Ultimate Practical Guide to review a Term Sheet in Venture Financing

Venture financing deals usually involve the signing of the following documents:

  1. Term Sheet: The term sheet is a non-binding document outlining the basic terms and conditions under which an investment will be made.
  2. Share Purchase Agreement (SPA): The SPA is a central document in any VC deal. It sets out the specific terms of the transaction, including the number of shares being sold, the price per share, and the total investment amount. This agreement also covers representations and warranties, conditions to closing, and indemnification provisions
  3. Disclosure Schedule for SPA: This schedule accompanies the SPA and provides specific disclosures related to the representations and warranties in the SPA. It often includes exceptions or additional details that qualify or explain these representations and warranties, which are vital for assessing risks and obligations.
  4. Voting Agreement: The voting agreement details how certain shareholders must vote their shares, particularly in the context of board composition, sale of the company, and other major corporate decisions. It's essential for maintaining investor rights and balancing interests among different shareholder classes.
  5. Investor Rights Agreement (IRA): This document outlines various rights and privileges granted to investors, including rights to information, registration rights, and other governance-related matters.
  6. Right of First Refusal / Co-sale Agreement: This agreement provides the company, and sometimes other shareholders, the right to buy shares before the selling shareholder can transfer them to a third party (Right of First Refusal). It may also allow shareholders to join in on a sale (Co-sale).
  7. Certificate of Incorporation: Outlining the rights and privileges associated with preferred stock, which is commonly issued to venture investors.

In this guide, we will focus on the Term Sheets. Our goal is to provide comprehensive guidance for effectively reviewing, negotiating, and advising on the Term Sheets in a VC deal.

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Understanding Term Sheets in VC Deals

A term sheet in the context of venture capital (VC) is a critical document that outlines the key terms of a deal between a venture capital firm and a company seeking investment. It serves as a preliminary agreement or a letter of intent, capturing the principal financial and legal conditions proposed for an investment.

The term sheet summarizes all significant terms related to a contemplated VC transaction. It includes details like the amount of investment, valuation of the company, equity stake to be received by the investor, voting rights, liquidation preferences, anti-dilution provisions, and other key terms.

Term sheets are typically drafted by the venture firm or the lead investor in an investment round. The document signifies the investor’s interest in the company and proposes the terms under which they are willing to invest. It is not just a proposal but also a starting point for negotiations. It is presented to the company's founder or executive team, who then engage in discussions with the investors to agree on the terms. These terms, once agreed upon, form the basis for drafting more detailed legal documents, such as Share Purchase Agreements, and modifying the company’s Articles of Incorporation as necessary.

Term Sheets are Non-Binding

A term sheet, in its essence, does not constitute a binding legal contract. It's important to recognize that while it outlines the proposed terms of a deal, it doesn’t legally compel either party to finalize the transaction. Despite its non-binding nature, there is an implied expectation that both parties - the investor and the entrepreneur - will negotiate in good faith. This means that while the terms are not enforceable by law, they reflect a mutual understanding and an intent to move forward with the deal as outlined.

Reviewing a Term Sheet Section by Section

1. Reviewing the Opening Section

  • The Preamble: The preamble of a term sheet can contain important exclusions or assumptions about the term sheet's validity period and the entrepreneur's capacity to present the deal to other investors. Look for any clauses that specify a quiet or lock-up period, which restrict the company's ability to discuss the term sheet with third parties or solicit other term sheets. This period typically begins on a specified date and includes restrictions on communication and agreements with parties other than the interested investors.
  • Opening Information: The first paragraph, although sometimes not present, is vital for providing a snapshot of the deal. It typically includes the name of the company being funded, a subtitle summarizing the terms for the proposed private placement (e.g., Series A Preferred Stock), and the name of the stock issuer. This section is particularly important for those not intimately familiar with the transaction, as it clarifies the nature and scope of the deal.
  • Investor Identification: In the opening, pay attention to how investors are identified. This might include the name of the VC firm, often a limited partnership (L.P.), and any individual or corporate investors who may be part of the syndicate investing alongside the venture fund. Understanding the composition of the investor group is crucial for grasping the dynamics of the investment round.

2. Reviewing Total Amount Raised, Number of Shares, and Purchase Price Per Share

  • Total Amount Raised: This section specifies the total capital the company aims to raise in this round of financing. It's a key figure that reflects the company's current valuation and funding needs. Ensure that this amount aligns with the company's financial projections and capital requirements.
  • Number of Shares: This represents the total number of shares to be issued in the financing. This figure is crucial for understanding how the investment will dilute existing shares and what percentage of ownership each new share represents. Confirm that the number of shares aligns with the company’s capitalization table and does not excessively dilute existing shareholders.
  • Purchase Price Per Share: This is the cost for each share being offered in the round of financing. It is critical for determining the valuation of the company and the cost for new investors to acquire equity. The purchase price per share should reflect the current market value of the company and be consistent with industry standards and valuations of similar companies at similar stages.
👉 **Note:** It's important to verify that **the Total Amount Raised equals the Number of Shares multiplied by the Purchase Price Per Share**. Any inconsistency in these figures can indicate errors in valuation or share allocation, which could significantly impact the deal's fairness and attractiveness to both current and prospective investors.

3. Reviewing the Post-Financing Capitalization Section

The Post-Financing Capitalization provides a comprehensive view of how the new financing will affect the company's capital structure and valuation. You should pay close attention to several key aspects:

  • Capital Structure Overview: This section provides a snapshot of the company's capital structure after the new financing. It should include both current and new securities to give a clear picture of the company's post-financing scenario.
  • Pre-Money and Post-Money Valuation: The Post-Financing Capitalization allows you to calculate the company's pre-money and post-money valuations, critical metrics for understanding the deal's impact on the company's value.
    • Pre-Money Valuation: To calculate this, multiply the total number of shares (excluding the new securities but including options and warrants) by the proposed purchase price per share. This figure represents the company's valuation before the new investment.
    • Post-Money Valuation: This is calculated by multiplying the total number of Total Common Equivalent shares by the purchase price per share proposed in the term sheet. This reflects the company's valuation after accounting for the new financing.
  • Total Common Stock Equivalent Calculation: This involves adding the number of common stocks, options, warrants, and any previously issued preferred stock to the number of shares being purchased in the new financing. This total number assumes all types of shares are treated equally in the company's valuation.
  • Preferred Stock Considerations: It's important to understand how preferred stock is treated in the valuation. Preferred stock can carry dividends which may accrue and add to the stock's value under certain circumstances, like liquidation. This factor can significantly affect the valuation, especially when considering the conversion of preferred stock to common stock in the future.

4. Reviewing Dividend Provisions

Dividend Provisions outline how dividends will be handled, affecting the potential return on investment. They provide guidelines for the board in terms of issuing dividends and are especially pertinent in scenarios like company liquidation.

  • Types of Dividend Clauses: Typically, there are three kinds of dividend provision clauses:
    • Investor Favorable: These clauses are structured to maximize benefits for the investor, often featuring a high rate of return and cumulative dividends. In this scenario, dividends are accumulated over time, and if not paid in one year, they are carried over to subsequent years.
    • Middle of the Road: These offer a balance between investor and company interests.
    • Company Favorable: These are more lenient towards the company, possibly featuring lower dividend rates and non-cumulative dividends, which do not accumulate if unpaid.
  • Cumulative vs. Non-Cumulative Dividends: Understanding the difference between these two types is key. Cumulative dividends, if not issued in one year, accumulate and are owed in subsequent years. Non-cumulative dividends, on the other hand, do not carry over. If the company decides not to issue a dividend in a given year, it is not obligated to make up for it in the following years.
  • Impact on Decision-Making: For example, in an Investor Favorable clause with a 15% cumulative dividend rate for Series A preferred shares, any dividends declared would first be allocated to meet this obligation before any distribution to common shareholders. This prioritization of preferred shareholders can significantly influence the company's financial and dividend policies.

5. Reviewing the Liquidation Section

The liquidation preference section outlines how proceeds are distributed in the event of a company's liquidation, sale, or bankruptcy. This clause is designed to protect preferred shareholders in the event the company is liquidated. It determines the order and proportion in which shareholders are paid out, prioritizing preferred shareholders. As you review this section, consider the following key points:

  • Investor Favorable Terms: In a scenario most favorable to investors, the liquidation preference might set a multiple (e.g., three times) on the value of their initial investment. This means that in the event of liquidation, preferred shareholders would receive a return of three times their initial investment before any proceeds are distributed to other shareholders, including common shareholders.
  • Middle of the Road Terms: A more balanced approach would first return the original purchase price plus any unpaid dividends to preferred shareholders. After this, the remaining proceeds are distributed among all shareholders (both common and preferred) proportionally until the preferred shareholders have received a predetermined multiple of their original investment.
  • Time Value of Money Considerations: Venture capitalists are acutely aware of the time value of money. A multiple return (like 3x over four years) must be evaluated in terms of annualized return. For instance, a 3x return over four years equates to a 32% annualized return. After accounting for venture fund fees, the net return might fall below 25%, which could be less attractive in the venture capital context.

6. Reviewing Redemption Clauses

The main objective of the redemption clause is to prevent the company from becoming a 'lifestyle' business or part of the 'living dead' – companies that fail to generate significant liquidity events. For VCs, particularly those operating as limited partnerships with a fixed lifespan, ensuring liquidity is crucial.

  • Structure of the Clause: The redemption clause outlines a specific timeframe within which the company must generate a return or face obligations to redeem the investors' interests. This can be triggered if a liquidity event, such as a public offering or buyout, does not occur within a stipulated period.
  • Investor Favorable Terms: In an investor-favorable scenario, the redemption is required relatively quickly and within a shorter timeframe. For example, if a company does not facilitate a liquidity event by a certain anniversary (e.g., the third year), it may be obligated to redeem a portion of the outstanding preferred shares at a predetermined rate, often including a multiple of the original purchase price plus any accrued dividends.
  • Middle of the Road and Company Favorable Terms: More balanced or company favorable terms would lengthen this timeframe or reduce the obligations. The most company-favorable term, of course, would be the absence of a redemption clause.
  • Practical Implications: The redemption clause places a significant responsibility on the company's management to work towards liquidity within the set timeframe. It acts as a motivator for the company to pursue growth and exit strategies aggressively. For instance, in the investor-favorable example, the company would need to start providing liquidity to stockholders after three years if no other liquidity event occurs, putting considerable pressure on management.
👉 **“Use it wisely”:** The aggressiveness of a redemption clause should be aligned with the stage of the company and the nature of the investment. For example, a strict redemption schedule might be more appropriate for later-stage, high-valuation deals, but it can be excessively burdensome for early or expansion-stage companies.

7. Reviewing Conversion and Automatic Conversion Clauses

This clause allows preferred shareholders to convert their shares to common shares, usually on a 1:1 basis. The decision to convert typically occurs during a liquidity event if it promises a higher return than the liquidation preference. This clause is neutral (neither Investor nor Company Favorable) as it benefits all parties during a successful liquidity event.

  • Interplay with Liquidation Preference: The conversion clause is closely linked to the Liquidation Preference clause. Investors may choose to convert their preferred shares to common shares if the potential return from a liquidity event exceeds the predetermined multiple in the Liquidation Preference clause.
  • Automatic Conversion in IPOs: The Automatic Conversion clause is particularly important in the context of an IPO. It specifies conditions under which preferred shares will automatically convert into common shares, addressing concerns specific to public offerings. This clause delineates parameters like the minimum IPO size and the original purchase price multiple that would trigger the automatic conversion.
  • Investor vs. Company Favorable Terms: The terms can vary between being Investor Favorable and Company Favorable. Investor Favorable terms might require a higher multiple of the original purchase price for automatic conversion, ensuring a substantial return. Company Favorable terms might set lower thresholds, making conversion easier to achieve in smaller IPOs.
  • Impact of IPO Quality: The quality of the IPO, including the underwriter's reputation and the amount of money raised, can significantly impact the stock's performance on public markets. A smaller, less prestigious IPO may result in thinly traded stock, affecting the ability of investors to liquidate their holdings.

8. Reviewing Anti-Dilution Clauses

Anti-dilution clauses protect investors from the dilution of their investment's value, particularly in subsequent financing rounds that might occur at a lower valuation (down rounds) or at the same valuation (flat rounds).

  1. Investor Favorable - Full Ratchet: In a full ratchet scenario, the conversion price for the preferred shares adjusts to the price of the new round. For example, if Series A preferred shares were purchased at $2 per share, and a down round occurs at $1 per share for Series B, the conversion price for Series A would adjust to $1. This is highly favorable to Series A investors but can significantly dilute the value of common shares.
  2. Middle of the Road - Weighted Average Conversion: This approach involves adjusting the conversion price based on a weighted average formula. It partially dilutes the value of existing preferred shares but is less drastic than a full ratchet. The weighted average takes into account the new share price and the number of shares issued in the new round relative to the existing shares. This method balances the interests of new and existing investors more evenly.
  3. Company Favorable - No Dilution Protection: In this scenario, there is no dilution protection for investors. This is more common in early-stage investments, like angel rounds, where all shareholders are treated equally regardless of subsequent financing rounds.
  4. Economic Implications of Down Rounds: Down rounds can significantly impact existing shareholders, leading to reduced marketability and potentially souring the attitude of current investors, which might deter new investors.
  5. Play-or-Lose Provisions: Some term sheets include a 'play-or-lose' provision, requiring existing investors to participate pro-rata in new financing rounds to maintain their anti-dilution protections. This encourages ongoing investment support from existing shareholders.

9. Reviewing Voting Rights Clauses

Typically, the term sheet stipulates that all shares, regardless of class, are treated equally when it comes to voting. This means that in shareholder votes, each share, whether common or preferred, has an equal say. This is a standard approach and is usually the same across investor favorable, middle of the road, and company favorable terms.

  • Conversion Ratio and Voting Power: For preferred shares, voting rights are often based on their conversion ratio to common stock. For instance, each share of Series A Preferred might have voting rights equivalent to the number of common shares it can be converted into. This means that if one share of Series A Preferred can be converted into four shares of common stock, it would have four votes in shareholder decisions.
  • Exceptions to Equal Voting: While the general principle is equal voting rights per share, there are exceptions. These exceptions might be specified in the term sheet or be required by law. For example, certain decisions might require a separate vote by preferred shareholders only, or specific issues might be decided by the board, where preferred shareholders may have appointed representatives.

10. Reviewing Protective Provisions

Protective provisions grant certain powers to preferred shareholders, typically requiring their consent for major corporate actions. These actions can include issuing new shares, altering existing shareholder rights, major corporate restructurings like mergers or sales, and changes to the company's charter or bylaws.

  1. Investor Favorable Provisions: In an investor-favorable scenario, these provisions give significant control to preferred shareholders. For example, actions such as altering the rights of Series A Preferred, creating new classes of shares with equal or higher preference, or undertaking significant corporate transactions like mergers may require the consent of a substantial majority (e.g., two-thirds) of Series A Preferred holders. This level of control ensures that the investor's interests are protected against actions that could dilute their investment or alter their rights unfavorably.
  2. Middle of the Road Provisions: These provisions offer a balanced approach, still requiring the consent of preferred shareholders for major actions but potentially lowering the threshold for approval or reducing the scope of actions covered. This setup aims to protect investors while giving the company more flexibility.
  3. Company Favorable Provisions: In a company-favorable setup, the protective provisions are minimized, giving preferred shareholders limited control over company decisions. This scenario might only require a simple majority (50%) of Series A Preferred consent for actions that adversely change their rights or decrease the authorized number of Series A shares. This approach is more lenient towards the company, allowing greater autonomy for management decisions.

11. Reviewing the Board Section

A term sheet normally includes sections related to the composition of board and sections related to board approval.

  • Board Composition Section:

    • Investor Favorable: In this scenario, the board composition is skewed in favor of the investors. They may have the right to appoint a majority of the board members, directly influencing the company's strategic decisions. This setup provides investors with significant control over company operations and major decisions.
    • Middle of the Road: This arrangement typically proposes a balanced board, with equal representation for common shareholders (usually management) and preferred shareholders (investors), plus an independent member agreed upon by both sides. This structure aims to balance the interests of the company and its investors, ensuring fair representation in decision-making.
    • Company Favorable: Here, the board composition is skewed in favor of the company's founders and management. The shareholders vote on an as-converted basis, which often allows the common shareholders to retain control over board composition, thus maintaining more autonomy in company decisions.

  • Special Board Approval Items:

    These items delineate specific actions or decisions that require board approval. They may include:

    • Hiring of officers and senior management.
    • Approval of employment agreements.
    • Setting compensation programs for officers and key employees.
    • Oversight of stock option programs and issuance of stock.
    • Approval of annual budgets, business plans, and financial plans.
    • Real estate transactions.
    • Execution of significant financial obligations or commitments.

    The inclusion and specifics of these items are negotiable but are crucial for understanding the control dynamics within the company. They define the board's role in key operational and strategic decisions, impacting everything from financial management to executive hiring.

12. Reviewing the Information Right of the Investor

Information rights in a venture capital term sheet outline the level of access investors have to a company's financial and operational information.

  • Investor Favorable Information Rights:
    • These rights are extensive and may include what is termed a "forensic audit." Investors can demand access to almost any document, whether audited or unaudited, financial or otherwise.
    • The company is required to deliver audited annual financial statements, unaudited quarterly statements, monthly and quarterly financial updates, and the annual operating plan.
    • Investors also have standard inspection and visitation rights, allowing them to examine company operations more closely.
  • Middle of the Road Information Rights:
    • This scenario still provides substantial access to financial information but might set a threshold for the level of investment that entitles an investor to these rights.
    • The company provides audited annual and unaudited quarterly financial statements, with monthly financial statements and annual operating plans provided under certain conditions.
    • These rights often terminate upon a public offering of the company's stock.
  • Company Favorable Information Rights:
    • In this case, the company limits the information provided to investors.
    • Typically, this includes only audited annual and unaudited quarterly financial statements.
    • As with the Middle of the Road scenario, these rights usually terminate upon a public offering.
  • Observation Rights:
    • Some investors might also require observation rights, allowing them to attend board meetings without voting power. These rights can significantly influence board discussions and provide strategic insights.

13. Reviewing the Right of First Refusal Clause

The Right of First Refusal (ROFR) clause allows investors to influence or control the sale of shares (both preferred and common) in the company. It provides them with the option to purchase these shares before they are offered to outside parties, thus maintaining their stake and influence in the company.

  • Investor Favorable ROFR:

    • Investors have a strong right to purchase any new equity securities the company proposes to offer. This includes any shares not taken up by one investor being offered to other investors. The company can only offer these securities to external parties on similar or better terms if the investors decline to purchase them. This right typically ceases upon a Qualified Initial Public Offering (IPO).

  • Middle of the Road ROFR:

    • The threshold for eligibility to exercise the ROFR is typically set at a certain percentage of share ownership. It provides a more balanced approach, allowing investors who meet the threshold the right to purchase their proportional share of new securities.

  • Company Favorable ROFR:

    • In a company favorable setup, the threshold for exercising the ROFR is usually higher, limiting the number of investors who can exercise this right. This approach provides the company with more flexibility in offering securities to new investors or for other purposes like employee compensation.

    14. Reviewing the Condition Precedent

    The Conditions Precedent section provides a roadmap for what needs to happen post-term sheet agreement and before the closure of the financing round. It ensures that all parties are clear about the steps required to complete the transaction.

    1. Investor Favorable Conditions:
      • Detailed and comprehensive conditions, including:
        • Rigorous due diligence review satisfactory to the investor and their counsel.
        • Customary stock purchase agreements, including plans for stock options.
        • Intellectual property, confidentiality, and non-compete agreements with key employees.
        • Review of the company’s compensation programs, stock allocation, and vesting arrangements.
        • Exclusivity in negotiations and adherence to "no-shop" provisions for a set period.
        • Conversion of all outstanding convertible securities prior to the new financing round.
    2. Middle of the Road and Company Favorable Conditions:
      • These conditions are less stringent compared to investor favorable ones and may include:
        • Completed due diligence reviews satisfactory to the investor and their counsel.
        • Customary stock purchase and related agreements, including stock option plans.
        • Agreement to negotiate exclusively and in good faith, with "no-shop" provisions for reasonable periods.
👉 The no-shop provision is particularly important as it requires the company to cease exploring other financing options for a specified period, ensuring commitment to the current deal.

15. Reviewing Closing Date, Expenses, and Finders Sections

  1. Closing Date:
    • The closing date should be realistic and achievable. Entrepreneurs need to consult with existing investors or advisors to set an optimal date, ensuring enough time for drafting and reviewing legal documents without pressuring new investors to rush the process.
  2. Expenses:
    • Legal expenses can accumulate, especially with multiple law firms involved. Entrepreneurs should be mindful that venture investors often expect the company to bear the legal expenses of the lead investor's counsel.
    • The term sheet might specify how these expenses are handled, ranging from the company paying all fees (investor favorable) to each party bearing their own costs (company favorable).
  3. Finders:
    • The Finders clause addresses the handling of finder’s fees, which are fees paid for introducing the deal to the investor.
    • Typically, the company and investors agree to indemnify each other for any finder’s fees, but it's common for the company to cover these expenses, especially if the deal isn’t highly competitive.

Related Articles:

  1. Share Purchase Agreement: Ultimate Practical Review Guide (https://www.legalnowai.com/pages/share-purchase-agreement-review-guide)

  2. Voting Agreements and Right of First Refusal / Co-sale Agreements: Ultimate Practical Review Guide (https://www.legalnowai.com/pages/voting-and-right-of-first-refusal-agreement-review-guide)

  3. Investor Rights Agreement (IRA) in Venture Financing: Ultimate Practical Review Guide (https://www.legalnowai.com/pages/investor-rights-agreement-review-guide)

  4. Certificate of Incorporation in Venture Financing: Ultimate Practical Review Guide (https://www.legalnowai.com/pages/certificate-of-incorporation-agreement-review-guide)