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Venture Capital Term Sheets – From the Founder’s and Company’s Perspective

By Steven Keeler

After you have won over a seed or Series A investor with your pitch deck and executive summary, you or the investor will usually circulate a term sheet. The term sheet highlights the most important terms to be included in the final legal documents. The following list of key terms and issues around the term sheet for a venture capital financing are based upon a helpful VC Experts blog post and our experience in preparing and negotiation term sheets. See https://blog.vcexperts.com/2016/11/03/term-sheets-important-negotiating-issues.

• Company Valuation
  Start-up company valuation is subjective. The gap between your and the investor’s proposed valuation is often closed by giving the investor certain downside and anti-dilution protection. If the company sells corporate stock or limited liability company (LLC) shares, the financing is considered a “priced” round as the number of shares acquired by the investor will be based upon current value. As an alternative, you can offer convertible notes (CNs) or simple agreements for equity (SAFES) so that the company’s value and other share terms can be deferred until a later priced financing. Be careful with CNs and SAFEs, as they can be especially dilutive to the founders and other owners if the future priced round is closed at a lower-than-expected valuation. This is because CN and SAFE investors now typically demand both a discount on the future conversion of their convertible notes (off of the price in the future round) and a valuation cap.
• Preferred Stock Variations.
  ‍Significant seed and certainly Series A investors will usually want a preferred equity that gives them their money back before the founder and others receive anything for their common equity. The preferred equity is usually convertible into common equity to give the investors upside participation if the company is successful. Sometimes it carries a preferred return or coupon which acts like interest on debt. Be careful with the rate of this preferred return and any “participating” or “double-dip” preferred equity, as these give the investor an increasing preferred return and the right to receive both their money back and then as-if converted participation in the upside. Preferred returns and participating preferred are much more dilutive  to the founders and other common equity owners.
• Investor Veto and Board Rights
  ‍Most seed and Series A investors will look for consent or veto rights over major company actions or transactions such as addition venture capital financings or a company sale. Many may also request a seat on your company’s board of directors or at least regular meetings and visitation rights allowing them to participate in board meetings.
• Founder Equity Strings
  ‍Investors often insist that the founder’s and other common equity be subject to new vesting and transfer restrictions, as well as a company repurchase right on termination of employment and other events. The founder should be firm in negotiating these restrictions, but expect that some of them may be reasonable and acceptable.
  
• Investor Anti-Dilution Protection
  ‍Most preferred equity term sheets protect the investor from future down rounds (financings at a lower company valuation than the investor’s) by entitling them to convert into a larger number of common shares. The founder should try to avoid so-called full-ratchet anti-dilution terms in favor of weighted-average terms.
• Preemptive Rights
  ‍Investors usually want the right to purchase their portion of future equity sales to preserve their ownership percentage. This is usually considered acceptable, but certain equity issuances should be excluded form this investor right (like option, warrant or share grants to employees, lenders or strategic partners). Aggressive companies may look for pay-to-play provisions which take away the investor’s anti-dilution protection if they don’t participate in future rounds.
• Founder Share and Employment Agreements
  ‍Start-up companies should seriously consider having an agreement among multiple founders and other owners providing for vesting of their equity tied to their continued work for the company and restricted transfers. They may also benefit later if they have standard employment agreements with the company, including non-disclosure, non-solicitation, and intellectual property assignment (or work for hire) terms. Why? Having these terms in place prior to a venture capital raise not only protects the current owners from each other, but also makes investors more comfortable with their investment and may avoid an investor request for more onerous terms.
• Right of Refusal, Tag-Along and Drag-Along Rights
  ‍Investors often request the first right to purchase any shares proposed to be sold by the current owners, and may also request co-sale or tag-along rights entitling them to sell some of their shares to any buyer of the founder’s shares. Both the founders and the investors will also benefit from drag-along or forced-sale rights, which require all owners to sell their shares in the event a controlling group of owners decide to sell control or all of the company. Investors may also request registration rights allowing them to register their shares in the event the company goes public. This is usually acceptable and for most companies it is unlikely to occur.
• Employee Option Pools
  ‍This is related to company valuation and the price the investors pay for their shares. Most investors will require that, in determining the price of their shares, outstanding options and warrants to purchase shares, and even shares that are authorized under the company’s stock option or equity incentive plan which have not been awarded, be treated as issued and outstanding shares in addition to the shares owned by the founders and other owners. This is pretty standard, but results in the founder and other owners absorbing the dilutive impact of these shares.
• Other Issues to Consider at the Term Sheet Stage

• C Corporation, S Corporation or LLC. If your company is an S corporation, you will usually have to convert to a C corporation for tax purposes in order to sell preferred stock (although there are ways to get around this). If your company is an LLC, many Series A investors will require that the company be converted to a C corporation. This can be done without immediate tax consequences, but the company should consult its accountants and lawyers as to the future implications of a conversion.

• Convertible Note Trap. Convertible notes are usually convertible into the same preferred stock that is sold in a future financing. Make sure that conversion only entitles the note holder to a liquidation preference (or right to receive their investment back) equal to what they paid for the note.

• Delaware or Another State. Many Series A investors require that the company convert from its current state of incorporation or formation to Delaware. This is generally acceptable and can be done without significant additional legal work. Delaware has laws and courts that are more clear and familiar to investors, and the company probably benefits as well from being domiciled in Delaware.

• Company No-Shop Covenant. The investor may require the company to sign a term sheet that gives the investor the exclusive right to negotiate with the company for some reasonable period of time such as 60 or 90 days. You should be very comfortable with the certainty of the investor being able to close before agreeing to this no shop covenant, especially if you have other investor interest.

• Minimum, Maximum and Milestone Offerings. If there will be multiple investors, some investors prefer that they not be obligated to fund unless and until the company receives investor commitments of some minimum amount. They may also want to cap the total amount raised. And investors occasionally request that their investment be made in multiple tranches or installments, with some money being paid up front and additional shares being purchased upon the achievement of agree milestones (development, regulatory approvals, sales, hiring new executives and others).

Venture capital term sheets can save a lot of time and legal expense by enabling the company and the investors to agree on the major terms of the deal prior to investor due diligence and the preparation of and closing on the legal documents and funding. There are many form term sheets out there, so companies and founders should educate themselves about term sheet variations and traps and be prepared to negotiate favorable terms that reflect the company’s prospects and current market conditions.

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