Term Sheet 101

I have been planning to write a newsletter on “Term Sheet” for quite a long time. I went through multiple term sheets from international and local investors as part of my fundraising experience. Today’s newsletter is an effort to help founding teams who are raising funds for the first time. I will try to explain some key topics of the term sheet in an easy-to-understand manner.

What is a Term Sheet?

A term sheet is a document outlining the crucial terms and conditions of a deal for mutual agreement of all parties involved. It is non-binding and covers broad discussion points.

Why Do We Use Term Sheet?

1. Building a common ground: It helps everyone involved get on the same page about the most important details of the deal. This mutual understanding is crucial, especially during fundraising.
2. Setting the stage for formal agreements: The term sheet lays out the terms that will be reflected in the binding contracts. This helps avoid any surprises or disagreements about what everyone thought the deal was supposed to include.
3. Showing seriousness: When parties agree on a term sheet, it shows they're serious about moving forward with the transaction.

Some Key Segments of Term Sheet

1. Valuation

This segment covers the pre and post-money valuation based on which investor(s) will invest. Pre-money valuation is the company’s valuation before the investment. Post-money valuation is the pre-money valuation + the new funding.

2. Liquidation Preference

Liquidation preference discusses the order and the amount in which investors are paid out in the event of a liquidation event. There are two key negotiation pointers in liquidation preference -

• Multiple: This is usually set at something like 1x or 2x the initial investment. Say at 1x, the investor gets their initial money back before anyone else gets a dime. At 2x, they'd get double their investment back first.
• Participation: This can be either participating or non-participating. With non-participating, once the investor gets their chunk (like that 1x we talked about), whatever's left goes to the other shareholders based on how much of the company they own. Participating means after getting their initial share, the investor also gets to take a slice of the remaining pie with everyone else.

3. Dividend Right

Dividend rights set the conditions under which dividends will be paid to shareholders. The two most discussed types of dividends are -

• Cumulative Dividends: Cumulative dividends ensure that if dividends are not paid in any year, they are accrued and must be paid out in future profitable years before any dividends can be paid to common shareholders.
• Non-Cumulative Dividends: These are more like a "use it or lose it" situation. If dividends aren’t declared in a particular year, preferred shareholders just miss out for that year and there’s no catching up in future years.

4. Conversion Right

Conversion rights specify when and how investors can convert their initial investment form (such as convertible notes or preferred shares) into common shares. Common types of conversion rights are -

• Automatic Conversion: This is like setting an automatic trigger for investments. For eg - if a company hits predetermined targets, an investor’s investment automatically converts into equity.
• Optional Conversion: Here investor can decide when to convert their securities into equity.

5. Anti-Dilution

Anti-dilution refers to protections for investors against dilution of their ownership percentage in a company, particularly when new shares are issued at a lower price than the investor previously paid. There are different types of anti-dilution provisions:

• Full Ratchet: If the company issues new shares at a price lower than what the original investor paid, the conversion price of the original preferred shares will be adjusted downward to match the price of the new shares. This increases the number of shares the original investor would receive upon conversion of their preferred shares, maintaining their percentage ownership.
• Weighted Average: It adjusts the conversion price based on the weighted average price of all shares sold before and during the new issue. This formula considers both the new lower price and the number of shares previously issued at the higher price.

6. Founders’ Lock-In

The "founders’ lock-in" refers to clauses that restrict the founders of a company from selling or transferring their shares for a certain period. Here are two key aspects typically covered in founders' lock-in clauses:

• Vesting Period: Founders' shares are often subject to vesting over a specified period, which means that the founders earn a percentage of their equity incrementally over time.
• Cliff Period: This refers to the initial period during which no shares vest. The cliff is typically one year and is intended to incentivize founders to stay at least this long.

7. Tag Along

Tag-along rights ensure that if a majority shareholder sells their shares to a third party, the minority shareholders have the right to join the transaction and sell their shares under the same terms and conditions as the majority shareholder. This protection helps prevent minority shareholders from being left with an undesirable new majority owner or from being stuck in a potentially less liquid and less valuable investment. However, it is a right, not an obligation for investors.

8. Drag Along

Drag-along rights allow majority shareholders to force minority shareholders to participate in the sale of a company. The primary purpose is to enable a smooth transaction process, allowing the majority shareholder(s) to sell the entire company without opposition from minority holders, which can be crucial in negotiating a sale to a buyer who wishes to acquire 100% of the company.

9. Voting Right

Voting rights refer to the powers granted to shareholders to vote on various corporate matters. These rights are critical as they influence the direction of the company and how it is managed. These are generally divided into board-reserved matters and shareholders-reserved matters.

10. Information Rights

Information rights allow investors the right to receive regular updates about the financial health, operations, and plans of the company. Some key expectations in information rights are access to - financial statements, annual budget, and material event notification

11. No-Shop Clause

No-shop clauses prohibit the company and its representatives from engaging in discussions or negotiations with any third party regarding the sale of the company, investment, or other similar transactions during a specified period.

12. Exit

Exit strategies detail how and when investors can exit their investment, usually through events that enable them to sell their shares, such as a public offering, a sale of the company (acquisition), or a buyback of shares. The purpose of designing exit strategies is to give investors a clear path to realizing a return.

13. Option Pool

An option pool is a portion of a company's equity that is reserved specifically for issuance as stock options to employees, and other key contributors. These stock options represent the right to purchase shares of the company at a set price, typically called the exercise or strike price, which is often determined based on the valuation of the company at the time the pool is created.

14. Conditions Precedent

Condition Precedent refers to a set of requirements that must be met before the formal closing of a financial transaction, such as an investment or acquisition. It’s there to make sure that everything is up to scratch legally, financially, and operationally, reducing risks for the investors before they go all in.

15. Redemption Right

Redemption rights grant investors the right to require the company to repurchase their shares after a specified period. This provides a mechanism for investors to exit their investment, ensuring liquidity if other exit opportunities do not materialize.

These are some of the key terms I have come across where mutual agreement between the parties plays a decisive role in successful fundraising but these aren’t the only terms. Different investors prefer different kinds of term sheets and founders need to prepare accordingly.