Understanding the term sheet

If you think of the ongoing relationship between you and a venture capital investor (VC) is a marriage, then you can think of the term sheet as the prenuptial agreement.

The term sheet outlines the terms by which an investor will make a financial investment in your company. It includes:

• Funding
• Corporate governance
• Liquidation

Funding

The funding section details:

• The valuation
• The amount of the investment
• Who the investor will be
• Whether the financing will be in a single lump sum or in tranches (typically triggered by pre-determined milestones)
• The type of security issued, which may be equity in the form of convertible preferred stock or debt
• The protection from dilution—protection from dilution includes anti-dilution, pre-emptive rights and right of first refusal

Corporate governance

The corporate governance section includes:

• Distribution of the decision-making powers
• Board composition
• Voting rights
• Revisions to the by-laws
• Information rights

Liquidation

The liquidation section details how investors will be able to get their money back out from the investment. It includes:

• Exit strategy
• Redemption rights
• Registration rights
• Drag-along and tag-along rights
• Participation rights

Key Considerations

Goals

When negotiating a term sheet, consider the investor’s motives and goals, as well as your own.

1. What is the investor trying to achieve?

• Maximize the proceeds upon their exit from the company by purchasing convertible preferred shares in your company in exchange for their investment.
• Protect their investment if the company performs poorly through provisions that allow them to gain a larger percentage of exit proceeds than would be determined by looking solely at their ownership percentage.
• Retain vetoes over certain corporate actions that could affect their ultimate ownership position.
• Maintain the ability to force the board and management to sell the company after the investors have been involved for a long time.
• Make sure that the founders and key members of the management team are locked into staying with the company (as long as they are performing and adding value to the venture). After all, they’ve invested in the venture in large part because they believe in the team.

2. What is the entrepreneur trying to achieve?

• Raise as much capital as possible to reach the key value-adding milestones without giving up too much of the ownership prize upon exit.
• Ensure that, in agreeing to provide downside protection to investors, he or she has not given up too much of the upside potential. This can be accomplished by: (a) avoiding participating in liquidation preferences that provide investors a guaranteed return of their capital plus dividends and that portion of the remaining proceeds equal to their ownership position, and (b), capping the participation so that when the investor has reached two to three times their initial investment, the participation feature disappears.
• Give up as little control as possible over the company’s actions.
• Protect their personal position if the board decides that the founders are not performing and/or their services are no longer required to continue the business.

Ensuring alignment of goals

Investors can use different methods and tools to make sure that the interests of founders and key management are aligned with the investors’ goals for the corporation:

• Reward the founder and key executives for value creation with a bigger piece of the pie upon completion of key milestones—via the founders’ shares and employee stock option plan (ESOP).
• Use key vetoes and tag-along rights to make sure that the founders and key executives do not sell the company before the investors believe that sufficient value has been created and they are ready to sell.
• Include a vesting schedule for the ESOP and initial founders’ shares to tie in the key people for the right amount of time.
• Include non-compete agreements and intellectual property (IP) assignment agreements to make sure that the full energy of the founders and management team is fully committed to building a successful venture.

Throughout the negotiation process, each side rarely achieves all of their objectives. If there is limited capital, then the investor will have the upper hand. If there are competitive term sheets on the table, then the entrepreneur will win important negotiation points.

What else you should know about term sheets

Non-binding nature

• Term sheets are not binding. If an investor presents you with a term sheet, it does not mean that you are going to close on the financing. The investor is still completing its due diligence. If the investor discovers something that he or she does not like, then the investor may step away from the transaction.

Responsibility for fees

• If the deal does not close in the late stages of negotiation, you are responsible for the fees (legal and other) incurred to date, which will likely include the investor’s fees. This will be detailed in the term sheet. When you negotiate the term sheet, try to get the investor to agree to a cap on expenses.

Expert Support

• If you have not done so already, engage a lawyer who is knowledgeable about this type of transaction. The lawyer who helped close the purchase of your house is not the right person. If you have counsel with deep experience, he or she can review the term sheet quickly and outline the key points for negotiation. Having strong legal representation provides you and your company with additional credibility.
• Key advisors can also provide guidance on terms that are (and are not) negotiable.

Timing is Crucial

• Try to raise money before you run out of cash. This will put you in a much stronger bargaining position.

Keep Confidential in Competing Offers

• If you have two or more competing term sheets, consider keeping the names of other investors to yourself. The venture capital community is small and they will contact one another. This could lead investors to partnering and presenting you with one term sheet. You will have lost the opportunity to better the offered terms through a competitive situation.

Include Capitalization Table

• All term sheets should include a current and future (pre- and post-financing) capitalization table. This helps to clarify any potential misunderstanding relating to the present and future issued and fully diluted shares (including options and warrants) in the company.

Clarity in Negotiation

• Negotiate a clear and precise term sheet in advance. This will save time and money during the process of drafting and finalizing the legal agreements.