Every month we see hundreds of startups here at CapitalPitch, and I can’t help but notice how few founders truly understand the importance of Term sheets to their business. In response to this, we felt it was necessary to simplify and explain the intricacies of a typical term sheet from an early stage venture capitalist.
For a full guide to understanding term sheets for both investors and entrepreneurs, feel free to check out our complete eBook below!
In the realm of venture capital, term sheets are distributed to successful candidates once the partners of a VC firm have agreed to begin the investment process and conduct due diligence. The idea is that once the term sheet is agreed and signed, the only scenario when an investment would not occur is if the founders have misrepresented the Company, which would be uncovered during the due diligence.
Term sheets are well suited and widely used in venture capital and fundraising rounds, to maximise business efficiency for both parties, whilst curbing legal costs during preliminary negotiations between an investor and a startup. During any term sheet negotiation, there are two main elements that must be considered: economic conditions and control conditions.
Put simply, economic conditions refer to the ROI for investors in a liquidity event, whereas control conditions refer to the mechanisms that allow investors to influence the strategic direction of the business.
To keep this as easy to follow as possible, we’ll be running through concepts from one of own term sheets for priced equity rounds, which are prototypical from an early stage VC. However, feel free to click here for Avcal’s similarly fantastic term sheet template, which you can use throughout your own investment journey!
At CapitalPitch, our focus is simplifying negotiations and ensuring founders can become quickly comfortable with what can otherwise be a daunting set of decisions. Our term sheets are broken down into 4 key segments:
1. The Offering Terms, which lay out the basic framework for the prospective deal, and include some of the most important dates of any term sheet.
2. Subscription Agreements, which are concerned with compliance and ensuring that all parties are briefed on the legal and financial aspects of the business.
3. Shareholders Deed, centred around the control aspect of the business, this ensures both parties are aware of the expectations and possible changes to the Company’s Board of Directors, strategic direction and future decisions.
4. Other Matters, which details the legal and compliance issues associated with the term sheet.
Remember, this is only a short summary of our complete guide to understanding term sheets, which can be found here. We’ll be briefly covering most, but not all of the concepts discussed within the eBook, to give founders a preliminary understanding of the layout of a term sheet, before they progress to our complete resource.
The Offering Terms:Closing Date:
This section stipulates that once both parties agree on the terms in the term sheet, there is a clearly documented process to move on to a more legally binding document.
The cash amount being offered in exchange for equity.
Price Per New Share:
The price paid for the equity being bought by the investor, which is dictated by the capitalisation of the Company. To accurately determine your own Company's capitalisation, feel free to download CapitalPitch’s free, powerful capitalisation table calculator.
Pre-Money and Post-Money Valuation:
Most term sheets will insist on defining fully-diluted pre and post money valuation price ranges, depending on the size of the investment. This is done to provide a comparison between valuations, given the size of the equity reserve and the expected multiplier impact of the capital raise. For further clarification, and an in-depth explanation of fully diluted valuations and their essential role in the term sheet process, click here to download our eBook.
Investors (especially lead or anchor investors) will usually expect preference shares, which may entitle them to a minimum return (unless otherwise negotiated), and whose payment in a liquidation event (sale of the Company) takes priority over that of ordinary share dividends. Think of this as an extra reward for early investors who have taken significant perceived risk with their investment in your Company.
The Subscription Agreement:
An application by an investor to join a limited partnership and sell stock shares in a Company. We recommend creating an up-to-date data room which you can share with investors, enabling a transparent line of communication and ultimately maximising goodwill and positive negotiation outcomes.
Representations, Warranties and Indemnities:
The clause is concerned with what the Company is expected to provide the investor with, including (but not limited to):
- Warranties in relation to capital structure
- Corporate capacity
The necessary conditions that must be fulfilled before a final offer can be put forward by the investors. Among other things, this can require:
- Obtaining regulatory approvals
- Satisfactory completion of financial and legal due diligence
- Key executives entering into satisfactory employment arrangements
The Shareholder’s Deed:
The Shareholder’s Deed contains the majority of the elements within a term sheet; however, we have hand-picked those most important during negotiations. For a complete rundown and simple explanations of how these specific clauses work, feel free to download our free eBook here.
Board of Directors:
Any smart investor, no matter at what stage of the funding process they join, will want a seat on the Board of Directors. They will not only want to add their expertise and value to the Company, but will attempt to influence decisions to protect their initial investment. It’s up to the Founders to decide how they wish to establish their board, to find the perfect mix of potential expertise and value of investors and directors, with the grassroots team they know and trust.
Following pricing, liquidation preferences are the next most important term to consider, especially for the investor. These preferences detail how the proceeds of the business are divided up following a liquidity event, such as the sale of the Company or a majority of its assets, or its acquisition, known as an “exit”, wherein the shares of the Company will be fully liquidated by the new owners. Liquidation preferences usually dictates the sale of preferred shares (those which initial investors are given). Participating and nonparticipating shares are also incredibly important for this point, and a full explanation of these can be found in our eBook.
Preventive measures are implemented to protect investors in the event the Company issues equity at a lower valuation than in previous rounds. Often, startups are evaluated on an optimistic “blue sky”, and if this proves to be inaccurate or the founders perform poorly, then the investors have some protection.
D&O and Director Indemnification:
Investors will often request the Company takes extra precautions by virtue of insurance, to protect their investment and safeguard the future of the business. Directors and Officers insurance is liability insurance that reimburses the Company (and investors) for the loss, by death or accident for example, of any key senior executive or employee.
Right to Participate in Pro Rata in Future Rounds:
This clause will stipulate whether shareholders will be eligible to participate in future rounds of funding through release of additional shares, and is usually dictated by their equity stake in the business and type of stock they own. This can avoid stock dilution if additional shares are released, to ensure lead investors maintain their equity percentage.
Buy Back of Founder Shares:
In the case a founder leaves the Company prematurely or as a result of misconduct, this point outlines how the Company is able to repurchase those shares before they are offered to current shareholders. There are 4 scenarios where the buy back of founder shares are an important issue: vesting, bad leavers, good leavers and exit. For a detailed explanation and breakdown of share price and categories, download our complete eBook.
Other Matters:Non-Compete and Non-Solicit Agreement:
This clause targets Founders and key employees of the Company, and dictates the length of time in which they are prohibited from selling similar products or services, or utilising similar techniques and business models. This is done to protect the interests of the Company against future damage.
Nondisclosure and Developments Agreement:
This point outlines that the current Founders and employees must enter into a nondisclosure and proprietary rights assignment agreement that is agreeable with the investors.
Costs and Expenses:
This point simply states who is responsible for any costs or expenses incurred throughout negotiations. Usually, discussions in good faith will see each party pay for their own expenses and fees for the duration of the term sheet and into legal counsel and final contracts.
Remember, this crash course is only a glimpse at the importance and power of a term sheet to both entrepreneurs and investors, and we strongly recommend after digesting this information that you download our free eBook to supplement your understanding and guide you through your own investment journey.
Our eBook contains a complete breakdown of 31 essential concepts in a term sheet, as well as alist of what each party should look for throughout term sheet negotiations.
For any more information, feel free to contact us!