A VC term sheet is a contract that defines the key terms in the agreement between a venture capital firm and the startup. While it does not legally represent a promise to invest, it is essential to understand the terms laid out.
There are so many different terms on a VC term sheet – so how do you decipher them?
Let’s review the most common items on a VC term sheet by breaking them down into three categories: economic terms, control clauses, and miscellaneous elements.
First, we must understand the common elements under economic terms, such as valuations, vesting schedules, and liquidation preferences.
Valuation or Price
The valuation, or the price, is an essential aspect of the VC term sheet. When negotiating, you have to be sure that you are both on the same page – so you must understand the difference between pre-money and post-money valuation.
Pre-money valuation is the value of your startup without the funding that you are trying to raise - while post-money valuation is the value that your company will have after you receive the venture capital.
The key is timing – let's assume your firm is worth $1,000,000 - and you are looking for an investment of $500,000. If your pre-money valuation is $1,000,000, you will own 2/3rd of the shares after the investment. On the other hand, if $1,000,000 is your post-money valuation, you will only own half of them.
Warrants are very similar to stock options, but rather than being gifted the stock, it gives the owner the ability to purchase a specific number of shares at a pre-set price. For example, you may have a 5-year stock warrant that allows you to buy 1,000 shares of stock at $2 per share.
Liquidation preference refers to an investor's right to get their money back before common stockholders do. In other words, the liquidation preference outlines how much money has to be returned to investors before others receive funds in case the company is sold.
Liquidation preferences are set as a multiple of the initial investment, and typically it is one time – so investors need to get their full investment back first!
An important note is that only preferred stockholders will receive liquidation preferences. The goal is to protect investors in case the company does not meet expectations or sells for a lower valuation than expected.
A pay-to-play provision is one that encourages investors to continue to take part in future financing. They require existing venture capitalists to invest in subsequent financing on a pro-rata basis – or else they may lose some or all of their preferred rights.
These rights are lost by being converted into a shadow series of preferred stock that have their rights stripped out, or through conversion into common stock. The goal of pay-to-play provisions is to keep venture capitalists invested!
Vesting is a term that describes ownership in shares of a company over time. This clause essentially describes what will happen if a founder leaves a startup during a certain time.
The vesting period is usually spread over time, such as monthly, quarterly, or even annually – and it is expressed as a percentage of the shares owned. There may be events that accelerate vesting as well.
When a founder leaves the startup, they can only retain the shares they are vested in.
An anti-dilution provision prevents the investor's ownership percentage from being diluted when the firm sells additional shares. Anti-dilution works in two ways: ratchet-based and weighted average.
Full-ratchet anti-dilution means that if the company issues new stock at a price below that of the original issuance, then the Series A price is reduced to that price. Simply put, if a share is issued at a lower price, the original investors get reprised, and the conversion rates will change.
Weighted-average dilution is the most common method, however. The number of shares issued at lower prices is considered on a weighted-average basis in the calculation of the new Series A price.
ESOP stands for the employee stock option pool. An ESOP is an aspect of employee benefit plans that allow workers to gain an ownership interest in the firm – encouraging them to do what is in the best interest of the firm and its shareholders. Not all employees are eligible for ESOP pools, and usually, it is reserved for key personnel.
Next, let's dive into control clauses. These clauses set the rules of investments and who is in control of the firm through things like voting and board rights.
Board of Directors
The board of directors is made up of elected individuals that serve as fiduciaries on behalf of the firm’s shareholders. They are the governing body that meets regularly to set policies for oversight and management of the company.
All public companies are required to have a board of directors, and their primary responsibilities include hiring senior executives, setting dividend policies and executive compensation, and setting broad goals.
A protective provision allows investors to block corporate actions - even if authorized by the board of directors. Certain decisions require a percentage of shareholders to consent so that they can protect their interests from majority stockholders.
Standard protective provisions include liquidation events, amendments to the articles of incorporation, changes to the number of authorized shares, and any declaration or payment of dividends.
Drag-along agreements allow majority shareholders to force the others into a sale – assuming that they are given the same terms! These are put in place to protect majority shareholders in the event of a merger or acquisition.
This is an important term since it allows potential buyers to negotiate the sale with just the majority shareholders to take over the entire company.
Tag-Along Provision or Co-Sale Agreement
Tag-along provisions go hand-in-hand with drag-along agreements. The goal of these is to protect minority shareholders by allowing them to join in company actions with majority shareholders – but not the obligation.
This prevents them from having to remain minority holders after a sale, or from being forced to accept a lesser deal. It also ensures that minority shareholders have adequate liquidity.
Conversions rights allow investors to convert preferred stock into common stock and are either optional or mandatory.
Optional conversion rights give the holder the right to elect conversion, usually on a one-for-one basis. Mandatory conversion requires that preferred stock be converted automatically.
There are other miscellaneous elements on a VC term sheet that should also be addressed – including dividends, redemption rights, and voting rights.
A dividend refers to when a firm distributes a portion of its profits, generally paid in cash or with additional stock. Most startups do not pay cash dividends, since there are typically no profits – or that cash is re-invested to grow the business.
Dividends can be cumulative or non-cumulative. Cumulative dividends are calculated for each year, and the right to that amount carries forward until it is paid, or the rights are terminated. Non-cumulative dividends are only paid for that specific year.
Redemption rights are a feature of preferred stock that requires the startup to repurchase shares after some time. Think of it as a put right, where the investors' shares can be put back to the company.
Although these are rarely exercised, they are designed to protect investors by allowing them to exit the investment.
Conditions Precedent to Financing
The conditions precedent to financing is a term that includes what needs to happen from the time the VC term sheet is signed, through the completion of the investment. Typically, this provision includes the following:
Completion of due diligence measures
Completion of legal agreements, warranties, and indemnities
Contacting specific customers or brand representatives
Other terms that the VC firm deems necessary
The information rights term on the sheet shows what information the startup has to deliver above and beyond state law requirements. For instance, this can include delivering financial statements and budgets to investors on a monthly or quarterly basis.
These information rights are usually terminated once a company goes public.
Registration rights allow investors to require that the startup register their securities with the SEC – this is documentation that shares have been sold. This allows shareholders to sell their ownership with the company more easily and can be done in two ways: piggyback or demand.
Piggyback rights allow shareholders to attach their shares to the IPO – so when the company goes public, they have the option for a clear exit strategy.
Demand registration rights allow shareholders to determine when the startup goes public without approval from the company’s founders.
Right of First Refusal
The right of first refusal, or ROFR, allows both the company or the investors the options to buy shares from founders or other majority shareholders – before they are sold to third parties. If this right is exercised, the shares must be sold on the same terms as they would have been if sold to a third party.
Some rights give the option to the company first, while others only give them to investors. If there are multiple shareholders interested, usually it is done on a pro-rata basis.
Voting rights are generally required by investors when providing VC funding to a startup. This allows them to vote on topics presented by the board of directors that require shareholder approval, such as issuing a dividend or changing the articles of incorporation.
Not all share classes confer voting rights, so this is an important distinction that needs to be made when deciding which shares to purchase.
As you can see, there are many terms on a VC sheet – hopefully, this guide will help you understand them better so you can make the best decisions for your startup!