Term sheet negotiations are a critical part of any agreement between venture capitalists or angel investors and startup founders.
Term sheets are a type of non-binding agreement that highlights the fundamental terms and conditions regarding an investment. This sheet also serves as a sample or template, laying the groundwork for legally binding documents with a great amount of detail. After the parties involved come to an agreement about the details present in the term sheet sample, a binding contract or agreement conforms to the details drafted in the document.
There are many scenarios where someone makes a pitch to investors, and ends up attracting their attention. While that is great, diving head first into the negotiations is sometimes not a wise choice. This is because it is far better to do some research and understand whatever there is to know about the term sheet sample and the term sheet clauses.
It would be fair to say that a term sheet will arguably be one of the most critical documents you may sign. Why? Because it lays an outline for the important terms of your agreement with investors, which decides the role you will play in your company’s growth.
What is a Term Sheet?
Term sheets tend to cover the major elements of a deal without listing or mentioning every small piece of contingency that you would find in a binding contract. This sheet basically lays the groundwork to make sure that every party involved in a transaction is in agreement about most of the major elements
What’s more, term sheets significantly minimize the likelihood of unnecessary dispute or understanding. In addition, term sheets are quite handy for making sure that there is not premature imposition of hefty legal charges associated with drawing a binding contract or agreement. Most, if not every term sheet consists of information regarding initial purchase price and assets, along with contingencies that could influence the timeframe or price for responses and pertinent information.
In many cases, people tend to associate term sheet negotiations with startups. This document is especially crucial for entrepreneurs running a fresh startup. Besides entrepreneurs, venture capitalists, and investors also have to go through the term sheet to ensure the regulations benefit all parties involved.
Let us take a look at some common conditions and clauses that a company’s term sheet includes:
- First off, this agreement is non-binding. So, neither the VC nor the entrepreneur has the legal obligation to follow anything outlined in the term sheet document
- Things like anti-dilutive provisions, the percentage/division of stakes, the amount of investment, and company valuations should be without any errors
- Companies that are looking to receive funding, are mostly dependent on VC’s looking to make the most out of their investment. Sometimes, this could lead to an unfavorable scenario, as an investor may ask for more influence on the company’s operation, direction that others may not agree with
- Every well-written term sheet includes mention of how a sale’s proceeds will be divided between the investors and entrepreneurs
- Term sheet negotiations should also state the amount of time an investor plans to stay vested to clear any ambiguity
What are the Advantages of a Term Sheet?
Term sheet negotiations are a critical part of any agreement between venture capitalists or angel investors and startup founders. This document creates a robust foundation for the terms to include in the contract. What’s more, it provides details for sealing the future of the parties involved, ensuring their investment relationship remains harmonious throughout the tenure. Let’s discuss some other advantages offered by term sheets.
- Dividends – Dividends are payments that corporations make to their shareholders, mostly for distributing profits. When a company earns a surplus or a profit, it can reinvest it and pay a part of the profit to shareholders in the form of dividends.
- Liquidation Preferences – This is a clause present in contracts, and its main purpose is to dictate payout orders if a company undergoes liquidation. Generally, the organization’s preferred stock holders or investors receive their money before other debt holders and stockholders.
- Post Money and Pre Money – This is an important step that most entrepreneurs, especially newer ones, must be clear about before a venture capitalist or angel investor enters. Before your startup becomes a publicly traded company, the cost of setting up the business is often realized due to which the shares are divided and established amongst the company’s founders.
- Participation Rights – Participation rights are quite helpful for preferred investors, as they help them regain their investment along with profit from the proceeds when exiting. Once this happens, there is very little left for the rest of the shareholders. Participation rights are sort of a double-edged sword in the sense that they benefit preferred investors, but may not be ideal for the company founder or minor investors.
- Option Pool – Option pools contain the stock’s share reserved for a private company’s employees. It is a great way to attract talented employees to up and coming organizations. If the workers help the business improve, making it go public, their rewards will be in the form of stocks. Major advantage for employees who enter startups early on is that they could receive a higher percentage of rewards compared to the people who join later on.
Key Term Sheet Clauses
As mentioned, these sheets include a variety of different clauses that ensure a conflict free relationship between the company’s founder and the investors. Mentioned below are some important term sheet clauses that will help you understand the context of every regulation and policy used for your company’s term sheet negotiations and documents:
- Issuer and investor details – These terms are quite self-explanatory. The investors and issuers are the main term sheet agreement.
- Investment Amount – The investment amount clause in a term sheet determines the amount an angel investor or venture capitalists plans to invest. This is to make sure that they do not sway away from their agreement down the line in parties participating in an agreement, which is why details are a vital part of any
- Securities Offered – As with any sort of agreement between companies and their investors, there is a clause for securities offered that details what the investor will obtain from their contributions.
- Valuation – There are three types of valuations present in a term sheet. They are pre-money valuations, post money valuations, and price per share. This clause highlights the organization’s value before and after the investment. As far as prices per share go, they are calculated by dividing post-money valuation with the fully diluted shares.
- Voting rights – Companies have a limited amount of seats for voting share classes. Therefore, the voting rights clause details the roles and responsibilities the investors will have to undertake when they come on board.
- Conversion Option – This clause allows the enable holders to convert their preferred stock’s shares into common stock. This usually happens on one to one basis, and these rights are based upon the liquidation preferences of an investor.
- Liquidation Preference – People often mistake the liquidation preference clause for a legal issue. However, that is not the case, as this clause simply defines the amount of returns an investor will get after the company undergoes liquidation.
- Dividends – As time passes, preferred stockholders can accumulate additional returns, also called “dividends”. This raises the liquidation preference and the clause is often present in most term sheet samples in the form of a percentage.
- Anti-Dilution Rights – Almost every VC gets anti-dilution protection that safeguards them from the preferred stock’s future sales at lower valuations. This clause can be quite different, depending on the individual who drafted it, and offer a varying level of protection.
- Ownership Structure and Percentage – There should be a great amount of balance in stockholder ownership. A large number of company decisions tend to fall outside the range of the company’s board of directors and into the hands of stockholders. This clause determines who will have the most say in the company’s decision making processes.
- Board of Directors – This clause details the organization’s governance moving forward. In most cases, the board consists of three people with two of them being the founder and one of them being the investor. However, the number could be different, depending on the company’s size.
- Founder Vesting – The founder vesting cause is a critical part of a term sheet agreement, as it gives a quick yet informative breakdown about the perspective of the founder. The important elements that this clause discusses are:
- The starting date of the vesting period
- Whether or not the vesting become accelerated due to termination
- If the vesting will accelerate due to a result of termination or control change
- Investors Right to Information – Some share term agreements enter this clause to highlight how much information shareholders and investors can be privy to. It also details that the information they do have access to must remain confidential.
Term Sheet Negotiations
Knowing the art of term sheet negotiation is a great way to find successful backing from a VC. However, a lot of newer entrepreneurs try to take too much control, which is never a good thing. In some cases, they even tend to negotiate excessively, and as a result, fail. The smart thing for any entrepreneur would be to ensure that they only settle for an adequate option pool shuffle and nothing less.
Business owners and VCs going back and forth during term sheet negotiations is quite common, but its important to remember that every term sheet is different. In some aspects, backing down simply will not suffice, which is why using the rule of three could be a great idea.
When in doubt, follow the “rule of 3”
All you need to do is focus on three of the most important elements you want to resolve. These can be things like valuation, dilution, protective provisions, or anything else that you believe is important.
Term Sheet Sample
If you are new to term sheet agreements, it is worth knowing that almost every term sheet sample has similar elements. Things like the investor’s and founder’s info, participation rights, voting rights, investment amounts etc. are common headings in every term sheet, and you should consider adding them in your document too. Also, don’t forget to add the expiration date, as any ambiguity about details like these can cause major conflict down the line.
With a document as critical as this one, you need to be extra careful when adding details. It will lay the groundwork for how your agreement/deal will go. It would also help if you went through your terms strategically and optimize them according to the result of your negotiations. Things like these will keep you in the clear, ensuring your term sheet sample is bullet proof.
Recording your Term Sheets on Eqvista
As the usage of term sheet for investment and private equity has increased over the years, more and more companies are finding online equity management software crucial for attracting investors. This is where Eqvista can help.
Our Cap Table software can help you record and manage all of your equity related documents, including your investor term sheets, all from one place. Once on the platform, you can upload the Term Sheets in the Documents section, and share with your investors with the click of a button.
Having these details in a management system not only helps to organize your shareholdings, but also shows your investors you are serious about the company’s Cap Table, and you have the details in mind.
Interested to Implement Term Sheets for your Company?
Term sheets legally bind investors and founders to long or short term agreements, making sure they abide by the provisions and regulations drafted in it. The information discussed in this piece provides a thorough low-down of what a term sheet is and the terms and clauses you can expect in sample term sheets. Now that you know why this document is so handy, you can draft one for your startup, making sure you and the shareholders can co-ordinate without any problems.
Eqvista’s sophisticated Cap Table software can help you manage and organize the equity in your company. Record and issue shares all from the platform, share documents online, and even run financial scenarios such as Waterfall Analysis and Round Modeling all from the platform.