Welcome to Docracy’s Term Sheet Guide. First things first: when you’re raising money from investors, always, always consult a lawyer. Modifying the equity structure of a company is a big deal with a lot of different legal and tax implications. Don’t go DIY, and don’t rely on the same counsel as your investors. That said, you should learn how a term sheet works to make informed decisions and protect your interests. Understanding the legal side of the process will help you direct your lawyer’s efforts and probably save you some money. For this reason, we dissected and explained all the relevant terms of the term sheet, the core document of any equity investment.
While there are many more legal issues surrounding venture capital investment, we will only focus on the ones raised by the standard term sheets currently available on Docracy (see full list on the right). Term sheets are very standardized documents and starting from a known template is a very good idea. Last but not least, this guide is heavily indebted to Venture Deals, the fundamental book by Brad Feld and Jason Mendelson and still the best manual on how to navigate a round of VC financing.
Good to know:
- External links are in italics.
- Defined terms are underlined.
- Sample language from actual clauses is highlighted in a box.
- Standard term sheets from reputable investors are listed on the right.
Table of Contents
II. The Term Sheet
- Employee Pool / Option Pool
- Liquidation Preference
- Right of First Refusal
- Redemption Rights
- Conditions Precedent to Financing
- Voting Rights
- Board of Directors
- Protective Provisions
- Information Rights
- Co-Sale Agreement / Tag-along
- No-Shop Agreement
- Capitalization Table
- Downside Case
- Drag-Along Agreement
- Fully Diluted
- Liquidation Event
- Vesting Acceleration
This guide assumes you have basic knowledge of venture capital financing. Venture capitalists (VCs) are a different type of investor than traditional players like banks, private funds or public stock offerings. VCs invest in high-risk, high-growth companies. In exchange for more risk, they receive a number of benefits: a special type of stock, some control in the company (in the form of at least one board member), and the potential for a higher return.
Before diving in, here are some suggested readings:
- Legal checklist for startups by Scott Edward Walker
- How to pitch a VC by Mark Suster
- Notes on Raising Seed Financing by Chris Dixon
- Discuss your plans before signing a term sheet by Nivi
- The most common mistakes startups make dealing with VCs by Scott Edward Walker
- If you can't buy your investor a beer, don't take their money by Sachin Agarwal
- The Three Terms You Must Have In A Venture Investment by Fred Wilson
- Good article about seed financing options (look for links to parts 2 and 3 in the comments)
- Short checklist of the typical conditions in a Series A financing agreement (includes a short description of how the signing/closing process generally occurs)
- Interesting take on the timing of financing
- Explanation of what preferred stock is
II. The Term Sheet
A term sheet is an outline of the basic relationship between the VC and the company. It's not a legal promise to invest; the actual investment contract (usually called a Purchase or Investment Agreement) is drafted later, based on the term sheet. This means that the investors have the right to walk away even after signing the term sheet.
The term sheet's core function is to sell shares to investors in exchange for money, as specified in the price clause. Price is typically expressed in price per share, making it important to keep in mind the total number of shares. The price reflects how VCs value the company (see valuation), and looks like this:
$0.23 = price per share (the “Original Issue Price”), based on a pre-money valuation of $3,000,000 including an available option pool of 15%
- A good breakdown on how Venture Capitalists calculate a company’s valuation (includes a link to a free spreadsheet to help with the calculations)
- Introduction on price valuation by Brad Feld
2. Employee Pool / Option Pool
The option pool or employee pool usually gets mentioned alongside price, as it's included in the company's capitalization table. Simply put, it refers to a group of shares of common stock set aside for future employees. The size of the employee pool should be proportional to the number of employees you anticipate having. A large option pool will make it less likely that the company will run out of available options, which are important for compensating and motivating the company’s workforce. Just remember that the size of the pool is taken into account in the valuation of the company (whenever a calculation is done on a fully diluted basis, it means it takes into account all of the shares, including the employee stock pool), lowering the actual pre-money per-share valuation.
Employee Pool: Prior to the Closing, the Company will reserve as the Employee Pool shares of its Common Stock so that the percentage set forth on page one of the Summary of Terms of its fully-diluted capital stock following the issuance of its Series A Preferred is available for future issuances to directors, officers, employees and consultants.
- Good explanation of pre and post-money valuations
- Rundown of the pros and cons concerning pre and post-money valuations by Fred Wilson
- What's a Reasonable Starting Point for an Option Pool by Brad Feld
3. Liquidation Preference
This is a crucial part of the economics of any financing, as it determines the terms of how investors will get their money back in a liquidity event (see definition).
- the actual preference - how much preferred stockholders will get per each share of preferred stock, based on a multiple of the original purchase price:
Liquidation Preference: In the event of any liquidation or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock a per share amount equal to [x] the Original Purchase Price plus any declared but unpaid dividends (the Liquidation Preference).
- Participation - how much of the rest of the money, if at all, preferred stockholders will share with common stockholders:
Participation: After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis.
This means that if an investor buys shares of preferred stock in the company at a price of $P per share and the company is sold (liquidation event), for each share that the investor owns, he will get a multiple of the purchase price that is determined by the term sheet: 2xP, 3xP etc. (this multiple is generally 1 in seed rounds). After the investors get their respective preference, they might also get some of the remaining money (along with the common stock owners) if the security allows for so-called participation. There are three levels of participation:
- Fully participating stock will share in the liquidation proceeds on an as-converted basis (as if the stock were converted into common stock based on its conversion ratio).
- Capped participation stock will share in the liquidation proceeds on an as-converted basis until a certain multiple is reached. This is a way to mitigate the risk that preferred shareholders get too much of the pie if there’s a very good exit.
- No participation, as the name says, won’t participate, and that’s of course the best option for the entrepreneur.
- Introduction to Liquidity Preferences
- Explanation of how to set up a liquidation table (with link to spreadsheet)
- Short breakdown of liquidation preferences and some things to watch out for by Scott Edward Walker
Dividends are cash that the company might decide to distribute to its shareholders, pro quota. A typical dividend clause in a VC investment looks like this:
The holders of the Series A Preferred shall be entitled to receive non-cumulative dividends in preference to any dividend on the Common Stock at the rate of 8% of the Original Purchase Price per annum, when and as declared by the Board of Directors. The holders of Series A Preferred also shall be entitled to participate pro rata in any dividends paid on the Common Stock on an as-if-converted basis.
There are 3 types of dividends:
- Cumulative: If a dividend is cumulative, it must either be paid out every year to holders of preferred stock, or, if the company does not pay out a dividend in a particular year, in future years it must pay the holders of preferred stock the dividends it owes them. So, for example, suppose a company issues preferred stock at a price of $100 and a cumulative dividend of 5% per year ($5). If, in year 1, the company does not pay the preferred stockholders the $5 dividend, in year 2, it must pay them $10 ($5 + $5). Remember companies have no obligation to pay common stockholders dividends, but any dividends that a company owes to its preferred stockholders must be paid out before it can pay out any dividends to its common stockholders.
- Non Cumulative: If a dividend is non-cumulative, holders of preferred stock only get dividends in years that the company issues them.
- Automatic: If a dividend is automatic, the preferred stockholders receive it every year regardless of whether or not the company declares a dividend.
An 8% non-cumulative dividend is currently the most standard term in seed rounds. Dividends don’t matter a much to early stage investors because they don’t provide significant venture returns, and are rarely issued in companies that prefer to invest all revenues in future growth. However, they can matter in downside cases (liquidations of the company at lower valuations than the investors’ initial investment), especially as the invested capital increases, and generally matter more as the investment amount increases and the expected exit multiple (the scale of return as compared to initial investment) decreases. You generally want to ensure that dividends have to be approved by a majority of your board of directors (and you have that control).
One item that is almost non-negotiable in deals with VCs is conversion. Preferred shareholders have the right to convert their shares into common stock at any time, initial conversion rate being usually 1:1.
Preferred Stock Conversion: Convertible into shares of Common Stock at any time at the election of each holder. The initial conversion rate shall be 1:1, subject to adjustment as provided below
Automatic Conversion: It’s rare for a VC backed company to go public with multiple classes of stock - bankers will want to see everyone convert to common stock. When there's an IPO, preferred stock will convert automatically to common stock upon the closing of a so-called "qualified" public offering of shares of common stock of the company. Thresholds for automatic conversion are negotiation material - entrepreneurs want them lower (to have more flexibility), investors want them higher (so they have more control over the timing & terms of the IPO). Be sure never to have different automatic conversion terms for different series of preferred stock - that can cause vetoes over an IPO.
Automatic Conversion: All of the Series A Preferred shall automatically convert into Common Stock upon the closing of a firmly underwritten public offering of shares of Common Stock of the Company at a per share price not less than four times the Purchase Price (as adjusted for stock splits, dividends and the like) per share and for a total offering of not less than $30 million (before deduction of underwriters commissions and expenses) (a “Qualified IPO”). Any or all of the Series A Preferred shall convert into Common Stock upon the election of holders of at least [a majority] of the outstanding Series A Preferred (the “Required Percentage”).
This is one of the hardest and math-heavy parts of the term sheet. Anti-dilution provisions are used to maintain the ownership share of earlier-round preferred stockholders in the event a company issues shares at a lower valuation (see downside case) than in previous rounds by modifying the conversion price (see Conversion, above) of earlier-round-shares. The practical effect of this is to increase the number of shares of common stock into which each share of preferred stock can convert if there is a liquidity event.
Anti-dilution comes in two main types:
- Ratchet-Based Anti-dilution - if the company issues shares at a purchase price lower than the conversion price for the series with the ratchet provision, then the earlier round conversion price is effectively reduced to the price of the new issuance. This is called full-ratchet conversion. Other ratchet-types that exist are half ratchet, or two-thirds ratchet (see the "learn more" links for more details).
- Weighted Average Anti-dilution - this is more common than ratchet-based anti-dilution and takes into account the magnitude of the lower-priced issuance, not just the actual valuation. If a company sells shares of its stock to someone for a purchase price lower than the previous conversion price, the previous round stock is repriced in accordance with the number of shares issued at the reduced price.
In general, ratchet-based anti-dilution provides investors with more control and should be reserved for smaller-scale investors (angels) when there is more risk of a subsequent down round. The rest of the time, weighted average narrow-based provisions are preferable.
Don't forget "carve-outs" - exceptions for shares granted at lower prices for which anti-dilution does not apply. More exceptions are better for the entrepreneur. For example:
The conversion price of the Series A Preferred will be subject to a [full ratchet / broad-based / narrow-based weighted average] adjustment to reduce dilution in the event that the Company issues additional equity securities (other than shares: (i) reserved as employee shares described under the Company’s option pool; (ii) shares issued for consideration other than cash pursuant to a merger, consolidation, acquisition, or similar business combination approved by the Board; (iii) shares issued pursuant to any equipment loan or leasing arrangement, real property leasing arrangement or debt financing from a bank or similar financial institution approved by the Board; and (iv) shares with respect to which the holders of a majority of the outstanding Series A Preferred waive their anti-dilution rights) at a purchase price less than the applicable conversion price. In the event of an issuance of stock involving tranches or other multiple closings, the anti-dilution adjustment shall be calculated as if all stock was issued at the first closing. The conversion price will also be subject to proportional adjustment for stock splits, stock dividends, combinations, recapitalizations and the like.
- Brad Feld explains anti-dilution
- Anti-dilution formulae applied to different scenarios by Nic Brisbourne
- A comprehensive treatment of typical anti-dilution mechanisms by Wilson Sonsini (PDF)
- Say no to full-ratchet anti-dilution (Venture Hacks)
7. Right of First Refusal
This defines the rights of an investor to buy shares in a future financing; also known as pro rata right.
Prior to a Qualified IPO, Major Investors shall have the right to purchase their pro rata portions (calculated on a fully diluted basis) of any future issuances of equity securities by the Company (with over-allotment rights in the event a Major Investor does not purchase its full allocation), other than Excluded Issuances.
One thing that can be negotiated is the multiple on the purchase rights. This is often referred to as a super pro rata right and is an excessive ask, especially early in the financing life cycle of a company.
A good policy is to make sure that shareholders keep the right of first refusal only if they play in every subsequent round (see next chapter).
Requires investors to participate in subsequent stock offerings in order to benefit from certain anti-dilution protections. If the stockholder does not purchase his or her pro rata share in the subsequent offering, then the stockholder loses the benefit(s) of the anti-dilution provisions. Ideally, investors who do not participate in subsequent rounds must convert to common stock, thereby losing the protective provisions of the preferred stock. A sample play-to-play provision:
[Unless the holders of [__]% of the Series A elect otherwise,] on any subsequent [down] round all [Major] Investors are required to purchase their pro rata share of the securities set aside by the Board for purchase by the [Major] Investors. All shares of Series A Preferred of any [Major] Investor failing to do so will automatically [lose anti-dilution rights] [lose right to participate in future rounds] [convert to Common Stock and lose the right to a Board seat if applicable].
- Brad Feld explains the pay-to-play provision and reasons for having it
- "What is a pay-to-play provision?" by Yokum Taku
- Pay to play provisions demystified by Scott Edward Walker
Vesting refers to the distribution of employee options or founder stock over a set period of time. If an employee or founder leaves before the vesting period, he/she does not get the full amount of stock.
Industry standard for early stage companies is four-year vesting with a one year cliff - if you leave before the first year is up, none of your stock is vested, and at the one year mark 25% of your stock is vested - after which you begin vesting monthly (quarterly and annually is also possible) over the remaining three years.
A related concept is the so-called "Reverse Dilution" - when someone leaves the company, their unvested stock is absorbed and all the shareholders benefit ratably from the increase in ownership. The stock doesn’t get reallocated, but rather it goes out of existence. Since this decreases the total amount of shares in existence, all the remaining stockholders now own a larger percentage of the company. Unvested employee options usually go back into the option pool to be reissued to future employees.
Stock Vesting: All stock and stock equivalents issued after the Closing to employees, directors, consultants and other service providers will be subject to vesting provisions below unless different vesting is approved by the Board of Directors (including [the] Series A Director) (the “Required Approval”): 25% to vest at the end of the first year following such issuance, with the remaining 75% to vest monthly over the next three years. The repurchase option shall provide that upon termination of the employment of the stockholder, with or without cause, the Company or its assignee (to the extent permissible under applicable securities law qualification) retains the option to repurchase at the lower of cost or the current fair market value any unvested shares held by such stockholder.
In certain circumstances, the vesting time is dropped, and all the remaining shares or options are vested at the same time. See vesting acceleration below.
- Brad Fed's primer on the vesting process
- Fred Wilson explains stock-options
- Fred Wilson's class on Employees' Equity (video)
10. Redemption Rights
Gives investors the right to have their outstanding shares redeemed by the company at a specified price; usually requires the approval of a majority of shareholders.
Redemption at Option of Investors: At the election of the holders of at least majority of the Series A Preferred, the Company shall redeem the outstanding Series A Preferred in three annual installments beginning on the [fifth] anniversary of the Closing. Such redemptions shall be at a purchase price equal to the Original Purchase Price plus declared and unpaid dividends.
These rights provide VCs with additional downside protection, particularly in cases where a company is successful enough to be an ongoing business but not quite successful enough to go public or be acquired. Also gives VCs a liquidity path, which can be particularly important for a VC making an investment in year five of the fund’s 10-year life span.
Beware the so-called "Adverse Change Redemption", which effectively gives the VC a right to a redemption in the case of a “material adverse change” to the company’s business.
Adverse Change Redemption: Should the Company experience a material adverse change to its prospects, business or financial position, the holders of at least majority of the Series A Preferred shall have the option to commit the Company to immediately redeem the outstanding Series A Preferred. Such redemption shall be at a purchase price equal to the Original Purchase Price plus declared and unpaid dividends.
As with dividends, make sure redemption rights require a majority vote of all classes of preferred shareholders.
- Brad Feld on the worth - to investors - of redemption rights
- "What are redemption rights?" by Yokum Taku
Even though a VC usually has less than 50 % ownership in a company, they may have some control provisions that give them a lot of control. Here are the key control terms, explained.
1. Conditions Precedent to Financing
Since term sheets are often non-binding, VCs will load them up with conditions precedent to financing, which occasionally have additional ways out of a deal for the investor. Try to avoid conditions precedent to financing as much as possible, and do not agree to pay for the VC’s legal fees unless the deal is completed. A standard condition for a first-time financing is:
Each Founder shall have assigned all relevant IP to the Company prior to closing.
Three conditions to watch out for:
- Approval by investors’ partners (or anybody): you should always deal with the decision maker.
- Rights offering to be completed by company: the VCs want to offer all previous investors in the company the ability to participate in the currently contemplated financing. Not necessarily a bad thing, as in most cases it serves to protect all parties from liability, but it does add time and expense to the deal.
- Employment agreements signed by founders as acceptable to investors. Be aware of what the full terms are before signing an agreement, and insist on spelling out key terms such as compensation and what happens if you get fired before signing a term sheet and accepting a no-shop clause. Here's a standard employment agreement and an Invention Assignment.
2. Voting Rights
Voting rights are very important as they determine who controls the company. When all of a company’s shareholders vote, they often do so in either a common-stock-“majority rules” fashion or by some other predetermined threshold. In most cases, preferred stock votes in an “as-if-converted basis”. That is to say, the number of votes each share of preferred stock gets is as if the preferred stock had been converted to common stock; the conversion rate is typically 1:1 at the time of stock issuance. A favorable conversion rate is preserved through subsequent financing rounds through anti-dilution measures (see above), and can result in a higher per-share voting power for preferred stockholders.
The voting rights of stockholders are written in the term sheet. A typical example of how voting rights are split up:
- Series A preferred holders (voting as a separate class) can elect one member of the company’s board of directors.
- Common stockholders (usually founders) can elect one member to the board
- The remaining directors are selected eiither:
- (If the VC controls more than 50% of the capital stock) by both the common and preferred, or
- (if the VC controls less than 50%) by the mutual consent of the board of directors
See next chapters on Board of Directors and Protective provisions for more ramifications of voting rights.
3. Board of Directors
The Board of Directors is the corporate organism that controls the direction of the company. A board that gives the VCs enough influence without giving complete control could be structured as follows:
- CEO / Founder (VC usually wants 1 board member to be the CEO)
- VC 1
- VC 2
- Outside (independent) member
VCs may want to include a board observer (in addition to/instead of an official member). He won’t have a vote, but he can sway the discussion. In small companies, the Board is only comprised of three members, for example:
Two directors elected by holders of a majority of common stock, one elected by holders of a majority of Series Seed.
The board of a mature company (contemplating its initial public offering) would be larger, with around 7-9 members. Board members are usually not compensated with a salary, but with stock options. Sometimes they get travel expenses to board meetings.
4. Protective Provisions
These are simply the veto rights of investors. Ideally you want to have few or none of these protective provision, but VCs want more and some typical ones often end up in the term sheet. Protective provisions say that you can not do any of the following, unless the investors agree:
- sell the company (liquidation event);
- change the terms of stock owned by the VC (e.g., the liquidation preferences: actual preference, fully participating, etc.);
- authorize the creation of more stock (this means that the next round of funding can be vetoed);
- issue stock senior to or equal to the stock held by the VC;
- change the certificate of incorporation or bylaws;
- change the size of the board of directors;
- pay or declare a dividend;
- buy back any common stock (which may happen if one of the original employees has founder’s stock with a buy-back guarantee and then leaves; the company will buy back the unvested portion of the stock);
- borrow money (it is normal to set a debt threshold).
Votes together with the Common Stock on all matters on an as-converted basis. Approval of a majority of the Preferred Stock required to: (i) adversely change rights of the Preferred Stock; (ii) change the authorized number of shares; (iii) authorize a new series of Preferred Stock having rights senior to or on parity with the Preferred Stock; (iv) redeem or repurchase any shares (other than pursuant to the Company’s right of repurchase at original cost); (v) declare or pay any dividend; (vi) change the number of directors; or (vii) liquidate or dissolve, including any change of control.
If there are other financing rounds (e.g. new class of preferred stock after a Series B);
- new investors can get their own protective provision, or
- Series B investors can vote with original investors as one class of shareholders.
Series B investors will usually ask for a different vote because their interests may be different from the original investors. It is in your best interest to have a single vote - otherwise there are 2 classes of possible vetoes
- Rundown of some standard, and some not so standard, protective provisions
- Brad Feld on protective provisions
5. Information Rights
Define the type of information the VC legally has access to and the time frame in which the company is required to deliver it. You should run a transparent organization anyway, and if you are paranoid about information getting out, feel free to insist on a strict confidentiality clause to accompany the information rights. THis is a very standardized term, and the following wording is common in a term sheet:
Investors who have invested at least $________ (“Major Investors”) will receive a standard information and inspection rights and management rights letter.
6. Co-Sale Agreement / Tag-along
We already covered the right of first refusal on sales of common stock: it defines who can stop the company or a major shareholder from transferring shares, and it is generally included in the bylaws of the company.
The co-sale / tag along provision takes this concept a step further: if a founder finds an opportunity to sell shares (liquidation event), the investors will have the right to sell a proportional amount of their stock as well. It is unlikely that you can eliminate this clause, but it's fair to ask for a floor to it; if you want to sell a small amount of stock to buy a house, why should a VC hold it up?
Company first and Investors second (to the extent assigned by the Board of Directors,) will have a right of first refusal with respect to any shares of capital stock of the Company proposed to be transferred by Founders [and future employees holding greater than 1% of Company Common Stock (assuming conversion of Preferred Stock and whether then held or subject to the exercise of options)], with a right of oversubscription for Investors of shares unsubscribed by the other Investors. Before any such person may sell Common Stock, he will give the Investors an opportunity to participate in such sale on a basis proportionate to the amount of securities held by the seller and those held by the participating Investors.
7. No-Shop Agreement
This clause forces you to stick to a leading VC and work in good faith towards closing a deal. The no-shop agreement lasts for a set time period - at least 30 days. You should ask that the no-shop agreement clause expire immediately if the VC walks away, and also consider an exception for acquisitions, as financings and acquisitions frequently follow each other around (remember Instagram's story?).
For a period of thirty days, the Company agrees not to solicit offers from other parties for any financing. Without the consent of Investors, the Company will not disclose these terms to anyone other than officers, directors, key service providers, and other potential Investors in this financing.
Gives investors the ability to transfer their shares to partnerships or funds, which agree to be subject to the terms of the Stock Purchase Agreement and related agreements. Make sure that “assignment without transfer of the obligation under the agreements” does not occur, since you need to make sure that anyone who is on the receiving end of a transfer abides by the same rules and conditions that the original purchasers of the stock signed up for.
Each of the Investors shall be entitled to transfer all or part of its shares of Series A Preferred purchased by it to one or more affiliated partnerships or funds managed by it or any or their respective directors, officers or partners, provided such transferee agrees in writing to be subject to the terms of the Stock Purchase Agreement and related agreements as if it were a purchaser thereunder.
States that the company will indemnify investors and board members to the maximum extent possible by law. Generally unavoidable, it means that the company needs to sign an Indemnification Agreement with each executive. Recommended to have reasonable and customary directors’ and officers’ insurance for yourself as much as for your VCs.
Summarizes who owns what part of the company before and after a financing; includes the following information for each owner: price per share, number of shares owned, the value of the ownership stake (number of shares multiplied by price per share), and the size of each ownership stake as a percentage of the total size of the company.
Also called "down round": the situation when actual return on investment is lower than the projected or expected return, i.e. a company who raises another round of financing at a lower valuation than the last round.
A provision that allow a shareholder (investors or founders) to "drag" the resto of the shareholders along to sell the company. You can read it as a reverse tag-along right. You can negotiate:
- to have a drag-along right agreeing to follow the vote of a majority of common stock holders (which would be the founders) instead of the preferred stockholders
- to require the drag-along right to be exercised only when there is a supermajority of preferred stockholders (2/3)
- to require the approval of the board of directors in order to be effective (the board would have to conclude that the sale is in the best interest of the company)
Taking into account all of the shares, including those in the employee/option pool.
A liquidity event in which the shareholders receive proceeds for their equity (money for their proportionate ownership stake in the company); includes mergers with other companies, acquisitions by other companies, changes in control and of course IPOs.
If an investor mentions a valuation without stating whether it's pre-money or post-money, make sure to ask him to clarify. A VC will usually mean post-money valuation.
- Pre-money valuation: what the investor is valuing the company at today, before investment.
- Post-money valuation: the pre-money valuation + the contemplated aggregate investment amount.
Vesting stock options or shares usually occurs gradually, unless special events happen and the vesting suddenly accelerates so that all options/shares are vested at once.
- Double-trigger Acceleration is the most standard type and requires two things to occur: an acquisition of the company and the employee in question being fired by the acquiring company without cause.
- Single-trigger Acceleration - simply if there's a sale or merger of the company; it doesn't matter if there's a lay-off.
It will be hard to remember everything, particularly if you're tight with time. Here's a checklist of the most important things to spot on the term sheet you just received.
- Price: Remember that price is expressed in price per share, on a fully-diluted basis, so note the total number of shares and keep that number in mind in order to have an accurate valuation amount in mind.
- Capitalization Table: Make sure you’re clear about all the numbers in the cap table and who owns what.
- Dividends: Standard dividends for seed rounds are 6-8%. Make sure that dividends have to be approved by a majority of the board of directors, and be aware of when dividends must be given out, and check that they are non-cumulative.
- Liquidation Preference: Make sure that the Actual Preference multiple is a 1x. If it’s not, find out why.
- Conversion: Remember that preferred shareholders can convert shares to common stock (to get paid better at liquidation or to control a vote) but they cannot convert back.
- Automatic conversion: Thresholds for automatic conversion are essential to negotiate- you want them lower to have more flexibility. Also remember to never have different automatic conversion terms for different series of preferred stock or you’re going to lose your mind. Everybody must convert in IPO scenarios.
- Anti-dilution: Just make sure you’re aware of what kind of anti-dilution is set out, and keep in mind that more exceptions are better.
- Pay-to-Play: The more severe the sanctions are on investors who don’t participate in subsequent rounds of financing, the better.
- Employee Pool/Option Pool: Make sure that the size of the pool is proportional to the number of employees you anticipate having, but not excessively large; 15% is usually a middle-ground number.
- Redemption Rights: Make sure redemption rights require approval by a majority of all classes of preferred shareholders. Never agree to an "Adverse Change Redemption".
- Conditions Precedent to Financing: Read these carefully as usually are obligations for the company. Don’t agree to pay for the VC’s legal fees unless the deal is completed. Here are 3 things to watch out for:
- approval by Investors’ Partnerships or anybody;
- rights offering to be completed by company (usually adds time and expense to the deal);
- employment agreements signed by founders as acceptable to investors (be aware of what the full terms are before signing, make sure to spell out key terms like compensation or what happens if you get fired before term sheet signing).
- Voting Rights: Remember that voting rights for common stock holders and preferred stockholders should be specified in the term sheet so that there is a clear procedure for how to elect the board of directors. In general, be aware of how the voting rights are distributed, since for many matters, that is how power in the company is allocated.
- Board of Directors: Be careful to give the VC enough influence without complete control, keep in mind that board members can sway the board’s vote. Remember that board members do not get a salary.
- Protective Provisions: You want to have fewer or none of these. The VC can veto your decision to do any of the actions mentioned in the protective provision. Remember to have a provision that provides for the Series A protective provision to no longer control once Series A investors control less than a certain percentage of the company’s capital stock (e.g., because of new investors).
- Information Rights: Don’t argue over information rights, since you should be running a transparent organization anyway, but if you want to make sure information doesn’t get out, insist on a confidentiality agreement.
- Co-Sale Agreement: Make sure there is a limit to how much stock investors can proportionally sell relative to yours.
- Restrictions on Sales: Be aware of who has the power to restrict sales/transfers of stock.
- No-Shop Agreement: Should not be longer than 60 days. Should expire immediately if the VC walks away.
- Assignment: Make sure there is no assignment without transfer of the obligation under the agreement.
- Drag-Along Agreement: You can propose a drag-along agreement so that investors will be forced into selling the company at a certain point or the investors may propose one, where you would be forced to sell if the majority of preferred stockholders vote that way. You can ask the investors to compromise by requiring that a qualified majority of the preferred stockholders need to vote to sell, or by requiring the board of directors to approve the sale.
- Venture Deals by Brad Feld and Jason Mendelson (and their Ask The VC blog)
- The Venture Hacks Bible by Venture Hacks
- Fred Wilson's MBA Mondays
- Quora Term Sheet Board
- Startup Company Lawyer by Yokum Taku and in particular his comprehensive comparison of financing documents
- Funders' Fund Guide to Term Sheets (PDF)