Entrepreneurs seeking venture financing are often presented by the potential investors with a term sheet. This is a good sign. It shows that the investors are seriously considering investing, beyond just talking to you! A term sheet is a document whose purpose is to negotiate and agree on the basic terms and conditions of the investment. Neither the company nor the investor is legally bound to follow through on the commitment unless and until formal agreements are reached by both parties. However, it provides the guidelines for the formal agreements and it is unusual for the parties to renegotiate fundamental terms after term sheet is signed. If the investor decides not to invest, the reasons are usually clear during the due-diligence process.
Validity and confidentiality: The term sheet is usually valid for a short period, during which the parties are expected to agree to the terms, or negotiate. Confidentiality is usually included, since venture investors would not want you to disclose their terms to competing investors or to the public. This could be the only legally binding clause in the entire term sheet.
Type of security: Venture investors demand ‘preferred security’, which means that in the case of a liquidation event, their money is returned first, before any of the founders see returns. Series A, B, C, etc, are ways to describe the number of financing rounds the company has gone through.
Amount of financing: This relates to the amount of money being raised by the company, and the amount the venture investor will invest.
Valuation: The “pre-money” valuation is the current valuation the venture investor has placed on the company. The “post money” valuation equals the pre-money plus the amount of money raised in this round of financing.
Purchase price: The purchase price of the security is determined by taking the pre-money valuation, and dividing it by the number of outstanding shares (on a fully diluted basis). For example, if the pre-money valuation is $1,000,000, and there are 10,000,000 shares outstanding, then the purchase price of the security is $0.10 per share. Experienced investors usually require the number of shares reserved for the stock option plan be included in the calculation, and if there is not enough reserved, increase the reservation so that the company shall have enough to hire all key employees in the next 3-5 years of operation.
Rights and preferences: Since these are preferred shares that the investor is buying, there are preference terms that are associated with them. Some of the common ones are:
Liquidation preference
If the company is liquidated (acquired, dissolved, etc), the holders of these preferred shares will receive their payouts before anyone else does. For example, if the term sheet has a 2x liquidation preference, and the investors put in $1,000,000, the first $2,000,000 of the liquidation proceeds will be paid to the preferred shareholders, and the balance will be divided among all the shareholders (including the preferred ones).
Drag along rights
This gives the investors the right to force the founders to sell the company when there is an outstanding offer to purchase, and mandates that if the investors decide to sell their shares to another company, the founders and other common shareholders will also do the same. For obvious reasons, this is a clause that shouldn’t be agreed to lightly by the founders.
Anti-dilution provisions
Some investors ask for this provision, which is also something entrepreneurs should get advice about. When raising money, it is common for the entrepreneurs to imagine that the valuation of the company will only rise. This provision demands that if the company sells shares in the future at a price lower than what the investor paid for them (when the valuation of the company drops), their past purchase price will be adjusted to match the lower price.
Future participation rights
The investors may require that they have the right to invest their pro-rata amounts in future financings, to maintain their equity ownership positions. The pro-rata amounts are determined by a simple formula, which essentially means that if the investor invests that amount in a future financing, their percentage ownership in the company remains the same.
Approval of business and operational plans: Some term sheets include provisions where the investors have the authority to approve the company’s business plans and annual budget, as well as key hiring decisions. While it is common for the entrepreneurs to seek advice from the board of directors for this, the ‘approval’ rights will require them to get all management hires and spending plans approved.
Protective provisions: There are a variety of protective provisions that may be part of the term sheet. These provisions should be carefully reviewed, but generally, they are meant to protect the investor from the founders taking actions that hurt the interest of the investors. For example, the company cannot change the rights, liquidation preferences, powers, etc, of the investors without prior approval from the majority of the investors.
While these may seem standard and fair, the one thing to remember is that the rights and preferences will most likely change during future financing, acquisition, etc. In order to raise future financing, the company will need to get approval from the previous investors, so it is always good to understand the percentage of votes needed, etc.
Board seats: With their investment, an investor may ask for one or more seats on the board of directors. This is common for any investor who takes on a reasonable percentage of ownership in the company. The one thing to remember is it is nearly impossible to reverse the appointment, so think through the board composition.
