Introduction
A venture capital term sheet is a non-binding document outlining the key terms and conditions of a potential investment.
Negotiating a term sheet can be challenging due to a number of factors, such as the pace of the negotiations, the negotiating positions of the parties, and the business situation. However, even in these cases, it is important to keep in mind a few fundamental issues that should be addressed in a term sheet. This article provides a guide to venture capital term sheets, covering deal economics, deal structure, control, and other typical provisions. It also includes some practical tips and insights for negotiating a term sheet that is fair to both parties.
You may find it useful in practice as having a well-thought-out term sheet will:
- provide clarity and certainty for both the VC and startup as to the fundamentals of the deal;
- save time and costs by reducing the risk of friction, delays and potential deal-breakers during further negotiations and at subsequent stages of the implementation;
- ensure that the interests of the VC fund and startup are aligned and make sure that there is chemistry between the parties;
- help in discussions with other investors (e.g. co-investors), lenders, creditors, and/or business partners;
- give the parties greater control over the negotiation process as the term sheet will set a framework for discussions and a basis for refusing to re-negotiate points that are not in line with the term sheet.
Deal Structure
The Term Sheet should serve as a roadmap for the deal, not only for the parties thereto, but also for third parties (advisors, creditors, minority shareholders). For this reason it is advisable that the term sheet begins with a high level description of the structure and fundamentals of the deal, current and targeted cap table, the main roles of the parties in the deal (e.g., operational, advisory, marketing, financial), the amount of the investment, the investment purpose (e.g., product development, hiring of talents), as well as a reasonable and doable timeline for the whole process (including signing the term sheet, providing draft documentation, negotiations, fulfilling all of the required conditions, and the closing of the investment round).
Economics of the Deal
The “economic part” of the term sheet should specify:
- Amount and Type of Investment – usually investments are made as convertible loans (convertible upon meeting certain milestones or at subsequent financing rounds) or equity (a share capital increase). It should be clear from the term sheet what type of financing is granted, when the amounts are to be paid out, whether payments are to be linked with certain conditions, and what is the start-up valuation (worth) before investment (pre-money) and after the investment is completed (post-money). You need to have a carefully prepared xls cap table which covers the existing shareholders (before the investment), their shareholding (the number and percentage of shares) and all the changes to the shareholding following the capital injection.
- Antidilution Provisions – these provisions commonly entitle the investor to a discounted rate if the company issues shares at a lower valuation (protection against a loss of value of their investment, especially if there is a “down round”). The term sheet may structure the antidilution mechanism as a weighted average or full ratchet-based anti-dilution and include standard exclusions (for example, ESOP related shares are normally not subject to anti-dilution). Bear in mind that a full ratchet approach is much more aggressive as it adjusts the conversion price of the investors' existing shares to the lowest issuance price, so any departure from the weighted average anti-dilution should be considered very carefully.
- Conversion of Debt – if the term sheet assumes a debt investment (typically in the form of a convertible loan) one of the key issues is the conversion ratio. In this context, parties regularly negotiate a conversion cap (a ceiling on the maximum valuation of the company at which a conversion may take place) and conversion discount (the percentage discount that the investor receives when converting the loan into shares at subsequent investment round(s)). From the founders perspective, it is important to make sure that the impact of the conversion is understood and their shareholding in the company is not diluted due to unfavorable conversion terms.
- Liquidation Preference – this clause defines the return that the investor will receive (before the founders) when exit occurs. How the liquidation preference is structured will significantly impact the return of the founders, especially when the company is sold for less than invested. So, it is strongly advised that the actual preference component (a multiple of the investment) and participation component (in accordance with either a participating or non-participating model) are understood by the founders. For this purpose, sample calculations of the exit should be prepared (preferably in a xls file with various exit scenarios and payments to the exiting shareholders) and confirmed by the parties. In short, in the non-participation model, the investors get an investment amount (with the agreed multiple), but they do not participate in any excess. In the participation model, the investors also get the investment amount (with the agreed multiple), but on top of this they are entitled to participate pro rata in the excess. The most common type of liquidation preference in VC term sheets is a 1x non-participating preference, but other types of preferences may also be encountered, such as the investment amount being increased annually with compound interest.
- ESOP Pool – it is important to get key team members on board and to decide how much of the equity or proceeds from the sale of the company to give them. A standard ESOP pool allocation is within 5-20% of the equity depending on size of the team and how important they are to the growth of the business. You should also discuss the legal structure of your ESOP (whether it will be equity-based or contract-based) and the tax implications for both managers and the company.
Control Over the Company
The “legal part” of the term should focus on control over the company and most common clauses usually include the following:
- Management Board Composition – the term sheet should specify who will be appointed to the Management Board and who will be responsible for the standard operations of the company, such as signing client contracts, recruiting new employees, and hiring new contractors. This role is normally given to founders, while the investors are appointed to the Management Board in certain agreed-upon circumstances, such as poor financial performance or meeting certain milestone in the company’s growth.
- Corporate Governance – the corporate governance part of the term sheet should specify how the decisions are made in the company and who supervises them. For this purpose, the parties often discuss (i) who has the right to represent the company (each Management Board member individually or the Management Board members acting jointly); as well as (ii) whether a Supervisory Board is to be appointed in the company. This can be helpful especially in the case of investors that bring business expertise and knowledge, as their representatives may help the founders and managers to make the right strategic decisions; (iii) what types of decisions require the consent of the Supervisory Board or the shareholders; (iv) the information rights of minority shareholders, such as monthly or quarterly financial statements, budget performance updates, and interim books and records. The term sheet should avoid regulating the above issues too much and should give the Management Board members enough flexibility to run the business without too many formalities or delays.
- Protective Provisions – investors will often ask for a veto right over certain corporate actions. Founders should try not to make this catalogue too broad. It is the norm to require investor approval for material actions, such as liquidating the company, borrowing money, entering into agreements with related entities, exits, and the payment of dividends. However, founders should be weary of extending the rights of investors to include blocking future financial rounds or standard decisions related to day to day business, unless there is a good reason for doing so in a particular case.
- Transfer of Shares – in most cases, the Term Sheet will also touch upon the transfer of shares and foresee standard provisions protecting founders and investors. The above normally encompasses (i) pre-emptive rights (the right to acquire shares intended for sale to maintain percentage interest in the company), (ii) the right of first refusal (the right to be offered shares to be sold to other shareholder or external investors), (iii) drag-along right (the right to force other shareholders to sell their shares with the leading seller under the same terms) or (iv) tag-along right (the right entitling other shareholders to sell their shares along with the leading seller). Most importantly, when negotiating a drag-along right clause, parties should make sure they have clarity on matters such as the percentage of ownership required to trigger drag-along (a common threshold is 75% ownership), the type of sale it applies to (this should cover all types of transfer of shares), the price and terms (make sure all of the shareholders are entitled to exit at the same terms), and standard exceptions (sale to related entities or controlled entities).
Other Customary Clauses
One should not forget that a term sheet is a non-binding agreement (meaning it cannot be used to enforce a deal or seek damages for failure to close in at the pre-agreed terms). The above does not apply to costs and expenses, governing law, choice of dispute resolution forum and confidentiality.
It is also common to include binding exclusivity clauses, but the latter should be granted thoughtfully. For example, instead of granting a 3-month exclusivity, one may first grant a 1-month exclusivity and then condition extending it for a subsequent 2-month period on meeting certain milestones (such as completing due diligence, confirming no red-flags, or receiving a full set of definitive agreements drafts). This will help both sides stay on track and complete the deal on time.
Closing Remarks
In order to sign a proper term sheet, you need to be well-prepared from the business, financial and legal perspectives. It is wise to involve advisors to help you develop a negotiation strategy for investment rounds and make sure that key issues are identified and addressed in the term sheet. Most importantly, think ahead and remember that giving too much (with or without awareness of its significance) during early investment rounds may significantly affect the position of the founders and investors at further investment rounds or at the exit.
