Term Sheets

Maret Delf

Here, we’ll describe the terms that a standard equity financing term sheet will likely cover*. There will inevitably be more to negotiate between signing the term sheet and closing the round - more on that process here - but a term sheet should cover the high-level economics, stockholder protections, and mechanics of the financing. An investor’s goal in drafting a term sheet is to be as concise as possible while also including all of the terms that are important enough to impact whether you move forward with the deal.

Economics & Ownership Terms

Round Size & Allocations: The term sheet will specify how much money the company will raise in connection with the proposed financing, as well as how much the lead investor (the one that drafted the term sheet) will invest. Other expected investor allocations (i.e. investment amounts) might be specified as well, but that’s not necessary.

Series of Stock: Will the investor be buying Series Seed Preferred Stock? Series A? Etc.

Valuation: The term sheet will include the company’s valuation that the investor is proposing for the new financing round, which impacts how much ownership they get. The valuation will usually be quoted on a “post-money” basis, i.e. what will the company be worth right after the financing is done. 

  • You can divide someone’s investment amount by the post-money valuation to see how much ownership their investment will result in. For example, an investor who invests $10 million at a $100 million post-money valuation will own 10% of the company (10 divided by 100) after the financing.
  • The valuation language will likely clarify that any SAFEs/Notes that will convert into stock in connection with the financing will be accounted for in the price that the new investors pay, i.e. on a “pre-money” basis, so that they don’t dilute the new investors.

Option Pool: Many term sheets specify what the post-financing available option pool should be, expressed in terms of its % of the cap table. E.g. requires a 15% post-round available option pool. 

  • Investors typically determine this number after talking to you about your future hiring plans - i.e. how many option shares will you need to offer people in order to recruit them?
  • Any option pool increase that the company needs to make in order to meet this % requirement will also be accounted for on a “pre-money” basis, such that the new investors aren’t diluted by the increase.

Liquidation Preference: The term “liquidation preference” refers to who gets paid back when the company exits, and how much, and in what order. Preferred Stock typically gets “senior” liquidation preference over Common Stock, which means it’s paid out first if there isn’t enough money to go around. 

  • The standard liquidation preference for Preferred Stock is “1x non-participating”. This means that, in a sale, the Preferred Stock can either get paid 1x back first (i.e. they get their money back), OR convert into Common Stock and be paid out that way along with everyone else. 
  • Sometimes you’ll see liquidation preferences higher than 1x (e.g. 1.5x, 2x). Usually, when investors ask for that, it’s because they think the investment risk is higher than normal; for example, if the company’s in distress. 
  • All classes/series of Preferred Stock (e.g. Series Seed, Series A, Series B) typically are on the same ‘level’ of liquidation preference in that they can all get paid out at the same time (“pari passu” or “on equal footing”), and then the Common is paid out. But, on rare occasions (e.g. in a distressed financing) you’ll see a later investor ask that their liquidation preference be senior to the other series of Preferred as well. 
  • “Participating” liquidation preference is rare; it allows investors to double-dip by getting paid back 1x (or more) first, and then also converting into Common and being paid out with everyone else that way, too.

Pro Rata Rights: A pro rata right is the right for an investor to invest a certain % of whatever future rounds the company raises. Although people sometimes conceptualize it as “the right to invest enough to maintain the same ownership amount,” that’s not quite right - largely because option pool increases in future rounds dilutes existing investors. So, even if they invest their pro rata amount, their ownership ends up being slightly lower post-round due to option pool-related dilution. 

  • The most typical way to calculate pro rata is to divide the investor’s current number of shares by the total number of shares on the cap table (excluding unissued option pool). This will give you the investor’s pro rata % - which is the % of the new round that they’re entitled to invest.
  • Often, companies only give pro rata rights to “Major Investors.” The definition of that term is a point of negotiation, but typically it will be drafted to include only the round’s lead investor (and any other investors putting in a large % of the round). If only a handful of investors have Major Investor status (and therefore the associated rights), it’s much easier for the company to manage.

Protections & Other Rights

Board Composition: This one’s pretty straightforward - who’s going to be on your Board of Directors? Usually, the lead investor from each round gets the right to appoint one seat on your Board. 

  • An important term re: Board compsition is whether a “service provider requirement” is applied to the Board seats that are elected by the Common Stock. This requirement says that only the folks who are providing services to the company (e.g. as employees or consultants) get to vote on who sits in the Common Stock Board seat(s). 
  • Service provider requirements prevent a situation in which someone leaves the company but still exerts control (via voting their shares) over key items like Board composition (or exits - see below re: Drag-Alongs). Ex-employees retaining that control can be especially problematic if they hold a bunch of shares, and/or if their departure wasn’t on good terms. This is definitely a nuance to discuss with your counsel. 

Protective Provisions: “Protective provisions” is the term for the major things that the company can’t do without consent of the Preferred Stockholders. These are your investors’ main way to protect (to some extent) their rights and ownership. 

  • Usually “getting consent of the Preferred” means getting approval from the majority of all outstanding Preferred Stock. But, you’ll sometimes see different thresholds (i.e. 65% of Preferred) in order to accommodate various cap table dynamics.
  • Protective provisions commonly cover major decisions like sales/liquidations, future financings, Board changes, and debt, among other things.

Drag-Along: A “drag-along” is a provision wherein your stockholders agree to auto-approve a sale of the company if specified groups / “buckets” of people have approved it already. Usually these buckets are: majority of Common Stock, majority of Preferred Stock, and (sometimes) the Board. 

  • A “drag-along” can really facilitate the acquisition of the company, because acquirers often require that the sale be approved by 95%-99% of the company’s stockholders. It’s a big hassle to get approval from 99% of your stockholders individually; much easier to rely on the drag-along to guarantee that everyone auto-approves the sale once the aforementioned “buckets” of stockholders have approved it.
  • The “service provider requirement” that we mentioned in the Board Composition section above is a term often applied to the drag-along as well. If that’s the case, then only the people who are currently working for the company get to vote on whether the drag-along is triggered (i.e. the “majority of Common” bucket is actually “majority of Common Stock held by those then providing services to the company”). 

Information Rights: These are rights (typically only given to “Major Investors”) that entitle an investor to some amount of information about the company - for example: financial statements, cap table, and annual budget. Investors often need this information for their own accounting and reporting purposes.

ROFR Rights: For context, if a holder of the company’s Common Stock wants to sell their shares, they first have to offer those shares to the company for repurchase. If the company doesn’t want them, the next step is to offer those shares to the investors (usually only Major Investors) who have a right of first refusal (aka ROFR). If those investors want to buy the shares, they have the right to buy them (on the same terms that they’re proposed to be sold otherwise).

Co-Sale Rights: This right is also usually only given to Major Investors. It means that, when a holder of the company’s Common Stock wants to sell their shares, investors with a co-sale right can choose to “participate” in that sale by selling some of their shares alongside the initial seller, on the same terms and to the same buyer(s) (thus decreasing the number of shares the initial seller ends up selling). Investors rarely use this right.

Investor Director Approvals: Investors sometimes ask for special investor director approvals, which is a list of things that require approval specifically from that investor’s Board member. These often relate to things that would either (1) impact the company in a meaningful way that the investor isn’t otherwise protected against (e.g. changing the principal line of business, or selling important IP), or (2) involve a conflict of interest for the founders who are on the Board (e.g. determining founder compensation, or approving related-party transactions).

Catch-All: There’s usually a catch-all sentence referencing other rights that aren’t important enough to spell out at the term sheet stage. For example, the term sheet will say something like: “Investors shall be entitled to other standard rights such as registration rights, antidilution rights, and conversion rights.” Since these terms are usually pretty boilerplate and noncontroversial in the financing docs, it’s not worth detailing anything about them in the term sheet.  

Other Terms You Might See

  • Vesting: Investors will often clarify in their term sheets (especially for early financing rounds) what they expect founders’ and others’ vesting schedules to look like. 
  • Expiration: Your lead investor may include a date upon which their term sheet expires, depending on the deal dynamics. If an expiration date is included, it’s usually between 2-5 days(ish) after the date they issue the term sheet.
  • Lead investor approval of other investors: Often, the lead investor who drafts the term sheet will request that they get to approve additional investors in the round. The dynamics of the round will impact how much your lead investor cares about this term.
  • Expense Reimbursement: It’s standard for the company to cover the investor’s legal costs, up to a certain maximum amount (e.g. “The company will cover investor legal fees up to $30,000”).
  • Exclusivity & Confidentiality: These are boilerplate rights, which say (respectively) that, the company can’t continue marketing the deal to other investors after signing the term sheet, and that the company will keep the round and its terms confidential. These rights are notable in that they’re often the only binding obligation in a term sheet (i.e. the only terms that the company is bound by even if the deal doesn’t go through). 
  • Documentation: Investors will often clarify that they expect the documentation for the financing round to be on industry-standard forms (i.e. NVCA forms). 
  • Closing Conditions: Sometimes investors will include a quick laundry list of some other items they need before closing the deal, like a Side Letter (or “Management Rights Letter”), or a document called a Legal Opinion.

Different investors have different priorities and requirements, so the term sheets you get might include a patchwork of the terms we listed above. 

We know this sounds like a lot, but it can usually be covered in 2-3 pages of a well-drafted term sheet. Happy fundraising!

*NOTE: Of course, as companies grow, they diverge and differentiate - and so do the circumstances in which they're raising money. So, the terms of later rounds of financings will sometimes look different than the "vanilla" stuff we refer to here as being the standard.

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