What are the key considerations in structuring a term sheet to protect against conflicts of interest?

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A term sheet is a document that outlines the key terms and conditions of a venture capital investment. It serves as a basis for negotiating and drafting the final legal agreements between the investors and the founders. However, a term sheet can also be a source of potential conflicts of interest, as different parties may have different incentives and expectations regarding the deal. How can you structure a term sheet to protect against these conflicts and ensure a fair and transparent process? Here are some key considerations to keep in mind.

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Alessandro Benigni

Web3 Marketing / Venture Capital / Grants / Advisor
Asha Kanta Sharma

Manager - Finance & Accounts @ Opendoors Fintech | Financial Accounting

1 Valuation and dilution

One of the most important and contentious aspects of a term sheet is the valuation of the company and the resulting dilution of the existing shareholders. Valuation is the amount of money that the investors are willing to pay for a certain percentage of the company's equity. Dilution is the reduction of the ownership and voting power of the existing shareholders due to the issuance of new shares to the investors. Both valuation and dilution have a direct impact on the returns and control of the founders and the investors. Therefore, it is crucial to agree on a valuation method and a capitalization table that reflect the true value and potential of the company, as well as the risks and rewards of the investment.

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Asha Kanta Sharma

Manager - Finance & Accounts @ Opendoors Fintech | Financial Accounting
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A term sheet is a non-binding agreement outlining key terms and conditions of a business transaction, aimed at protecting against conflicts of interest. Key considerations include clear definitions, roles and responsibilities, confidentiality, exclusivity, non-compete clauses, conflict of interest disclosure, corporate governance, valuation and pricing mechanisms, earnouts, dispute resolution mechanisms, change of control provisions, exit strategies, representation and warranties, insurance coverage, assignment and transfer restrictions, and legal and regulatory compliance. These elements help ensure a fair and transparent framework for all parties involved in a business transaction.

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Alessandro Benigni

Web3 Marketing / Venture Capital / Grants / Advisor
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When setting valuation and dilution terms, a venture capitalist would seek to establish a fair valuation that accounts for future growth potential while ensuring existing shareholders are not excessively diluted. A nuanced understanding of the startup's trajectory and market dynamics is critical. They might employ third-party valuation experts to ensure an impartial assessment, aligning interests and preventing future conflicts over valuation disputes.

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2 Liquidation preference and participation

Another key term that can affect the alignment of interests between the investors and the founders is the liquidation preference and participation. Liquidation preference is the right of the investors to get their money back (or a multiple of it) before the common shareholders (usually the founders and employees) in the event of a sale, merger, or dissolution of the company. Participation is the right of the investors to share in the remaining proceeds after they receive their liquidation preference, or to convert their preferred shares into common shares and participate on a pro rata basis. Both liquidation preference and participation can influence the distribution of outcomes and incentives in different exit scenarios. Therefore, it is important to balance the protection of the investors with the motivation of the founders and avoid excessive or unfair terms that may create conflicts or disincentives.

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Alessandro Benigni

Web3 Marketing / Venture Capital / Grants / Advisor
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Liquidation preference terms must protect the VC's investment without disincentivizing the founders. A VC might structure these preferences to convert from multiple to single upon achieving certain milestones, aligning the exit incentives with company performance, which can be a fair compromise for all shareholders.

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3 Board composition and voting rights

Another aspect of a term sheet that can impact the governance and decision-making of the company is the board composition and voting rights. The board of directors is the body that oversees the management and strategic direction of the company. It consists of representatives from the founders, the investors, and sometimes independent or external members. The board composition and voting rights determine how much influence and control each party has over the company's affairs and how they can resolve disputes or disagreements. Therefore, it is essential to design a board structure and a voting mechanism that ensure a constructive and collaborative relationship between the investors and the founders, as well as respect the interests and rights of the minority shareholders.

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Alessandro Benigni

Web3 Marketing / Venture Capital / Grants / Advisor
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When determining board composition, the goal is to create a governance structure that supports effective decision-making. A VC might propose a balanced board with an equal number of investor and founder representatives, supplemented by industry experts as independent directors to mitigate potential conflicts.

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4 Anti-dilution and preemptive rights

Another term that can affect the future financing and ownership of the company is the anti-dilution and preemptive rights. Anti-dilution rights are the rights of the investors to adjust the conversion price of their preferred shares in case the company issues new shares at a lower valuation than the previous round. This protects the investors from losing value due to a down round. Preemptive rights are the rights of the existing shareholders to purchase new shares in proportion to their current ownership before they are offered to new investors. This allows the existing shareholders to maintain their percentage of ownership and avoid dilution. Both anti-dilution and preemptive rights can influence the availability and attractiveness of capital for the company, as well as the dynamics and relationships between the existing and new investors. Therefore, it is important to negotiate and specify the terms and conditions of these rights and how they will be applied in different scenarios.

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Alessandro Benigni

Web3 Marketing / Venture Capital / Grants / Advisor
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The structuring of anti-dilution provisions should protect investors from equity erosion while ensuring that founders are not disproportionately affected by future fundraising. A VC might advocate for a weighted-average anti-dilution clause as opposed to a full ratchet, which is more equitable in the event of down rounds.

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5 Vesting and acceleration

Another term that can affect the alignment and retention of the founders and key employees is the vesting and acceleration of their equity. Vesting is the process by which the founders and key employees earn their shares over time, usually based on a certain period of service or performance milestones. Acceleration is the event that triggers the immediate vesting of some or all of the unvested shares, usually due to a change of control or termination of employment. Both vesting and acceleration can influence the commitment and loyalty of the founders and key employees, as well as their incentives and expectations in case of a sale or departure. Therefore, it is important to agree on a vesting schedule and an acceleration clause that reflect the contribution and value of the founders and key employees, as well as the best interests of the company and the investors.

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Alessandro Benigni

Web3 Marketing / Venture Capital / Grants / Advisor
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Vesting and acceleration clauses need to incentivize founders to remain committed over the long haul. A VC might implement a vesting schedule that accelerates upon achieving significant performance targets or upon a change of control, ensuring that founders are motivated to drive the company towards success.

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6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Alessandro Benigni

Web3 Marketing / Venture Capital / Grants / Advisor
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Ultimately, the key considerations in structuring a term sheet revolve around creating a framework that promotes the long-term success of the company while safeguarding the VC's investment. It's about finding a middle ground where risks are mitigated, but growth is not stifled—a delicate equilibrium that requires both financial acumen and a deep understanding of human motivations.

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What are the key considerations in structuring a term sheet to protect against conflicts of interest?

1

2

3

4

5

6

1 Valuation and dilution

2 Liquidation preference and participation

3 Board composition and voting rights

4 Anti-dilution and preemptive rights

5 Vesting and acceleration

6 Here’s what else to consider

Venture Capital

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What are the key considerations in structuring a term sheet to protect against conflicts of interest?

1

2

3

4

5

6

1 Valuation and dilution

2 Liquidation preference and participation

3 Board composition and voting rights

4 Anti-dilution and preemptive rights

5 Vesting and acceleration

6 Here’s what else to consider

Venture Capital

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