Understanding venture capital term sheets

What is a venture capital term sheet?

A venture capital term sheet is the blueprint for an investment. It is a preliminary, non-binding document that outlines the essential terms and conditions of a proposed investment. Although term sheets have a set of formalized components, terms are generally undefined, leading to different interpretations of the parties involved.

How do you analyze a term sheet?

Analyzing a term sheet involves a detailed review of its key terms and conditions. Focus on critical aspects such as valuation, liquidation preferences, vesting schedules and governance terms. Nonetheless, the term sheet requires everyone to forecast the likelihood of various outcomes for the business, including its value as well as the timing and terms of future financing.

Legal nature of the term sheet

The term sheet is not a legal promise to invest. Typically, it serves as a contract that mandates confidentiality during negotiations and may prevent soliciting other investors for a specific time.

Is a VC term sheet binding?

Generally, a VC term sheet is non-binding until a definitive agreement is signed, though it outlines the intentions of both parties.

Documents following the term sheet

While the term sheet lays the groundwork, it's important to remember that several other crucial documents will be drafted and negotiated based on its terms. These documents more definitively spell out the obligations of the relationship with your investor and are negotiated later. They are based on the initial term sheet:

1. The Stock Purchase Agreement (SPA)
2. Investor Rights Agreement (IRA)
3. Certificate of Incorporation
4. Right of First Refusal (ROFR) & co-sale agreement
5. Voting agreement

What is included in a VC term sheet?

A typical VC term sheet includes key elements such as the amount of investment, pre-money valuation, liquidation preferences and specific rights for both investors and founders. Understanding these components is crucial for effective negotiation.

While these elements may vary in detail, a venture capital term sheet is essentially the same from one VC firm to another. So, it may be surprising to see that often the terms can fit on a single page, making the document relatively user-friendly, though the terms can be confusing.

Before signing a term sheet, however, you need to do your due diligence. Although it is exciting to have someone interested in your company, you should confirm that your potential investor is trustworthy. You should also try to limit the number of conditions outlined in the term sheet and define terms as precisely as possible to avoid misunderstandings and confusion.

Common clauses in a term sheet

Certain clauses in a term sheet are common. Here are 10 terms you'll likely encounter and should be familiar with.

1Money raised

Your investor will likely require that you raise a minimum amount of money before they disburse their funds. You'll be responsible for raising this money, so the amount must be realistic from your point-of-view.

2Pre-money valuation

You and your investor will need to determine the value of your company before they make the investment. These negotiations will revolve around the value of all issued stock and anything that can be converted into common stock. This will set the valuation used to compute your investor's percentage of ownership.

3Non-participating liquidation preference

Liquidation preferences will always specify that investors have a higher priority than common shareholders when calculating returns at exit. However, you can negotiate for a 1x plus interest non-participating liquidation preference. 2x means preferred investors are in line to get double their money back if the proceeds allow.

41:1 conversion to common

Conversion to common stock is a non-negotiable item in term sheets. It enables preferred stockholders to convert to common stock if it's better for them to get repaid on a pro-rata common basis instead of simply taking their liquidation preference.

5Anti-dilution provisions

If you need to sell stock at prices lower than what the investor paid, this clause stipulates that the investor receives additional stock to preserve their original percentage of ownership without additional investment.

6The pay-to-play provision

Usually, companies and investors seek this arrangement. The provision requires investors to participate in future financing rounds to avoid having their preferred stock converted to common stock.

7Boardroom makeup

This designates who has control of the board seats and therefore the company. The most founder-friendly structure is 2-1. On the other hand, 2-2-1—two seats for the founders, two for the investors and one outside member—could lead to the founders losing control of their own company.

8Dividends

These are not a main focal point. They are simply a modest deal sweetener and usually range between 5% and 15%. There are two kinds, cumulative and non-cumulative. Cumulative dividends sometimes create economic obstacles that require solving before founders can realize any value. Non-cumulative dividends are preferred stocks that don't pay the investor any dividends that are omitted or unpaid.

9Voting rights

Investors need to have protection from some actions that founders could take that may be harmful to their investment. To prevent this, investors receive voting rights that generally equal the number of common shares the agreement allows them to convert anytime.

10Drag along

A drag along assures investors that founders and the common-stock majority will not block the sale of a company. You should try to increase leverage by negotiating a sales trigger point that is as high as possible to protect your interests.

VC term sheet examples

There is a trend toward making VC term sheets shorter, more transparent with clearer definitions and easier for founders to understand. Whereas VC firms work with term sheets every day, for first-time founders a full understanding of what's at stake facilitates better discussion and negotiation. While one-page term sheets exist, some can extend to dozens of pages.

Y-combinator, one of the world's most respected accelerators, has shared what they believe to be a good term sheet template.

How to get a fair VC term sheet

Although a VC term sheet is non-binding in many respects, it may be filled with unfamiliar terms that require definition because this plan will serve as a guide for your investor agreements going forward. Therefore, you need to protect your interests and the interests of your business. Although it is imperative to have legal representation, you also need a working knowledge of terms to ensure you can negotiate effectively.

Work with your partners and advisors to identify the most important terms to you and your team and focus on those. Not only are you negotiating for favorable terms, but you are also building credibility with the VC. If you take the term sheet "as is" or inversely argue every point without strong rationales, you're creating a negative image for yourself and your team going forward.

Identify terms that are most important to you and your team and focus on those.

Be willing to stand up for the important issues—and show that you know what the most critical issues are. Then, the VC will understand what is important to you and will respect you for trying to strike a good and fair deal.

If you are uncertain about which terms to prioritize, work with a trusted advisor or an experienced startup lawyer to identify those that will help you the most. Typically, however, the most salient points are:

• Valuation/dilution: First, determine your startup's value and recognize that a lower valuation from a respected investor may be a better deal than a high valuation from one with a less than stellar reputation. Second, understand the importance of negotiating for a minimal option plan reserve in the fully diluted pre-money valuation. It could enable you to get a higher price per share for your company at the exit.
• Liquidation preference: This defines the return an investor receives when you sell your company and can significantly impact your return. Take the time to model various anticipated exit values to understand the actual dollar differences between liquidation preference options.
• Protective provisions: These are veto rights that investors have over specific corporate actions. Some make sense, particularly for early-stage startups, but others that limit where you can raise funds or how you can amend your certificate of incorporation may cause problems in the future.
• Founder vesting: The important things to consider include:
  1. What date does vesting commence?
  2. Does vesting accelerate upon termination without cause?
  3. Does vesting accelerate (in whole or in part) upon a change of control?
• Anti-dilution protection: Nearly all deals have some provisions to protect the VC from dilution and most are reasonable. However, if it is a "broad-based anti-dilution protection" or "full ratchet," you may want to get advice from an expert and even reconsider the deal.
• Exclusivity: This is a standard condition that requires that you don't talk to other investors for a specific period after you sign the term sheet and while the investor is doing their due diligence. But be sure the time period isn't too long—30-45 days is about right.

How to negotiate a VC term sheet?

When you get your first term sheet, remember that it is only a starting point. So, before signing, be sure you have done your best to negotiate advantageous terms:

• Talk to more than one VC: This will put you in the best negotiating position and make it possible to push for favorable terms and the best possible valuation. Try to avoid entering into an exclusivity period with one VC until you gauge the interest of others.
• Confirm VC's interest: If you receive a term sheet the VC is interested in, be wary of "no shop" clauses. If you need to agree to give the VC exclusivity, be confident they have the commitment, resources, and money you need before the negotiations go too far.
• Work with an attorney with VC financing expertise: An expert will provide the support and advice you need. It will also show the VC that although you're inexperienced, you still have the good sense to enlist an expert to achieve success.
• Take control: You're the face and voice of the company; you're leading the negotiations for your team. It's not your lawyer's responsibility to negotiate terms. They are there for backup, but you're there to strike a deal.
• Prioritize your terms: You and the VC will not agree on everything. So before you begin negotiating, identify issues that are deal killers and issues where you can afford to be more flexible.

Conclusion

When negotiating a term sheet, it's easy to think that the investor has all the power. But if you are confident in your vision and team—this is the opportunity to demonstrate your value. With a solid knowledge of the issues, a reasonable approach, and a desire to negotiate fairly, you'll be able to get favorable terms and respect from your new VC partner.