Thu Apr 25 2024
Founders & Tech Leaders

Understanding Term Sheets: Key Clauses Founders Should Know

Tazeen Fatima
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The fundraising journey for a startup is exciting, but navigating the legalese can be daunting. A term sheet is a crucial first step, outlining the core terms of an investment deal. While not enforceable by law, it sets expectations and guides negotiations. But before celebrating a handshake agreement, founders need to understand the key clauses that impact their company's future.

Key Clauses for Founders

Term sheets typically cover a range of topics, but founders should pay close attention to these essential clauses:

1. Valuation and Ownership

  • Valuation: The term sheet specifies your company's valuation before (pre-money) and after (post-money) the investment. This valuation determines how much equity investors will receive in exchange for their investment.
  • Ownership: It outlines the percentage of the company that investors will hold post-investment. As a founder, you want to strike a balance between attracting capital and retaining control.

2. Types of Investment

  • This clarifies what kind of funding is being offered. It could be in the following form:
  • Equity: Investors receive shares in your company in exchange for their investment.
  • Convertible Notes: A debt instrument that converts into equity at a later stage (usually during a subsequent funding round).
  • SAFE (Simple Agreement for Future Equity): A flexible instrument that provides investors with the right to future equity without setting a valuation upfront.

3. Investment Amount and Terms

  • The term sheet specifies the amount of investment and any conditions attached (e.g., tranches, milestones).
  • Investment Terms: These include the investment timeline, disbursement schedule, and any protective provisions.

4. Liquidation Preferences

  • Investors often negotiate for liquidation preferences. These determine the order in which proceeds are distributed during an exit (e.g., acquisition or IPO).
  • Participating Preferred: Investors receive their investment amount plus a share of the remaining proceeds.
  • Non-Participating Preferred: Investors choose between their investment amount or their share of the remaining proceeds.

5. Anti-Dilution Provisions

  • These protect investors from dilution caused by future funding rounds at a lower valuation.
  • Full Ratchet: Adjusts the conversion price of existing shares to match the new valuation.
  • Weighted Average: Dilution is calculated based on the average of old and new valuations.

6. Voting Rights and Controls

  • This outlines voting power for major decisions and board representation for investors. Founders should ensure they retain enough control for strategic direction.
  • Protective Provisions: Investors can veto certain actions.
  • Board Seats: Investors may request representation on the board.

7. Founder Vesting and Equity Ownership

  • Vesting: This specifies how founders acquire full ownership of their company shares over time. Vesting schedules typically range from 3-4 years.
  • Equity Pool: Reserved shares for future employees and advisors.

8. Rights of First Refusal and Co-Sale

  • Right of First Refusal: These rights give investors the first option to buy shares if a founder wants to sell.
  • Co-Sale Rights: Investors can sell their shares alongside founders during an exit.

9. Exit Rights and Restrictions

  • This outlines how investors can exit their investment, potentially through acquisition or IPO (Initial Public Offering). Founders should be aware of any restrictions on their ability to sell the company. E.g.
  • Lock-Up Periods: These restrict founders and investors from selling their shares for a set time, ensuring company stability.
  • Drag-Along Rights: Investors can force founders to sell their shares during an acquisition.
  • Tag-Along Rights: Investors can participate in a founder’s sale.

Understanding these clauses empowers founders to negotiate effectively and secure a term sheet that aligns with their company's vision and long-term goals. Consulting with a lawyer experienced in startup financing is highly recommended to ensure all terms are clear and favorable.

Remember to:

  • Not rush the process. Take time to understand each clause and its implications.
  • Negotiate! Term sheets are starting points, and many clauses can be adjusted.
  • Get it in writing. Even though a term sheet is non-binding, ensure all agreed-upon terms are documented.

By understanding term sheets and approaching them strategically, founders can secure funding that fuels their startup's growth and sets them on the path to success.

What are the Next Steps After Agreeing on a Term Sheet?

Once both parties have agreed on the term sheet, the next steps involve finalizing the deal and moving towards closing the investment. Here’s what founders should consider:

1. Due Diligence:

The investor will conduct thorough due diligence on your company. This involves reviewing financials, legal documents, contracts, intellectual property, and other relevant information. Be prepared to provide the necessary documentation.

2. Definitive Agreements:

Draft and negotiate the definitive legal agreements based on the term sheet. These agreements include the Stock Purchase Agreement (SPA) or Asset Purchase Agreement (APA). Seek legal counsel to ensure clarity and alignment with the term sheet.

3. Legal Review:

Both parties should engage legal advisors to review and finalize the agreements. Address any discrepancies or concerns during this process.

4. Conditions Precedent:

Identify any conditions that must be met before closing the deal. Common conditions include regulatory approvals, shareholder consent, and third-party consent.**

5. Closing:

Once all conditions are met, the closing occurs. This involves signing the definitive agreements, transferring ownership, and disbursing funds. Legal representatives facilitate this process.**

6. Post-Closing Obligations:

After closing, fulfill any post-closing obligations outlined in the agreements. These may include reporting requirements, transition services, or other commitments.**

Remember, each deal is unique, and seeking professional advice ensures a smooth transition from a term sheet to a successful investment partnership.

Frequently Asked Questions

What is included in an Investment Term Sheet?

An investment term sheet typically covers:

  • Investment Amount: The amount of money the investor will provide.
  • Valuation: The pre-money valuation of the company and the resulting ownership percentage.
  • Investment Terms: Conditions of the investment, such as equity or convertible note.
  • Liquidation Preference: Priority of payment to investors in the event of a liquidation.
  • Governance Rights: Rights regarding board seats, voting rights, and information access.
  • Protective Provisions: Measures to protect investor interests, such as veto rights.
  • Conditions Precedent: Conditions that must be met before the investment is finalized.
  • Legal and Regulatory Considerations: Compliance with laws and regulations governing investments.

Term Sheet vs LOI(Letter of Intent): what’s the difference?

Term sheets are non-binding documents outlining key deal terms, serving as a negotiation roadmap. LOIs, while also non-binding, express a stronger commitment to a deal with more detailed terms, initiating due diligence processes.

What does a typical Term Sheet format include?

Term sheets generally follow a structured format that includes:

  • Header: Identifying the parties involved and the date.
  • Introduction: Brief overview of the proposed transaction.
  • Deal Terms: Key terms such as valuation, price, and payment terms.
  • Conditions: Major conditions that must be met for the deal to proceed.
  • Legal Provisions: Clauses regarding confidentiality, exclusivity, and governing law.
  • Signatures: Space for signatures or acknowledgment of agreement.
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