VC term sheets 101: What a Term Sheet is and What a Term Sheet is Not
What are VC term sheets? As explained by Founders Fund, the VC firm started by Peter Thiel, a term sheet is simply a contract that outlines the key terms of a deal between the startup and a VC and does not represent a legal promise to invest. The “Five Documents” that follow a term sheet – stock purchase agreement, investors rights agreement, certificate of incorporation, ROFR & co-sale agreement and voting agreement – are the true legal deal documents, based on the term sheet.
Key Terminology and Components of the VC Term Sheets
- Pre-Money Valuation- the value of the company before cash is invested. Beware of the option pool shuffle when negotiating pre-money valuation with VCs.
- Post-Money Valuation- pre-money valuation + total new investment = post-money valuation. Brad Feld and Jason Mendelson did a deep dive on VC term sheet pricing back in 2005.
- Type of Security- investors usually receive “preferred” stock in which they often receive the proceeds of an exit before common stock holders.
- Liquidation Preference- primarily a down-side protection for investors in the event of a less than desirable liquidity event (sale, merger, bankruptcy, etc.) that returns money to preferred shareholders before common shareholders. Liquidation preferences today are typically 1x. Bo Yaghmaie of Cooley LLP has written a good primer on liquidation preferences.
- Participation- enables investors to both see a return on their dollar-for-dollar investment defined by the liquidation preference, in addition to participating in the distribution of remaining proceeds based on their ownership percentage. These days, most investors see participation as piggy and less than friendly to those building the company, but if participation enters in to your negotiations, there are lots of details around capping participation outlined (See Founders Fund & Cooley article).
- Option Pool- an amount of equity reserved for future hires. As mentioned in the price section above, option pools can have a great impact on the valuation of your company, as outlined by VentureHacks and Fred Wilson. Make sure you know the real valuation of your company with the option pool added in to the pre- and post-money valuations and make sure the amount is based on your real hiring plan.
- Conversion- transforms preferred stock into common stock. As explained by Founders Fund, conversion can get sticky when participation caps, drag-alongs and IPO rights enter the game.
- Anti-Dilution- provision used to protect investors in the event a company issues equity at a lower valuation then in previous financing rounds. Both Brad Feld and Fred Destin of Accel have covered anti-dilution and where it can really hurt entrepreneurs.
- Pay to Play- ensures investors must invest a certain amount in later rounds or suffer penalties such as forced conversion to common stock, losing anti-dilution protection, losing various control rights. Pay-to-play can benefit the company if they hit hard times, though if a lead investor requires this provision it can make follow-on investors uneasy.
- Dividends- sum of money paid regularly by a company to its shareholders out of its profits or reserves. As outlined by Brad Feld, dividends do not come in to play often in early stage VC deals.
- Warrants- a security that gives investors the right to buy stock at a certain price within a certain timeframe. Warrants can add complexity to a cap table, but are a useful tool in certain situations.
- Cost of Counsel- investors typically ask for some of their legal fees to be reimbursed. This should typically be between $25k-$75k.
Control, Investor Rights and Protection Terminology
- Participation Rights- investors right of first refusal to invest in future rounds, usually their pro rata portion of the new financing. This is a market term and is in most every VC deal you will see.
- Co-Sale and ROFR- investors right to sell stock to the same buyer, at the same price and same percentage that a founder or other major holder sells to. This provision is market and is fair to all parties.
- Registration Rights- require the company to register investor stock for sale on the public markets. This is in just about every VC deal and not worth spending time on.
- Board of Directors- body of elected or appointed members who oversee the activities of a company. Negotiations over board seats and board control are some of the most important points in negotiating your term sheet and there are varying opinions on how to go about building your board. Steve Blank advises entrepreneurs to be very cautious giving out board seats and to generally wait. Brad Feld advises startups to build their board early. VentureHacks advises startups to build a board that reflects the ownership of the company and for founders to care more about control than valuation. Paul Graham writes that it is becoming more common for founders to control a company through Series A rounds. Finally, Startup Lawyer outlines when having the majority of the board seats doesn’t mean controlling the company.
- Voting Rights- investors require an approval right over actions that could be harmful to them. Founders Fund explains that a percent of holders of a particular class or series of stock is required to engage in certain acts such as a sale, additional financing, etc. This is normal, but they warn of investors seeking personal blocking rights by negotiating for approval thresholds they alone can block.
- Information Rights- right to certain company information, usually performance metrics, financials, etc. This is typically required by VCs and understandably so. In order to protect sensitive company information, some companies will require a minimum amount of shares to be purchased to receive information rights.
- Drag Along- provision that enables a majority of shareholders, sometimes in one class or series of stock, to force a sale of the company. If this provision is written so that a majority of all shareholders can force a sale, this can make sense, but Founders Fund explains how this can get sticky.
VC Term Sheets’ Hacks and Tips
- Term sheet hacks – Naval Ravikant of AngelList
- A quick hack for speeding up term sheet and other negotiations – Mark Suster of Upfront Ventures
- 9 tips learned while raising $33M in venture capital – Dharmesh Shah of Hubspot
- How to negotiate a term sheet – Jo Tango of Kepha Partners
- What’s in a term sheet? The world’s most irritating not-quite-contract – Bruce Gibney of Founders Fund
- Term Sheet Series Wrap Up – Brad Feld and Jason Mendelson of Foundry Group