Fundraising
Term sheet

Understanding the term sheet

Receiving a term sheet from investors is the first big milestone in closing a funding round.

The lead investors will send over a termsheet of typically 1-2 pages, with a short deadline of 48-72 hrs to accept. Often times, founders are so excited (or exhausted) when they receive a term sheet that they simply sign it without fully understanding the terms.

This puts founders at a significant negotiating disadvantage, because you are scrambling to comprehend it, while VCs have seen hundreds of term sheets and know exactly what they are pushing for.

Getting this wrong can also have negative downstream implications in future fundraising rounds, as incoming investors will also push for the same or better terms than earlier ones.

_Please, please, please ALWAYS consult a lawyer on any termsheet you receive. You are dealing with highly experienced professionals on the other side of the table.

So, what is a term sheet?

A term sheet is a non-binding document that outlines the key terms of an investment. It is generally sent by the lead investor in a round, and is used to negotiate the final terms of the investment.

IMPORTANT - A term sheet is NOT a binding contract. Most terms are non-binding, and it is simply a framework to negotiate the full financing documents and Shareholders Agreement (SHA), which can often run into 100+ pages

That being said, you often don't deviate significantly from the termsheet till closing documents, so it is important to understand what you are signing.

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Download a standard series A template (opens in a new tab). This is a balanced and clean termsheet with founder-friendly terms

Once again, please consult a lawyer on any termsheet you receive

Deconstructing the terms

Securities

[_share class_] Preferred stock of the company

This denotes the type of shares being issued. In nearly all cases, investors will be issued preferred stock. This is because preferred stock has a liquidation preference, which means that in the event of a liquidation event (sale of the company), preferred shareholders get paid out first.

Every stage of stock issuance will typically have a different name, e.g. Series A Preferred stock, Series B Preferred stock, etc.

Investment amounts and Valuation

$[_] million from [__________] (“Lead Investor”)
$[_] million from other investors

Convertible notes and safes (“Convertibles”) convert on their terms into shadow series of preferred stock (together with the [_share class_], the “Preferred Stock”).

$[_] million post-money valuation, including an available option pool equal to [__]% of the post-Closing fully-diluted capitalization.

This is generally the most negotiated part of the term sheet. The amount of money raised, at what valuation can vary vastly based on the sector, stage of the company, and how 'hot' your deal is.

One point that founders often are surprised by is the option pool. The option pool is typically issued before the round, and is included in the pre-money valuation.

We have separate blogs on how much to raise, and how to think of dilution coming shorty

Liquidation preference

1x non-participating preference

There are two parts to this clause -

  • 1x - this denotes the multiple of the investment amount that the investor will get back in the event of a liquidation event. In this case, the investor will get back 1x their investment amount. Anything larger than 1x is generally not founder friendly.

  • Non-participating - this means that the investor will get back 1x their investment amount, OR their pro-rata share of the proceeds, whichever is higher. This is generally founder friendly, as it means that the investor will not get back 1x their investment amount AND their pro-rata share of the proceeds.

On the other hand, participating, also known as double-dipping, means that the investor will get back 1x their investment amount AND their pro-rata share of the proceeds. That is a sharky offer, and should be avoided.

Conversion to Common Stock

At holder’s option and automatically on (i) IPO or (ii) approval of a majority of Preferred Stock (on an as-converted basis) (the “Preferred Majority”).  Conversion ratio initially 1-to-1, subject to standard adjustments.

This clause is generally standard, and means that preferred stock will convert to common stock in the event of an IPO or a majority of preferred shareholders voting to convert.

Keep an eye out on the conversion ratio. 1:1 is the standard norm, but we've seen some investors push for a 2:1 conversion ratio, which is definitely not founder friendly, and can result in significant dilution for the founders at later stages

Voting Rights

Approval of the Preferred Majority required to 
  1. change rights, preferences or privileges of the Preferred Stock; 
  2. change the authorized number of shares; 
  3. create securities senior or pari passu to the existing Preferred Stock; 
  4. redeem or repurchase any shares (except for purchases at cost upon termination of services or exercises of contractual rights of first refusal); 
  5. declare or pay any dividend; 
  6. change the authorized number of directors;
  7. liquidate or dissolve, including a Company Sale.  Otherwise votes with Common Stock on an as converted basis.  

Please note that the clauses can vary quite a lot here, and you should consult a lawyer on the exact clauses. Broadly, these voting rights hav a few implications -

  • Points 2 and 3, collectively means that any future rounds of financing will require the approval of the preferred shareholders. This is generally standard, and is not a big deal.

  • Point 4 means that the company cannot buy back shares from employees or founders without the approval of the preferred shareholders. This is also generally standard, to prevent founders from using company money to buy back their shares (effectively giving themselves free liquidity)

  • Point 7 means that you cannot sell the company without the approval of the preferred shareholders. Your investors must necessarily agree to a sale. Founders are in turn protected by the fact that investors also cannot sell without consent of the common majority (which is generally the founders)

Board

Lead Investor designates 1 director.  Common Majority designates 2 directors.

The 2-1 structure is generally founder-friendly, as it gives founders control of the board. However, this can vary quite a lot, and you should consult a lawyer on the exact clauses.

Sometimes, you may also see a 2-2-1 board, which is 2 founder seats, 2 investor seats and an independent observer. This is NOT ideal for founders, as you do not have control of the board. If the independent observer sides with the investors, they can effectively fire you from your own company.

Board observer rights are generally not a big deal, and are often given to investors who are not able to get a board seat. Freely give these away, as they do not have voting rights.

But please be mindful when you circulate board documents. It is an unfortunate but common practice that update notes and board materials get circulated (partners->associates->friends->etc.). Consider using a secure document sharing platform like Hashdocs (opens in a new tab) to share your board documents

Other Rights & Matters

Other Rights & Matters:	The Preferred Stock will have standard broad-based weighted average anti-dilution rights, first refusal and co-sale rights over founder stock transfers, registration rights, pro rata rights and information rights. Company counsel drafts documents.  Company pays Lead Investor’s legal fees, capped at $X.

You should definitely have a lawyer look into this. Often, there are a lot of clauses stuffed into this section, and it is important to understand what you are signing.

Examples of unfriendly clauses are preferred majority for operational matters e.g. hiring / firing executives, investments, etc.

What to do once you receive a term sheet?

Generally, when you receive a term sheet, you will have a short deadline of 48-72 hrs to accept. This is because investors want to close the round quickly, and also want to prevent you from shopping around for better terms.

  1. Immediately inform all other investors that you have received a term sheet and confirm the deadline to receive offers. This will put pressure on them to move quickly, and also prevent them from trying to negotiate better terms.

  2. Hire a lawyer to review the termsheet. Strongly recommend that you do not rely on a lawyer friend. Pick one that is experienced in venture funding

  3. Negotiate the termsheet. This is a tricky one, as you are negotiating with experienced professionals. You should definitely negotiate, but be mindful of the fact that you are negotiating with people who have seen hundreds of term sheets, and know exactly what they are pushing for.

  4. Once you are ready to sign, you will effectively be bound by a no-shop clause (typically for a 4-6 weeks). This means that you cannot negotiate with any other investors for better terms in this duration.

  5. Once you sign the term sheet, the lead investor will start the due diligence process. A separate blog is coming on this soon