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Institutional venture capital term sheets are often quite detailed, and are almost exclusively prepared by the investor (called the “lead”) who is sponsoring the transaction and fixing a value on the enterprise.
As with angel investments, most of the terms are non-binding, with the exception of certain confidentiality and exclusivity rights. Founders should absolutely resist any upfront fees for due diligence or expenses. In Canada and the United States, this is not market practice for credible venture capital investors.
Founders should consider the following key provisions of a VC term sheet:
Institutional venture capitalists overwhelmingly favour convertible preferred shares as the investment structure of choice for their transactions. Such shares include a liquidation preference over common shares, and are, in accordance with a formula, convertible to residual value common shares. The term sheet will fix an enterprise valuation and a resulting per share price associated with the proposed investment.
Essentially, the key economic terms of the sheet consist of:
Preferred returns: Preferred returns represent an amount that the startup must return to the venture capitalist before it distributes any assets (payments) to the holders of common (residual) equity shares.
The default preferred rate of return is the original investment amount. If the founders have aggressively negotiated the startup’s valuation, occasionally investors will require an additional sum to be paid on liquidation. This can be expressed as a multiple to the investment amount (2X or 3X, for example), or as a “double-dip”—the investor’s right to get their money back, plus an amount equal to the as-if-converted value (that is, the amount the investor would receive on liquidation had they converted their preferred shares to common shares).
Accruing returns: With convertible preferred shares, accruing returns take the form of accrued dividends. It is very rare that such dividends would actually be payable in cash. Rather, such amounts accrue and are converted into common shares on the same terms as the preferred shares. While strictly a matter of negotiation, accruing return rates most commonly range from 4% to 8%. Rates in excess of 10% rarely occur.
For a startup’s initial external investment round, VC term sheets often stipulate that they must have an odd number of directors, representing both the founders and institutional investors.
Typically, the board’s swing votes are held by independent directors who have no formal employment relationship or affiliation with either camp and who ideally possess expertise in the industry.
The term sheet will specify the proposed manner in which founders and investors nominate and approve independent members. The term sheet will also typically list the standard financial reports required by the institutional investor, including annual audited statements, monthly or quarterly prepared management statements, and immediate notice of certain material events (such as litigation).
Institutional VC investments inevitably involve a range of shareholder agreements. Generally, in a Canadian transaction, these include
In the U.S, they generally include a subscription (share purchase) agreement, a right-of-first-refusal and co-sale agreement, an investors’ rights agreement, and a voting trust agreement. Note that the National Venture Capital Association has developed a comprehensive set of annotated draft agreements for its members, and this provides entrepreneurs with a useful starting point to understand the manner in which VCs approach corporate governance and other issues.
In reviewing or crafting any term sheet proposal regarding these agreements, keep these fundamental points front and centre in your mind:
The term sheet should define the timeline and process from the date of signing the term sheet to the closing date, as well as the conditions for closing, including due diligence. Most term sheets include some basic confidentiality obligations, as well as exclusivity covenants that require the start-up to cease investment discussions with anyone else, usually for a period of 30 to 60 days.
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This article was produced by James Smith and Shane MacLean and is made available through the generosity of Labarge Weinstein Professional Corporation.