When a startup begins to attract interest from investors, one of the first formal steps in the investment process is the negotiation of a term sheet. A term sheet outlines is the basic terms and conditions under which an investor is willing to invest in your startup. It’s a crucial document that sets the foundation for the final investment agreement and can significantly impact the future of your business. Understanding the key clauses in a term sheet is essential for founders to ensure they are making informed decisions and protecting their interests. In this write-up, I will explore the most important clauses in a term sheet and explain what they mean.
- Valuation
Pre-Money Valuation: This is the valuation of your company before the new investment is added. It represents the current worth of your company as agreed upon by you and the investor. For example, if your startup has a pre-money valuation of $5 million and an investor is putting in $1 million, the post-money valuation would be $6 million.
Post-Money Valuation: This is the valuation of your company after the new investment has been added. It’s calculated by adding the pre-money valuation to the amount of the new investment. The post-money valuation determines the investor’s ownership percentage in your company.
Understanding your company’s valuation is critical because it directly affects how much equity you are giving up in exchange for investment.
- Equity Structure
Common Stock: Common stock represents ownership in the company and usually comes with voting rights. Usually, employees and founders own common stock.
Preferred stockholders: Preferred stockholders have a higher claim on the company’s assets and earnings than common stockholders. They may receive dividends and have liquidation preferences, which I will discuss below. Investors typically receive preferred stock.
Convertible Notes: In some cases, investors may provide funding through convertible notes, which are debt instruments that convert into equity at a future date, often during a subsequent funding round. The conversion terms are usually tied to the company’s valuation at that time. The equity structure outlined in the term sheet determines the rights and privileges of different classes of stockholders and can have significant implications for control and profit distribution.
- Liquidation Preference
Liquidation preference determines the order in which investors are paid in the event of a liquidation event, such as the sale of the company or its assets. It specifies the amount that preferred stockholders receive before any money is distributed to common stockholders.
1x Liquidation Preference: This means that preferred stockholders will receive their initial investment back before any remaining proceeds are distributed to common stockholders. For example, if an investor puts in $1 million, they will receive $1 million back before others share in the proceeds.
Participating vs. Non-Participating:
Participating Preferred Stock: Investors with participating preferred stock receive their liquidation preference first and then participate in the remaining proceeds alongside common stockholders.
Non-Participating Preferred Stock: Investors with non-participating preferred stock only receive their liquidation preference and do not participate in the remaining proceeds. Liquidation preference can significantly impact how the proceeds of a liquidation event are distributed and is a crucial clause to understand in a term sheet.
- Dividends
A company’s dividends are disbursed to its stockholders from its profits. The term sheet will specify whether dividends are cumulative or non-cumulative.
Cumulative Dividends: These are dividends that accrue over time, even if they are not paid out in a given period. When dividends are finally paid, cumulative dividends are given priority.
Non-Cumulative Dividends: These dividends do not accrue if they are not declared. If the company doesn’t declare a dividend in a given period, shareholders do not have the right to claim those missed dividends in the future.
While startups typically don’t pay dividends early on, this clause becomes important as the company matures and generates profits.
- Anti-Dilution Protection
Anti-dilution protection is a clause that protects investors from dilution of their ownership stake if the company issues new shares at a lower price than they initially paid. There are two primary categories of protection against dilution:
Full Ratchet: This provision adjusts the price of the investor’s shares to the price of the new issue, regardless of the number of shares issued.
Weighted Average: This method takes into account both the price and the number of new shares issued to adjust the investor’s share price. It’s less dilutive than full ratchet protection.
Anti-dilution protection can significantly affect the ownership percentages of existing shareholders, so it’s essential to understand how this clause impacts your equity.
- Board Composition
The term sheet will often outline the composition of the company’s board of directors. The board composition determines who has control over major decisions and the strategic direction of the company.
Investor Seats: Investors may request one or more seats on the board. This gives them a direct role in overseeing the company’s operations and making key decisions.
Founder Seats: Founders will typically retain a certain number of seats on the board, allowing them to maintain control over the company’s direction.
Independent Seats: Sometimes, the term sheet will call for the appointment of independent directors, who are not affiliated with either the investors or the founders. Independent directors can provide unbiased perspectives and help balance the interests of both parties.
Understanding the board composition clause is crucial for maintaining the balance of power within the company and ensuring that your interests are protected.
- Voting Rights
Voting rights determine how decisions are made within the company and can vary based on the class of stock. The term sheet may include provisions that give preferred stockholders certain voting rights on key issues.
Protective Provisions: These are specific matters that require the approval of preferred stockholders, such as issuing new shares, selling the company, or changing the company’s charter.
Drag-Along Rights: These rights give majority shareholders the power to compel minority shareholders to participate in the company’s sale on the same conditions. This ensures that a sale can proceed smoothly without minority shareholders blocking the transaction.
Tag-Along Rights: These rights allow minority shareholders to participate in a sale if a majority shareholder sells their stake, ensuring that they receive the same terms as the majority shareholder.
Voting rights are essential for understanding how control is exercised within the company and ensuring that major decisions align with your vision and interests.
- Exit Strategy
The exit strategy clause outlines the possible scenarios for how investors can exit their investment and realize a return. Common exit strategies include:
IPO (Initial Public Offering): Taking the company public by listing it on a stock exchange. As a result, shareholders are able to sell their shares on the open market.
Acquisition: selling the company to another company or a private equity firm. The terms of the acquisition will determine how proceeds are distributed among shareholders.
Buyback: The company or founders may buy back shares from investors at a predetermined price or valuation.
Understanding the exit strategy clause is crucial for aligning your goals with those of your investors and planning for the long-term future of your company.
- Founders’ Vesting Schedule
A vesting schedule dictates when the founders earn their shares outright. This clause is crucial in protecting both the founders and investors by ensuring that founders remain committed to the company.
Standard Vesting Schedule: Typically, founders’ shares vest over a period of four years, with a one-year “cliff.” The cliff means that if a founder leaves the company before the one-year mark, they won’t earn any equity. After the cliff, a portion of the shares vests, and the rest vests gradually over the remaining period.
Acceleration Clauses: These clauses accelerate the vesting schedule under certain conditions, such as a company sale (single-trigger acceleration) or if the founder is terminated without cause following a sale (double-trigger acceleration).
Understanding the vesting schedule helps align the founders’ interests with the long-term success of the company and ensures that equity is earned through continued contribution to the business. A term sheet is a foundational document in the investment process that lays the groundwork for your relationship with investors. Understanding the key clauses and their implications is crucial for making informed decisions that align with your business goals. While this guide provides an overview, it’s always advisable to work with legal and financial professionals to review and negotiate the terms. Properly navigating a term sheet can help secure a favorable deal that supports the growth and success of your startup.
