti-dilution provisions - protects against equity dilution
• Voting rights - board seats and shareholder voting control
• Pay-to-play provisions - requirement for investors to participate in future rounds
• Restricted stock - restrictions on selling or transferring shares

While not legally binding, a term sheet provides the basis for further negotiations and ensures both parties share the same understanding of major deal terms as they proceed to close the investment.

Key Terms in a Term Sheet

One of the most important parts of a term sheet is understanding the key terms involved. These outline the basic agreement between the startup founders and investors. Some key terms to know include:

a. Equity Percentage

• This refers to the percentage ownership stake in the company that the investors will get in exchange for their investment. Typical equity percentages range from 10-40%.

b. Valuation

• The valuation is the total estimated worth of the company. The post-money valuation accounts for the startup's valuation after the investment.

c. Investment Amount

• The total amount of money the investor(s) agree to invest in the startup. Typical early stage investment amounts range from $500K to $2 million.

d. Liquidation Preference

• This determines payout order if the company is liquidated. A 1x liquidation preference means investors get their money back first. A 2x preference gives them 2x their investment amount first.

e. Full Ratchet Anti-Dilution

• This protects investors from dilution. If a future down round occurs, investors' shares are increased to maintain their ownership percentage.
• Full ratchet is generally not founder-friendly. Weighted average anti-dilution is more common.

These are some of the most important terms that establish the finances and ownership between founders and investors. Understanding the implications of each is crucial during term sheet negotiations.

Control and Voting Rights

One of the most important parts of a term sheet are the control and voting rights granted to investors. These provisions determine the amount of influence investors will have over major corporate decisions.

a. Board Seats

Term sheets specify the number of board seats investors can appoint. Typically, venture capital firms will request 1-2 board seats depending on the size of their investment. Founders should push for independent board seats to maintain control. The board is responsible for hiring/firing the CEO, approving budgets, and other major choices.

b. Voting Rights

Beyond board seats, the term sheet outlines the voting rights granted to preferred stock vs common stock. Investors will want veto rights over certain items like new stock issuance, changes to charter/bylaws, acquisition offers, and liquidation events. Founders should limit veto rights as much as possible.

c. Protective Provisions

Also known as “supermajority provisions,” these give investors veto rights over major corporate actions. Common protective provisions include vetoing acquisition offers, increasing/decreasing shares authorized, liquidation/dissolution, and changes to charter/bylaws detrimental to investors.

d. Drag-Along Rights

If a certain percentage of investors vote to sell the company, drag-along rights allow them to force other shareholders to approve the sale as well. Founders will want to negotiate the minimum threshold of investors required to trigger drag-along rights.

Clearly spelling out control and voting rights prevents misunderstandings down the road. Founders should push for independent board seats and limited investor veto rights to maintain control. Investors want influence over major decisions to protect their investment.

Founder Vesting

Founder vesting refers to the process by which a startup's founders earn or "vest" their stock in the company over time. This is an important mechanism to align the founders' incentives with the long-term success of the company.

The typical founder vesting schedule lasts 4 years, with a 1 year cliff. This means:

• No founder shares vest initially at founding. The shares are subject to vesting.
• After 1 year (the cliff), the founder can vest 25% of their shares
• Afterwards, the remaining shares vest monthly over the next 36 months.

By the end of the 4 year period, the founder will be fully vested and own 100% of their shares if they remain actively involved with the company.

If a founder leaves or is fired before the end of the vesting period, they only keep the vested shares as of their departure. Any remaining unvested shares return to the company. This ensures that founders don't just walk away with equity without having put in the work to build the company over an extended timeframe.

The vesting schedule also typically accelerates upon certain events like an acquisition or IPO, allowing founders to fully vest their shares if the company has a successful exit event.

Vesting applies not just to individual founders, but is also important for founder teams to vest together. This maintains alignment between co-founders over the long run.

Overall, founder vesting protects the company from early departure of founders while incentivizing founders to build the company for the long-term. It is considered a best practice in the startup industry. Proper founder vesting terms are crucial when negotiating term sheets.

Liquidation Preference

Liquidation preference determines how the proceeds from a liquidity event (like an acquisition or IPO) are distributed among investors and shareholders. It specifies the order and proportion in which investors get their money back in case the company is liquidated or sold.

There are two main types of liquidation preference:

i. 1x Non-Participating Preference

With 1x non-participating preference, investors get back their original investment amount first before common shareholders receive any proceeds. For example, if an investor put in $1 million for 10% equity and the company is sold for $10 million, the investor recoups their $1 million first. The remaining $9 million is distributed pro-rata among common shareholders.

The investor's payout is capped at their original investment and they do not get to "double dip" by participating in the remaining proceeds. This offers downside protection but limits upside.

ii. Participating Preference

With participating preference, investors not only get their investment back but also get to share in the remaining proceeds pro-rata along with common shareholders.

Using the example above, the investor would first get back their $1 million. But they also get to participate in the remaining $9 million pro-rata, meaning they get 10% of the $9 million or $900,000. So the total payout to the investor is $1.9 million compared to $1 million for 1x non-participating preference.

Participating preference gives investors downside protection plus the ability to gain upside by sharing further in sale proceeds. But it also means less upside for founders and employees holding common stock.

Negotiating liquidation preferences is a key aspect of term sheet discussions between investors and founders. Founders generally want 1x non-participating preference while investors push for participating preference to increase their potential returns. The agreed terms depend on relative negotiating leverage between the parties.

Anti-Dilution Provisions

Anti-dilution provisions are clauses designed to protect investors from equity dilution resulting from subsequent issuances of stock at a lower valuation than their investment. There are three main types of anti-dilution protections:

a. Full Ratchet Anti-Dilution

Full ratchet anti-dilution gives investors full protection against dilution. If a subsequent round is priced lower than the protected round, investors' conversion price is reduced to the price of the new round. This recalibrates the number of shares to compensate for the lower valuation.

Full ratchet provisions heavily favor investors, as founders bear all the dilution. However, they are rarely accepted by entrepreneurs today except in seed rounds or extreme down-rounds.

b. Broad-Based Weighted Average Anti-Dilution

Broad-based weighted average anti-dilution is the most common type today. The conversion price is reduced based on the broad-based weighted average of the outstanding shares prior to the new issuance and the shares issued at the lower price. This reduces dilution for investors while spreading it between new and old shareholders.

The broad-based approach is reasonable for founders because it acknowledges they should not bear all the dilution. The weighted average method also minimizes extreme dilution swings for investors.

c. Narrow-Based Weighted Average Anti-Dilution

Narrow-based weighted average anti-dilution excludes common shares and only factors in preferred shares in the calculation. This tips the math toward favoring investors more than a broad-based approach.

Narrow-based provisions are viewed as more investor-friendly. But broad-based provisions are the standard, as founders balk at provisions skewed wholly to investors.

The type of anti-dilution provision can be a point of contention during term sheet negotiations. Founders will push for broad-based weighted average, while investors may argue for full ratchet or narrow-based provisions.

Pay-to-Play Provisions

Pay-to-play provisions give investors the right to force founders and employees to participate in future funding rounds to avoid dilution. If the founder or employee chooses not to participate, the investor can force them to forfeit some or all of their equity.

How Pay-to-Play Provisions Work

Pay-to-play provisions are triggered when a startup raises a new round of funding. The founders and employees who received stock options have two choices:

• Exercise their options to purchase stock and participate in the new round at the new valuation. This requires them to spend real money to exercise the options.
• Decline to participate and get diluted. The pay-to-play provision allows the investor to take back a portion of the founder or employee's equity.

Investors include pay-to-play provisions to ensure founders and employees have "skin in the game" in future funding rounds. If the startup does well and raises at a higher valuation, everyone benefits. But founders and employees can't just sit back and let their equity stake increase without participating.

Pros of Pay-to-Play Provisions

• Aligns incentives between founders, employees, and investors
• Ensures key team members participate in future funding rounds
• Motivates the team to grow the company and raise at higher valuations

Cons of Pay-to-Play Provisions

• Requires founders and employees to spend money to exercise options
• Can result in founders or employees being forced to forfeit equity
• Adds complexity to cap table and equity ownership

Overall, pay-to-play provisions protect investors by preventing free riders. But they also impose financial burdens on founders and employees, so they're controversial. Both sides negotiate heavily around these provisions during term sheet discussions.

Term Sheet Negotiations

Negotiating a term sheet can feel daunting for founders and investors alike, but understanding the most negotiable terms and effective tactics can help both parties reach an agreement. Here are some tips for navigating term sheet negotiations:

Most Negotiable Terms

• Valuation - One of the most heavily negotiated items. Founders should aim high while investors anchor low.
• Vesting schedule - Standard is 4 years, but can sometimes negotiate down to 2-3 years.
• Board composition - Depends on investor's desire for control vs founder's desire for independence.
• Liquidation preference - Can sometimes negotiate down to 1x or eliminate.
• Anti-dilution provisions - Details like the cap can be negotiated.

Key Negotiation Tactics

• Founders should have mentors or advisors with negotiation experience to rely on. Don't go it alone.
• Both sides should remain calm, professional and focus on shared goals. Avoid ultimatums.
• Founders should clearly communicate their vision and progress made to instill confidence.
• Investors should explain their reasoning on certain terms, not just make demands.
• Make compromises, but don't surrender on core priorities and dealbreakers.

Important Considerations

• Term sheets aren't binding, but set the stage for closing the investment. Stay collaborative.
• Have alternatives ready (other investors, advisors, backup plan) for leverage. But avoid pitting investors against each other excessively.
• Build relationships first, negotiate second. Investors invest in founders just as much as ideas.
• Pick your battles. Don't sweat the small stuff that won't significantly impact the company's future.
• Keep end goals in mind. Giving up too much control/ownership early can hurt long-term vision.

With preparation, patience and compromise, both founders and investors can negotiate a fair term sheet that sets the relationship up for mutual success.

Term Sheets in India

The Indian startup ecosystem has seen tremendous growth in recent years. As more homegrown startups emerge and foreign investors take interest, term sheets in India have adapted to cater to the unique local landscape. Here are some key aspects of term sheets for Indian startups:

• More founder-friendly terms: Investors in India have realized that strong, empowered founders are key to startup success. Terms like founder vesting cliffs, liquidation preferences, and board control are more relaxed compared to those in the US.
• Government incentives: The Indian government offers programs like Fund of Funds and Startup India to encourage VC funding. Investors incorporate these benefits like tax exemptions into term sheets.
• Corporate governance: To align with India's Companies Act 2013, terms sheets include clauses about number of board members, quorums, use of the company seal, auditor rotation, etc.
• Restrictions on foreign ownership: India has limits on foreign direct investment in certain sectors. Term sheets are adapted to accommodate these regulations.
• Focus on exits: With a still-maturing mergers & acquisitions environment, Indian term sheets focus heavily on terms and timing of exits via IPOs or strategic sales.
• Stock options for employees: ESOPs are an important incentive for hiring talent. Term sheets may specify ESOP pools, vesting schedules, exercise prices, etc.
• Dispute resolution: Arbitration in India can be time-consuming. Term sheets tend to specify alternative dispute resolution mechanisms like mediation.

While global term sheet practices are followed, India's unique startup ecosystem and regulations require adaption of certain terms and investor mindsets. As the market continues to grow, founder-friendly and India-centric term sheets will further evolve.

Conclusion

For founders fundraising in India and beyond, having a deep understanding of term sheets is absolutely critical. Not all term sheets and funding deals are created equal. Seemingly small differences in terms, like liquidation preferences or anti-dilution clauses, can have an enormous impact on founders' control and equity stake in their own companies in the future.

Founders should take the time to carefully review all aspects of proposed term sheets, seek expert advice, and negotiate for the most founder-friendly terms possible. Having the knowledge to craft fair term sheets that balance both investor and founder interests will pay dividends and avoid potentially giving up more of your company than necessary. Some concessions may be unavoidable, but founders able to recognize and push back on particularly aggressive or one-sided terms will be in a much stronger position.

Overall, term sheets contain the blueprint for the future relationship between investors and founders. The terms agreed upon at these early fundraising stages can influence control and financial outcomes for many years and future funding rounds to come. Rather than rushing to close deals, India's startup founders should ensure they fully understand the implications of proposed terms, always keeping their own interests and those of their company at heart. With preparation and persistence, founders can negotiate deals that provide needed capital while allowing them to maintain the greatest possible equity, control and flexibility over their startup's future.