Securing investment: Venture capital (VC) term sheets

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Read the highlights

• A venture capital (VC) term sheet is a statement of the proposed terms and conditions for a proposed investment.
• Most of the terms are non-binding, except for certain confidentiality and exclusivity rights.
• Founders who receive a term sheet need to understand, from a legal perspective, how to manage the process.
• Key provisions of a VC term sheet include: investment structure, key economic terms, shareholder agreements, due diligence, exclusivity and closing.

As an entrepreneur, you may have worked long hours and spent a tremendous amount of energy in demonstrating your worth and due diligence to a venture capital (VC) firm. But if at last you receive a VC term sheet, do you know how to proceed? Founders need to understand, from a legal perspective, how to manage the process.

Term sheet: A statement of the proposed terms and conditions in connection with a proposed investment

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.

Term sheet key provisions

Founders should consider the following key provisions of a VC term sheet:

Investment structure

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.

Key economic terms

Essentially, the key economic terms of the sheet consist of:

• Quantifying the preferred return of the investment
• Quantifying any accruing earnings on the investment

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.

Board structure and reporting

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).

Shareholder agreements

Institutional VC investments inevitably involve a range of shareholder agreements. Generally, in a Canadian transaction, these include

• A subscription (share purchase) agreement
• A unanimous shareholders’ agreement
• A registration rights agreement

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:

• Accept that VCs need instruments of control. Startups should recognize and accept that institutional venture capitalists wield significant control over their portfolio companies. It is one of the fundamental characteristics that define venture capitalists as financial intermediaries. Founders who are uncomfortable with this basic fact might want to consider a different strategy for raising their needed capital. Startups should do as much diligence as possible to determine how their proposed investor partners have supported their portfolio companies in the past. This includes contacting CEOs that the investors have worked with previously.

• Balance your stakeholder groups. The key to fine-tuning your startup’s corporate governance structure lies in having a balance among your stakeholders. In part, this will emerge from ensuring a proper board structure with appropriate influence from independent directors. Where possible, the term sheet should also make an effort to establish voting thresholds for key corporate events that involve a range of stakeholders—including founders, angels and institutional investors.

• Look forward to the next transaction. As with any round of financing, founders should understand very clearly what it will take to change the shareholders’ agreements and the share capital structure in the future. Staged investment strategies (that is, funding upon achievement of milestones) are the principal tool VCs use to extract future concessions from management. Consider carefully the pre-emptive rights provided to investors, or any consent rights over future financing rounds. Ideally, you can create a corporate governance regime that includes an independent evaluation of available alternatives and offers some protection against investor misfeasance or opportunism.

• Continue the corporate governance conversation. Founders should recognize that the legal controls required by VCs furnish a mere backdrop to a continuing corporate governance conversation with the start-up, and that the various investor rights are as often waived as they are followed. In fact, the legal details often take a firm back seat to the quality of a founder’s personal relationship with investors as the main driver to help a start-up succeed. Of course, you should not neglect to pay attention to the shareholder agreements that accompany a proposed investment. Nevertheless, founders should realize that regular, deliberate and honest conversations regarding the firm’s progress form the prerequisite for establishing a healthy and supportive engagement with institutional investors.

Due diligence, exclusivity and closing

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.

Summary: If you receive a venture capital term sheet (a statement of proposed terms and conditions for a proposed investment), you need to understand, from a legal perspective, how to manage the process.

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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.