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  • Joshua Poulton

Term Sheets: Definition, What's Included, Examples and Key Terms

Navigating the world of a funding round and the proposed investment from a new or existing investors can be stressful. That's why term sheets emerge as crucial, yet often perplexing, documents that you need to understand.

What is a Term Sheet

A term sheet outlines the proposed investment's basic terms, serving as evidence of serious intent between startups and investors. While many view term sheets as non-binding, certain aspects, like confidentiality clauses, can be legally binding. Key issues such as liquidation preferences, pre-money and post-money valuation, and voting rights are typically detailed, impacting both existing shareholders and future investors. The term sheet specifies the equity stake, board seats, and investor consent rights, ensuring all parties are on the same page.

As startups progress from early-stage to later-stage funding rounds, the term sheet's complexity can grow, with provisions like anti-dilution clauses and board structure becoming pivotal. Whether you're a founder working with the lead investor or exploring joint ventures, understanding term sheets is vital. They not only lay the groundwork for legally binding contracts post due diligence but also set the tone for future rounds, ensuring clarity and alignment in business decisions.

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Basics of a Term Sheet: Company Valuation

A term sheet typically includes details about the valuation of the company, the amount of investment, the structure of the deal, and the rights and obligations of each party.

Example: TechFlow, founded by Jane, has a pre-money valuation of $10 million. An investor offers to invest $2 million. The term sheet will outline this valuation and investment amount.

What does it all mean for you and your startup? Each term in the sheet has implications for control, dilution, and the future of your startup. Impact on Jane: If Jane currently owns 100% of TechFlow, after the $2 million investment for a post-money valuation of $12 million, her ownership will be diluted to 83.33%.

TechFlow's pre-money valuation before the Series A round is $10 million. An investor offers to invest $2 million.

Post-Money Valuation = Pre-Money Valuation + Investment Amount Post-Money Valuation

= $10 million + $2 million = $12 million

Investor's Ownership Percentage = Investment Amount / Post-Money Valuation

Investor's Ownership = $2 million / $12 million = 16.67%

Jane's diluted ownership after the investment (excluding the options pool) = 100% - 16.67% = 83.33%

How Term Sheets Changed depending on the investment round.

As a startup progresses, it's natural for the terms and conditions set by investors to undergo changes. For instance:

  • Seed and early-stage term sheets: tend to be relative more during a company's nascent stages. Given the lower amounts of investment and associated risks during these early rounds, term sheets tend to have fewer terms and conditions. A typical seed-stage term sheet, for example, would predominantly focus on the amount of equity being exchanged for the investment, steering clear of intricate clauses or provisions that might be seen in later stages.

  • VC and later stage funding rounds: sees increasing complexity of term sheets as startups advance to more substantial funding rounds. As startups grow and the stakes rise, investors naturally seek more protection and a clearer definition of their rights. By the time a startup is negotiating a Series C round, it's not uncommon for the term sheet to be laden with detailed provisions. These can range from anti-dilution provisions to specific liquidation preferences and even stipulations about board composition, reflecting the heightened investment and associated risks.

Key Terms and Provisions

1. Options pool

Explanation: An options pool is a block of shares set aside for future issuance to employees, advisors, and consultants. It's a way for startups to attract and retain talent by offering equity as part of compensation.

Example in a Term Sheet: The Company shall reserve an options pool amounting to 10% of the total outstanding shares post-financing for future issuance to employees, advisors, and consultants.

Impact: The creation of an options pool dilutes the ownership percentages of existing shareholders, including founders. However, it can be essential for attracting top talent and aligning the interests of employees with the company's success.

2. Liquidation preferences

Explanation: Liquidation preference determines the payout order in the event of a company's sale, liquidation, or another exit event. Investors with a liquidation preference get paid before common shareholders, ensuring they recoup their investment (or more) before others see any returns.

Example in a Term Sheet: In the event of any liquidation or winding up of the Company, the Series A Preferred shall be entitled to receive in preference to the holders of Common Stock a per-share amount equal to [e.g., 2x] the Original Purchase Price plus declared but unpaid dividends.

Impact: For founders and common shareholders, a high liquidation multiple can be unfavourable. If the company is sold at a value close to the invested amount, the liquidation preference can consume a significant portion (or all) of the sale proceeds, leaving little to nothing for the common shareholders.

3. Board seats

Explanation: a Board seat refer to the positions on a company's board of directors. Investors often request board seats as part of their investment to have a say in significant company decisions and to protect their interests.

Example in a Term Sheet: Upon the closing of the financing, the Company's Board of Directors shall be composed of five persons: two designated by the Series A Preferred shareholders, two co-founders, and one independent member.

Impact: Allocating a board seat to investors can reduce the founder's control over company decisions. However, it can also bring in expertise and guidance from seasoned investors. Founders should ensure a balanced board composition to retain influence while benefiting from the investors' insights.

4. Pre-emption rights:

Impact on Jane: If Jane wants to raise more money in the future, her initial investor gets the first chance to invest. This can be both good (guaranteed interest) and bad (less flexibility).

5. Tag-along rights and drag-along rights

These terms relate to the sale of the company. Tag-along protects minority shareholders, ensuring they can sell their shares under the same terms as majority shareholders. Drag-along ensures that minority shareholders can't block a sale.

6. Liquidation preferences

This determines the payout order in the event of a company's sale or liquidation. Using the example of TechFlow: The investor demands 2x liquidation preference for their $2 million investment in TechFlow. Impact on Jane: If TechFlow is sold for $20 million, the investor first gets $4 million (2x their investment) before other shareholders get anything. This could significantly reduce Jane's payout in an exit.

7. Preference shares or "Preferred shares"

Preference shares, often referred to as preferred shares or preferred stock, represent a class of ownership in a company that has a higher claim on assets and earnings than common shares. These shares typically come with specific rights that are not granted to holders of common shares. In the context of startups and venture capital, preference shares are often issued to investors during funding rounds.

Key Features:

  1. Dividend Preference: Preferred shareholders usually receive dividends before common shareholders and may have a set dividend rate.

  2. Liquidation Preference: As mentioned earlier, in the event of a company's liquidation or sale, preferred shareholders get paid out before common shareholders.

  3. Conversion Rights: Preferred shares often come with the option to convert them into a set number of common shares, giving investors potential upside if the company's valuation increases.

  4. Voting Rights: Preferred shares may or may not come with voting rights. When they do, it can influence significant company decisions.

Example in a Term Sheet: The Series A round will comprise the issuance of Preferred Shares. These shares will carry a [e.g., 2x] liquidation preference, have the right to convert into common shares at the option of the holder, and will accrue dividends at a rate of [e.g., 5%] per annum.

Impact: Issuing preference shares can be a way for startups to attract investment without immediately diluting voting control, as these shares can be issued without voting rights. However, the special rights attached to preferred shares, like liquidation preferences, can impact the potential returns for founders and other common shareholders in exit scenarios. It's essential for founders to understand the terms attached to preferred shares and negotiate them in a way that aligns with the company's long-term interests and growth trajectory.

8. Voting rights and board seats

These terms dictate who gets a say in company decisions and can significantly impact your control over your startup. Control terms in a term sheet go beyond standard "Voting Rights" and delve into board composition and operational decision-making. A common pitfall for founders during Series A is a 2-2-1 board alignment, comprising 2 founders, 2 investors, and an independent member. This setup can jeopardize founder control, potentially leading to them being ousted from their own venture.

You should aim for the board structure to be founder-centric, allowing founders a 2-1 control.

Another subtle control shift is when investor director approval becomes mandatory for key operational choices, from budgeting to business pivots. While investors might justify these terms as governance measures, it's evident they're hedging against perceived risks. Founders should be wary: if an investor's verbal commitment doesn't align with the term sheet's clauses, always trust the terms

Legal Aspects of a Term Sheet

A term sheet is primarily a document that outlines the key terms and conditions of an agreement between parties, often used in the context of venture capital or angel investment deals. Its main purpose is to serve as a foundation for further negotiations and to guide the drafting of more detailed legal agreements, such as a definitive Share Purchase Agreement or Investment Agreement.

Are Term Sheets Legally Binding Documents?

Most of the terms in a term sheet are typically non-binding. This means that they serve as a general framework or understanding between the parties but do not legally compel either side to finalize the deal on those terms. The non-binding nature allows both parties to continue negotiations and make changes as they move towards a definitive agreement. However, certain provisions within a term sheet can be binding. These often include:

  1. Confidentiality Clauses: These provisions require both parties to keep the terms and the negotiation process confidential.

  2. Exclusivity or "No-Shop" Clauses: These provisions prevent the company (usually a startup seeking investment) from seeking or accepting alternative offers from other investors for a specified period.

  3. Expenses: Sometimes, a term sheet might specify that one party (often the company) will cover certain expenses, such as due diligence costs, regardless of whether the deal is finalized.

  4. Governing Law and Jurisdiction: This provision, if included, specifies the legal framework and the location for resolving disputes related to the term sheet.

It's crucial for parties to clearly identify which provisions are binding and which are not. This distinction should be explicitly stated in the term sheet.

What is a liability cap?

A liability cap is a contractual provision that limits the amount of damages one party can claim from the other in the event of a breach or other specified circumstances. It sets a maximum limit on the financial responsibility or liability one party might have towards the other.

In the context of contracts, especially in business-to-business agreements, liability caps are common. They provide a degree of predictability and risk management for both parties involved.

Example: The liability cap is set at $500,000.Impact on Jane: This protects both Jane and TechFlow. If the investor believes they lost $1 million due to a deal not proceeding, they can only claim up to the capped amount.

Impact and Considerations:

  1. Risk Management: Liability caps allow businesses to assess and manage potential risks. By setting a cap, a company can ensure that potential liabilities won't exceed a certain amount, making financial planning and risk assessment more predictable.

  2. Negotiation Point: The amount or terms of the liability cap can be a significant point of negotiation in contracts. One party might push for a higher cap, while the other might want it lower.

  3. Fairness: While liability caps can protect a party from excessive claims, they might also be viewed as unfair, especially if the damages significantly exceed the cap. It's essential to strike a balance that protects both parties.

  4. Regulatory Restrictions: In some jurisdictions or types of contracts, there might be legal restrictions on the use of liability caps, especially if they're deemed to be unfair or if they contravene public policy.


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