Raising funds? Here is an attempt to demystify Term Sheets...

In an ideal world, all term sheets would look like the one used by Passion Capital or the one by Sam Altman — simple and to the point. Well, that’s not happening.

So, in the sections below what I have tried to do is to explain in simple English some key terms that are part and parcel of every term sheet. Along with the explanation, you will also find the relevant section from a real world term sheet.

For this my primary resource is the term sheet used by a Company named Buffer. They chose to make their Series A fundraising details public, including the term sheet! The blog that they wrote post their fundraising round is a great read.

I have also relied upon a term sheet for the e-commerce Company, Wish, unearthed from regulatory filings by the data analytics company CB Insights.

1. Stock Type

The stock most commonly issued to the investor is Preferred Stock. It is a class of stock which provides the investor certain economic and control rights and protections which are not available to the common stock holders (usually founders and other employees) — hence “preferred”. There are several facets to the Preferred Stock structure some of which we will analyze later.

2. Dividends

Dividends are really not the reason why venture capital firms invest in companies. This is because for a VC Fund with a finite time horizon of usually 10 years, even 10% dividend at best will generate a 1X return, not the 5X or 10X return VC firms aspire for. However, in a tough economy, dividends do provide some downside protection to the investor.

Dividends are of two types: cumulative and non-cumulative. Cumulative dividends are carried forward till they are paid out or the right is extinguished. Non-cumulative dividends on the other hand depend on the Board of Directors. If they are not paid in a particular year, they are not carried forward.

Case study : Following is a snapshot from the US$11mn Series B financing in 2014 for RiseSmart led by Accel-KKR and joined by Norwest Venture Partners. Investors received a 14% cumulative dividend.

3. Liquidation Preference

This clause protects the VC firm’s investment in the Company. Tomorrow if the prospects of the Company turn south and the Company is sold off, the investor will be paid off prior to anyone else getting paid. In scenarios where the valuation of the Company has run up a lot in a short period of time, this clause provides comfort to a new investor. Say an investor is putting money at US$10 a share in Series D round while the A, B and C rounds have happened at US$1, US$2 and US$5 respectively, the risks of the Series D investor are much higher. This is because the liquidation event has to happen at a higher value for the Series D investor to make money when compared to those investors who participated in the earlier rounds.

In the case of Wish (below), the e-commerce Company, the Series F investors will get back all their investment before the earlier investors see a penny.

The clause above is what is called 1X Liquidation Preference — which means one time the investment made by the investor is paid off. However, there are versions which assure higher returns for the investor such as liquidation preference of 2X or 3X. That’s when it starts eating into the gains of the holders of common stock (mainly held by the employees who have been around for a long time)and is a point that should be negotiated carefully by the Founder so as not to impact employee morale.

Seen from the point of view of the investor — liquidation preference of more than 1X provides comfort to the VC firm especially if they participate in late stage funding when the valuation of the company is not exactly cheap. If the company does well post the fundraising, everyone goes home happy.

Case Study 1: When Zappos was sold to Amazon back in 2009, Sequoia Capital did very well for itself thanks to the >3X liquidation preference that it had negotiated with the founders.

There is a related concept of Participating Preferred. When a liquidation event takes place, such investors are first paid back their original investment. The investor then also gets a cut of the remaining funds that is distributed amongst the other shareholders. Hence essentially a “double dip”. Suppose a company gets sold for US$100mn. Investor A holds 20% of the company and has invested US$50mn in the last round. Since there is a 1X liquidation preference, this is how funds will be paid out:

1. Investor A gets back his US$50mn

2. Of the balance US$50mn, Investor A will get paid US$10mn as he holds 20% of the company.

3. Only then will the balance US$40mn be paid out among the other shareholders.

Case Study 2: Sequoia Capital was an investor in Freecharge, which was sold to Snapdeal in what was the largest internet M&A in India at that time. Speaking about their investment, the Sequoia partner recounts how Sequoia volunteered to change its Participating Preferred to non-participating as this was more company friendly and helped to bring in more investors.

Case Study 3: Below is a snapshot from Uber’s Series C financing round with participation from Google Ventures and TPG Growth. The investors got Participating Preference with guaranteed return of 1.25X.

4. Protective Provisions

These are a fairly standard set of protections that all investors will bargain for. It ensures that the Investor has a say in such matters as issuance of new shares, increasing the debt of the Company and liquidation/sale of the Company.

5. Anti-Dilution Provisions

The anti-dilution provision protects investors in the scenario that the Company raises equity at a lower valuation than in previous financing rounds. In such a scenario, the price of the earlier round is lowered. There are two mechanisms that are mainly used — full ratchet and weighted average formula. In Full Ratchet the price of the earlier round is lowered to that of the new round, irrespective of how many shares are issued in the new round. In the second method (weighted average formula), the number of new shares issued is taken into consideration to arrive at the new price.This protection becomes particularly important for investors during times when down rounds are common (read : 2015 and 2016).

6. Mandatory Conversion

For an IPO, the preferred stock held by the investors mandatorily converts into common stock based on a couple of key criteria: 1) Share Price needs to have crossed a certain threshold 2) The proceeds from the IPO should be high enough so as to provide sufficient liquidity for the stock in the market. Needless to say, “Gross Proceeds” are more favorable to the Founders than “Net Proceeds”. In case neither of the above conditions is met, the Company also has a clause where IPO can go ahead provided a certain threshold (60% in case of Buffer) of the investors consent.

Another example of the Mandatory conversion (also called “automatic conversion”) clause from the e-commerce Company Wish is presented below. It has a couple of conditions: 1) pre-money valuation of US$6bn and 2) Gross Proceeds of at least US$500mn. Unlike Buffer there is no clause where a certain number of thresholds can override this condition.

7. Redemption Rights

Redemption rights ensure that the investor recoups his investment in case the Company turns out to be a “zombie” — one which is not doing well, at the same time one which is not dead. With no future prospects of the Company, the VC Firm might decide to walk out of the investment by recovering its investment. This is very important as VC funds have a finite life. Most of the time, the amount will also include unpaid dividends. From the perspective of the Company, it is important that the redemption right kicks in only after a certain period from the date of investment. In the case of Buffer, the agreed period is five years. Lastly, there is the minor matter of paying back the investors — most companies which are not doing well will not have adequate cash flows to repurchase their stock which makes matters tricky for the Company.

8. Pro Rata Rights

Pro rata rights help investors maintain their shareholding in the Company. Suppose Investor A holds 25% of the Company today which equals 200,000 shares. Tomorrow the Company wants to raise fresh capital in the Company and issues 200,000 new shares. So, if Investor A does not participate in the new round, his shareholding will come down to 20%. However, if the Investor A buys an additional 50,000 shares in the new round, his shareholding will remain at 25% as he now holds 250,000 shares out of a total of 1,000,000 shares. Pro rata rights thus give the opportunity to the Investor to ensure its shareholding is not diluted when fresh funds are raised.

A pro-rata right in a promising company such as Facebook or Uber is worth a lot. What happens though if you do not have the funds to “capture the pro rata”? You miss out. That is exactly what happened to Union Square Ventures. They were given the opportunity to exercise pro-rata in Zynga and Twitter but unfortunately they had to pass!

An associated provision is what is called “pay to play”. This stipulates that in case the company chooses to raise additional capital, the existing preferred stock holders will need to participate pro-rata in the fundraising. Else they lose all rights associated with their preferred stock such as liquidation preference. This is unfavorable from the VC firm point of view in case the economy is in trouble; it is forced to fork out additional funds despite the unfavorable investment environment.

9. Right of First Refusal, Tag along and Drag along

Right of first refusal gives the Company and existing shareholders right to purchase shares before they are offered to new investors.

Right of co-sale (“take me along” or “tag along”) rights give the opportunity to other shareholders to participate in a sale of shares on terms similar to those offered to the seller. This is beneficial for minority shareholders who may not have the resources or connections to ensure that they get a favorable exit. So if the Founder or a well-known VC firm manages to negotiate a good deal, others can participate in the sale. For the minority shareholders, it is akin to a “put” option — it is a right not an obligation.

And then there is the Drag along provision where the exiting majority shareholder can force other minority shareholders to also sell their shares. It protects the interests of the majority shareholder. This is because if there are any holdouts among the minority shareholders, the attractiveness of the deal will go down for the Buyer. For example, if the Buyer wants to buy 100% of the company, a scenario where 5% of the existing shareholders refuse to sell is not ideal for the Buyer.

In case you would like to see what a Right of First Refusal and Co-Sale agreement looks like, here are a couple from Responsys and Bazaarvoice.

10. No shop (Exclusivity)

No shop or “exclusivity” clause stipulates that the Company will not engage with any other party for raising funds for a certain period of time (say 30/45/60 days). This is the period within which the Investor needs to complete the due diligence process and make up its mind. At the end of the No Shop period, the Company is free to re-engage with other prospective buyers in case the due-diligence process of the preferred VC firm appears to be dragging on forever.

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I have tried to keep this piece to a reasonable length. In case you believe any of the sections need further detailing, please leave a comment for me.

Hope you found the piece useful. Thanks for reading!

Further Reading:

Term Sheet Series Wrap Up (Foundry Group)

Valuation and Option Pool (Fred Wilson — Union Square Ventures)

The Three Terms You Must Have In A Venture Investment (Fred Wilson — Union Square Ventures)

VC Terms that can really hurt — Part 1 and Part 2 (Fred Destin — Accel Partners)

How Startup Options (and Ownership) Works (Scott Kupor — a16z)

Ultimate Guide to VC Term Sheets and Negotiations (Ventureapp)

Liquidation Preference (Cooley LLP)

Negotiating Term Sheets (Cooley LLP)

Term Sheets: The Definitive Guide for Entrepreneurs (Capshare)

Guide to VC Term Sheets (BVCA)

What’s in a term sheet? (Founders Fund)

NVCA model term sheet