Author: Fayza Mohamed
For a wide range of investors such as Angel investors, Seed Investors and Venture Capitalists, term sheets are the foundational blueprints that set the stage for collaborative ventures. This article will focus on the Venture Capitalist’s term sheet and aims to touch on and briefly explain the many provisions falling under the scope of both the Economic and Control terms of a term sheet, unraveling their intricacies and highlighting their critical roles in shaping the course of a business endeavor.
Economic Terms:
In essence, economic terms of a term sheet refer to the return that investors will ultimately get in the case of a liquidity event. This event is usually either the sale of the company, an initial public offering (IPO) or a wind down. Naturally, as a result economic terms tend to also cover the terms that have a direct impact on this return.
Valuation:
Valuation, which is usually categorized as ‘Price’ in a term sheet; is considered the bedrock of economic terms. This is due to the fact that it determines the value of the business and subsequently influences the ownership structure post-investment. In short, the Valuation decided and agreed upon by the company as well as the Venture Capitalist, determines how much of the company is to be sold. Thus, also determining how much dilution the company is due in the financing.
There are many methods that a company and investor may implement to determine the Valuation of the company in question, the two most prevalent methods being the Pre- Money and the Post-Money Valuation. The Pre-Money Valuation is what the investor values the company at prior to the actual investment. As for the Post-Money Valuation, in simple terms, it is the Pre money Valuation + the contemplated aggregate investment amount. The interplay between Valuation and the Investment Amount is crucial, establishing a fair distribution of equity and building the foundation for a balanced and mutually beneficial partnership.
Following the Valuation is usually the Price Per Share, this is also known as the ‘Purchase Price’ under the term sheet and is often expressed in vague terms. This is due to the fact that so long as the Valuation and Option pool are agreed to under the term sheet, then dilution is determined thus leaving the ‘Purchase Price’ as largely irrelevant.
Investment Amount:
The Investment Amount, intricately woven with the Valuation, is more than a mere capital injection. It delineates the ownership percentage the investor secures, necessitating transparent communication to prevent misunderstandings.
This term usually sets out the type of security that the investment is in respect of. For most Venture Capitalists the type of security expected in return would be preferred shares.
Liquidation Preferences:
Liquidation Preferences are a critical component designed to protect investors in the event of an exit or liquidation of the startup. This term ensures that, before any other stakeholders receive proceeds from a sale or liquidation, the investors have the right to recoup their initial investment.
While serving as a safety net for investors, offering a layer of protection in scenarios where the company is sold at a lower valuation than anticipated, Liquidation Preferences can create complexities for founders and other equity holders. The main advantage lies in shielding investors from downside risk and securing a priority position in the distribution of proceeds.
However, from the perspective of founders and other shareholders, particularly in successful exits, Liquidation Preferences can result in a more significant portion of the proceeds going to investors, potentially diluting the returns for other equity holders. Striking the right balance in negotiating Liquidation Preferences is crucial for fostering trust between investors and founders while aligning the interests of all stakeholders in the overall success of the venture.
Conversion/Auto-Conversion of Preferred Shares:
Conversion or Auto-Conversion provisions in Venture Capital Preferred Stock Term Sheets are critical mechanisms that enable preferred shares to be converted into common shares upon specific events such as an IPO or an acquisition. These provisions offer flexibility to investors, allowing them to convert their preferred shares into common shares at a predetermined conversion ratio. This feature benefits investors by providing them with the opportunity to participate in potential upside and liquidity events. However, the inclusion of Conversion/Auto-Conversion provisions may raise some concerns, particularly in the context of dual-class stock structures.
Dual-Class Stock Structures involve the issuance of different classes of shares with varying voting rights. Typically, founders and early investors hold shares with superior voting rights, granting them greater control over corporate decisions compared to holders of common shares. While dual-class structures may provide founders with the autonomy to execute their long-term vision without undue influence from short-term shareholders, they also raise governance issues and can lead to conflicts of interest.
In this regard, the presence of a Dual-Class Stock Structure can influence how the Conversion or Auto-Conversion of preferred shares in an IPO impacts the distribution of voting rights and control within the startup company (i.e., potentially shaping investor sentiment and corporate governance dynamics). Accordingly, Investors with preferred shares may be concerned about their ability to influence corporate decisions effectively if the company employs a dual-class structure.
Balancing the interests of investors with the founders’ need for control is crucial when incorporating Conversion/Auto-Conversion provisions and Dual-Class Stock Structures into preferred stock term sheets. These provisions should aim to strike a fair balance between investor protection and founder control, ultimately contributing to the company’s long-term success.
Dividend Rights:
Dividend Rights represent a less common yet notable provision that outlines whether and how investors would receive dividends from the startup’s profits. While Dividend Rights can offer investors an additional avenue for returns, they are often considered non-standard in the venture capital world where the focus is primarily on long-term growth.
The potential advantage lies in providing investors with periodic returns, akin to traditional equity investments, and can be particularly appealing in mature and profitable companies. However, the inclusion of Dividend Rights may pose challenges in startups, especially those in early growth phases, where reinvesting profits for expansion is a typical strategy.
Control Terms:
Control pertains to the systems implemented that enable investors to effectively influence the operations of the business or to have the authority to reject (in the form of veto power) specific decisions made by the company.
Protective Provisions:
Protective provisions are terms that grant specific rights to the venture capital investor to protect their interests and ensure certain safeguards in significant company decisions. These provisions typically empower the investor to veto or block specific actions that might have a substantial impact on the company’s direction, financial structure, or value.
Board Composition:
The Board Composition term outlines the structure of the startup’s board of directors, a pivotal aspect influencing governance and decision-making. The term typically addresses the allocation of board seats to investors and founders, defining the power dynamics within the company. A board heavily weighted towards investors can offer valuable strategic insights and guidance but may potentially limit the decision-making authority of founders.
Conversely, a more founder-centric board can maintain the entrepreneurial spirit of the company but might face challenges in aligning with the interests and expectations of investors. The pros of a carefully crafted Board Composition term include the potential for balanced decision-making, drawing on the expertise of both investors and founders.
Drag-Along and Tag-Along Rights:
In short, Drag-Along rights provide a mechanism for majority shareholders, often investors, to compel minority shareholders to participate in a company sale. This streamlines the sales process, ensuring a cohesive decision among stakeholders and facilitating efficient deal execution. However, it can limit control for minority shareholders and lead to potential disagreements if their interests diverge.
On the other hand, Tag-Along rights act as a safeguard for minority shareholders, allowing them to join in a sale initiated by majority shareholders. This ensures protection and preserves the ownership percentage for minority stakeholders in favorable exit scenarios. Yet, Tag-Along rights may limit the control of majority shareholders and introduce complexity to the negotiation process, potentially deterring buyers.
The inclusion of these rights in a term sheet necessitates careful consideration to balance the interests and dynamics between majority and minority stakeholders.
Common Terms and Strategic Benefits:
Vesting of Founder Shares:
Vesting refers to the gradual accrual of ownership rights over a specified period for founder shares. Founders and early team members agree to a vesting schedule, typically four years with a one-year cliff, to align their commitment with the long-term success of the startup.
Vesting aims to mitigate the risk of premature founder departure and protect the investment of Venture Capitalists. Vesting of founder shares is the bridge fostering long-term commitment as it ensures that founders remain dedicated over time, aligning their interests with those of investors.
Anti-Dilution Protection:
Anti-Dilution protection in venture capital term sheets serves as a crucial shield for investors, safeguarding their ownership stakes in the face of down rounds and lower valuations. This term preserves the value of the initial investment, maintains investor confidence, and protects against substantial dilution. However, this is not to say it is without fault.
An Anti-Dilution terms implementation increases dilution for existing shareholders, particularly founders, potentially straining relations between different investor groups. Furthermore, the inclusion of Anti-Dilution provisions may also limit the company’s negotiating flexibility in subsequent funding rounds, affecting its ability to attract new investors. Balancing the protection of investor interests with the overall growth trajectory of the company is essential when incorporating Anti-Dilution protection into a Venture Capitalist term sheet.
Right of First Refusal “ROFR”:
The Right of First Refusal “ROFR” stands as a term that bestows existing investors with the exclusive right to purchase additional shares before external parties. This mechanism, while empowering current stakeholders with control over the ownership structure, serves to maintain stability and alignment with the company’s strategic vision.
By granting investors the initial opportunity to acquire shares, ROFR acts as a deterrent against the entry of potentially undesirable external investors. However, the exercise of ROFR may introduce delays in transactions and limit the liquidity options for shareholders intending to sell their shares, adding intricacies to the negotiation process.
Deadlock:
A Deadlock refers to a situation where a significant decision requires unanimous or majority approval from the company’s stakeholders, typically the founders and the venture capital investors, and an impasse occurs due to a lack of consensus.
Deadlocks can paralyze decision-making processes and hinder the company’s ability to move forward on critical matters such as strategic initiatives or corporate governance changes. Consequently, to address potential deadlocks, term sheets may include provisions outlining dispute resolution mechanisms or buy-sell arrangements, providing a predefined process for resolving impasses and ensuring the continuity of the business despite disagreements among key stakeholders.
Confidentiality:
A Confidentiality term typically involves provisions aimed at safeguarding sensitive information exchanged during the due diligence process. It underscores the importance of maintaining the Confidentiality of non-public information shared between the startup seeking funding and the potential investors.
This term commonly includes restrictions on disclosing, using, or allowing third parties access to the confidential information without the explicit consent of the disclosing party. The purpose is to protect the intellectual property, financial data, business strategies, and other proprietary information of the startup. It sets the expectations for both parties to handle confidential information responsibly and may specify the duration of Confidentiality obligations, often extending beyond the term sheet stage into the broader investment process.
No Shop:
A “No Shop” provision in a Venture Capitalist term sheet restricts a startup from actively seeking or engaging in discussions with other potential investors for a specified period, providing the Venture Capitalist firm with exclusivity during the negotiation and due diligence phases. This clause aims to protect the time and resources the Venture Capitalist invests in assessing the investment opportunity by preventing the startup from entertaining competing offers simultaneously.
While the duration of the “No Shop” period is negotiable, it serves as a commitment mechanism, fostering an environment of trust between the parties and allowing the Venture Capitalist firm a reasonable timeframe to finalize the investment terms without the risk of competing negotiations.
Directors and Officers Insurance (D&O):
A D&O insurance provision delineates the rights, responsibilities, and safeguards extended to Directors and Officers within a company. This provision grants Legal protections including indemnification, liability limitation, and insurance coverage; thereby shielding the Directors and Officers from personal liability stemming from specific actions, such as breaches of fiduciary duty or negligence in corporate decision-making.
Such clarity and protection serve to attract and retain competent individuals for the company and while this provision is usually considered a minor and non-controversial section; the provision of these safeguards can pose financial challenges for the company. Encompassing increased insurance premiums and potential Legal expenses. This burden may prove especially daunting for nascent startups grappling with limited resources.
Employee Stock Ownership Plan (ESOP):
An Employee Stock Ownership Plan “ESOP” allocates a certain percentage of the company’s equity for issuance as stock options or shares to employees, aligning their interests with the company’s success.
ESOPs are usually used in order to attract and retain top talent, particularly in startups, as they offer employees a stake in the company’s growth and success. Term sheets may include details on the size and structure of the ESOP, ensuring that a portion of the funding is earmarked for incentivizing and rewarding key contributors to the company’s value creation. It is worth noting that the ESOP term is a strategic component and is in no way a necessity within a Venture Capitalist Term Sheet.
Information Rights:
The Information Rights provision in a Venture Capital Series A preferred stock financing term sheet delineates investors’ entitlement to company information, covering aspects such as frequency, format, and extent of disclosure.
Investors holding Series A preferred stock necessitate regular updates on financial performance, operational status, and strategic direction to facilitate informed decision-making. Therefore, this provision typically stipulates requirements for quarterly financial reports, annual audited financial statements, and updates on key operational metrics.
Moreover, investors may gain access to confidential data, including board meeting minutes, investor presentations, and strategic plans, to cultivate transparency and foster trust between the company and its investors, thereby nurturing a robust investor-company relationship.
Conclusion:
To conclude, term sheets are generally non-binding and are considered to be a crucial guidepost or blueprint that facilitates alignment between the investors and the company; prior to the creation of the Shareholders Agreement and any financing being carried out. It sets the tone for the agreement and allows for a preliminary understanding of the investment to be made and the securities required in return.
On the other hand, it is imperative to take note of the fact that in some situations there are a limited number of terms that are to be considered as binding. For example, term sheets that include a No Shop and/or Confidentiality term usually note at the end of the term sheet that these terms are to be considered legally binding at the enforcement date of the term sheet.
