Making Sense of Term Sheets: Provisions Founders Should Look Out For
This is not an alternative to legal counsel as the actual wording and language of the document can change and is important. The term sheet is a high-risk document which memorializes the founder's rights, control, and voice in the company. It is the start of a longer process. But this is a post to familiarize founders with some of the important pieces of a term sheet.?
OVERVIEW
A term sheet is a nonbinding agreement that shows the basic terms and conditions of an investment. The term sheet serves as a template and basis for more detailed, legally binding documents. Once the parties involved reach an agreement on the details laid out in the term sheet, a binding agreement or contract that conforms to the term sheet details is drawn up.
The term sheet should cover the significant aspects of a deal without detailing every minor contingency covered by a binding contract. The term sheet essentially lays the groundwork for ensuring that the parties involved in a business transaction agree on most major aspects. The term sheet reduces the likelihood of a misunderstanding or unnecessary dispute. Additionally, the term sheet ensures that expensive legal charges involved in drawing up a binding agreement or contract are not incurred prematurely.
All term sheets contain information on the assets, initial purchase price including any contingencies that may affect the price, a timeframe for a response, and other salient information.
Term sheets are most often associated with startups. Entrepreneurs find this document crucial for investors, often venture capitalists (VC), who may offer capital to fund startups.
Whether you are a founder or thinking about building a company (startup), here are the provisions that you should keep an eye on.
THE BASICS
The founder’s objective is to build their company, while the venture capitalist’s objective a maximum rate of return.
A term sheet will define the (1) control rights and (2) the economic rights of each party as the startup/company matures, grow, and, hopefully, exits either through M&A or an IPO.
The main part of the term sheet that every one thinks about is the VALUATION. Term sheets have other provisions and clauses that can cause issues such as preventing a higher valuation or wreck the economics of the deal. Some of these provisions and clauses are: “Liquidation preference”, “Participation rights”, “Voting rights”, “Conversion” and “Anti-dilution”.
Key parts of the Term Sheet are: “offer of new securities”, “capitalization following financing”, “council rights”, “dividends”, “additional provisions”, and “investor safeguards”.
(1) SIZE AND VALUATION
The size is the total $$$ raised, which includes allocation for the “lead” investors vs. follow-ons. In the term sheet, valuation can be defined as either (1) pre-money or (2) post-money. Pre- means value of company excluding the current $ raised. Post- means value after/including the current funds. This is an important issue for founders and VCs are it changes the economics of the deal considerably.
Here is a chart from Investopedia:
Another clause to be aware of is the ‘option pool’ which is newly issued for future hires. The size of the option pool is typically 10-15%. For founders, the important thing to define in the term sheet is whether it comes out of the pre-investment cap table or the post-investment cap table. If it comes out of the pre-investment cap table, then it would dilute the founders. If it comes out of the post-investment cap table then it would dilute both the founders and the investors.
(2) Liquidation preference
The liquidation preference is a term which is generally attached to preferred shares that give the shareholders priority in the event of a company’s liquidation or sale. In general, preferred shareholders WITH LIQUIDATION PREFERENCES ARE PAID BACK BEFORE common shareholders. Liquidation preferences are sought by investors because they help investors in their attempt to not lose money on an investment. What the liquidation preference does is it ‘guarantees’ some payout to the investor. So the liquidation preference acts as a “downside protection mechanism”.
How does it work? Basically, the venture capitalists get their money on a sale or acquisition BEFORE the common shareholders. A 1x liquidation preference means that the venture capitalist makes back their original investment. A 2x liquidation preference means that the venture capitalist makes back double. The typical liquidation preference is 1x.
Another wrinkle is whether (at exit) the liquidation preference is “participating” or “non-participating”. Participation has also been termed “double-dipping” and you’ll see why in a moment. Participating preferred shareholders get the amount based on their liquidation preference AND receive their share of the remaining proceeds. So, a participating preferred shareholder gets their LIQUIDATION PREFERENCE AMOUNT + their SHARE OF THE REMAINING PROCEEDS after their liquidation amount has been paid to them. The remaining upside would be the common shares on a pro-rata basis.
A non-participating preferred shareholder must make a choice between their liquidation preference amount OR the proceeds.
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There is a lot more to the liquidation preferences, but these are the main categories I’d like you to think about for now. In a later article, I’ll spell out multiples vs percentages, caps on the liquidation preferences, and “pari pass’ vs ‘stacked’ liquidation preferences.
(3) Conversion Rights
Conversion rights are the right to convert shares of preferred stock to common stock. The typical rate is one to one. Two types of conversion rights are (1) ‘mandatory’ or ‘automatic’ and ‘optional’ conversion rights. ‘Mandatory’ or ‘automatic’ conversion rights take place during an IPO or when a preferred majority votes for the conversion. The ‘optional’ conversion rights are in all other situations.
(4) Voting Rights
Voting rights are the rights of a shareholder to vote on matters of corporate policy. This clause of the term sheet points out how voting rights are divided across different instruments (A, B, Preferred). It also defines for which corporate action a voting majority is required. Typical corporate actions: Issuance of new securities, repurchasing of shares, dividend declaration, adding/removing Board seats, sale/exit events, and changes to bylaws.
(5) Board Seats
For founder, this is the most dangerous clause which can cause the founder(s) to lose control of their company. For a founder, then, it is important to choose your “lead” investor carefully and with a lot of thought because the ‘lead’ investor will be the one choosing additions to your company’s board. Typically, boards for startups vote on (1) hiring/firing senior executives and (2) executive compensation. Boards being able to fire senior executives mean that the board can vote the founder out.
Generally, one board seat comes at Series A. A ‘founder friendly board’ at Series A, then, will be 2 seats for founders and 1 seat for the investors. The 1 seat for the investors will be appointed by the ‘lead’ investor. A common arrangement that you will see to benefit investors at Series A will be a five seat board with 2 seats for founders, 2 seats for investors, and 1 independent seat which is appointed by the company.
(6) Drag-Along Rights
“Drag-along rights” are relevant when there is a pending exit. The drag-along rights give the majority shareholders the ‘right’ to ‘drag’ along the minority shareholders into the exit (be it a merger or an acquisition). This means that the majority shareholders can force the minority shareholders to sell their shares on the same terms and conditions. This provision is to ensure that the minority shareholders cannot block the exit.
(7) Tag-Along ("Co-Sale") Rights
Tag-along or otherwise known as “co-sale” rights are similar to drag-along rights but THE OPPOSITE. These rights allow minority shareholders to ‘tag-along’ with the majority shareholders during a liquidity event. The ‘tag-along’ rights generally do not apply to employees. Employees should review the term sheet, then, if they want to sell their shares alongside existing investors in secondaries.
(8) Anti-Dilution
The anti-dilation provision prevents a company from selling or issuing stock at a lower price than what the VC paid. In other words, the anti-dilution provision protect investors from down rounds by issuing new shares to the investors. In this way, the anti-dilution provision allows investors to maintain their ownership percentage in the company during a down round which will protect the investors interest.?
There are two main types of anti-dilution: (1) full ratchet based and (2) weighted average. A full ratchet based anti-dilution provision is rarer as the weighted average is more common. But let’s dive into the mechanics of both.
The “full ratchet” anti-dilution adjusts the conversion price of existing preferred shares to the new lower prince in a down round. In terms of the founder, this is particularly bad, so it should be avoided if possible.
The “weight average” on the other hand is more founder-friendly and is the common practice in the industry today. The weighted average anti-dilution provision adjusts the conversation price based on THE PROPORTION OF NEW SHARES issued at the lower price.?
For the weighted average, you can have a ‘broad-based’ or a ‘narrow-based’ average. Broad-based includes all shares in the calculation, whereas narrow-based considers only a specific class of shares. For founders, the broad-based is more common and more favorable to founders.
In addition, there are pay-to-play provisions, carve-outs, and exclusions that affect the anti-dilution provisions, but I will discuss those more in depth in a later post. As well, anti-dilution provisions can be subject to price-based or dilution-based triggers.?
And anti-dilution provisions can be on a series-by-series or ‘pari-passu’ approach. In addition, the anti-dilution terms can have an affect on the voting rights. So, it is best to watch carefully how these are written and hire legal representation.?
(9) Pro-Rata Rights
Pro-rata rights give the venture capitalists the right, but not the obligation, to maintain their level fo ownership throughout subsequent (later) financing rounds. For example, if the founder has 100 shares and sells 10 shares (10%) to a VC with pro-rata rights. Then, in the next round, the startup issues 500 shares, the venture capitalist with pro rata rights is allowed to buy 50 shares before anyone else.
(10) The “No-Shop" Provision
The “no-shop” provision is part of the term sheet that sets a period of X numbers of days where the founder/startup can’t shop the term sheet around town. It is a standard provision. The norm for the time period is thirty days. For a founder, it is important to have this capped at 30 days as a VC can sign a term sheet, but then, for many reasons, decline to go forward with the deal on Day 30. And in the lifetime of a fundraise, 30 days is quite a long time.
In conclusion, founders are at a disadvantage here because they have not had to deal with term sheets as often as VCs have. Venture capitalists have seen, negotiated hundreds to thousands, while founders don’t usually familiarize themselves with the basics until they need to. It is crucial to have legal representation to aid in your startup journey. What we have just covered are the provisions and clauses that are necessary for a founder or startup to know that will affect: (1) control, (2) dilution, (3) their claims to profits, and (4) their ability to approve or decline an M&A deal. But the term sheets are a huge hill to climb and legal representation is vital to have.?