Startup Funding Masterclass: Part Nine
You have pitched to investors and some of them are interested. Now before going into concrete negotiations, it is time to learn everything there is to know about the term sheet and its commonly used clauses.
The term sheet will be one of the most important documents you ever sign. This document can dictate how much you will enjoy seeing your startup grow, as it outlines the key terms of your deal with investors. 👈
The problem is that when you receive your term sheet, it will probably be your first time. The party on the other side of the table will already have seen 100s.
That is why you should prepare as best as you can and read on to understand all of its basic building blocks.
This post is Part Nine in a new Masterclass series on Startup Funding. Funding is the fuel that every business runs on. Knowing the ins and outs of funding is therefore essential if you want your startup to be successful. We searched for a compact-yet-comprehensive guide on startup funding and found it nowhere, so we decided to build one ourselves. This is that essential guide.
We bring it to you in partnership with Belgium’s largest startup and scale-up accelerator Start it @KBC, supporting and promoting more than 1.000 entrepreneurs with innovative ideas and scalable business models.
– Jeroen Corthout, Co-Founder Salesflare, an easy-to-use sales CRM for small B2B companies
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First, what is a term sheet?
A term sheet is a written document that includes the important terms and conditions of a deal. The document summarizes the key points of the agreement set by both parties, before actually executing the legal agreements and starting off with time-consuming due diligence.
The document will later serve as a template for the legal teams to draft a definitive agreement. It is, however, non-binding, as it reflects only the key and broad points.
For example templates of term sheets take a look at what Y Combinator and Capital Waters have shared.
What is the term sheet negotiation about?
As an entrepreneur, you try to raise the needed capital while retaining upside, keeping control and limiting downside risks.
The term sheet is all about dividing the upside and risk between parties. To do so, there are a number of standard clauses that can be included. Any situation might differ, but understanding these clauses is already a good first step towards making the right decision.
Never forget that this document is also a key moment to see who your investor really is. Depending on what they push for or don’t, you can get a good feel for where they stand.
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We’ve highlighted the term sheet’s importance, refreshed its definition, and zoomed in on the goal of the term sheet negotiation. Now let’s explore the different concepts, terms and clauses. 🧐
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Understand the different types of shares
By the time you are letting investors into your company, you have already set up the company and thus created common shares.
In order to facilitate investment, you will issue additional shares. While doing so, you might want to add specific clauses which could justify creating a new share class.
An example would be that a B class share is created with which holders have less voting rights than A class shareholders (original shares).
Another and related instrument are preferred shares. This is commonly used in the startup world, as it allows to set different types of rules.
It is by definition more senior than regular equity. This means that preferred shares have more claim to the company’s assets than regular shareholders. In the event of liquidation, this can be of great importance. 😅
Venture investments are typically issued in preferred shares, therefore, we will continue this article assuming that we are negotiating a preferred shares term sheet.
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Understand the capitalization table
A cap table is, in essence, an overview of the total capitalization of the company.
Typically created and stored in a spreadsheet, the cap table is one of the most critical documents for a company, as it tracks the equity ownership of all the company’s shareholders and security holders, as well as the value assigned to this equity.
Cap tables need to be comprehensive and accurate. They also need to include all elements of company stakeholders such as convertible debt, stock options and warrants in addition to common and preferred stock. See below for what a basic cap table looks like.
The table highlights the most basic information such as the holding of the founders and key investors.
Key terms regarding the cap table
Like with anything in finance, the capitalization table uses a specific language. 🤔
Valuation
The key terms related to valuation are:
- Pre-Money Valuation - Valuation of the company before the investment (more on this later)
- Post-Money Valuation - Valuation of the company after the investment (more on this later)
- Price per Share - This is calculated by taking the post-money valuation and dividing it by the fully diluted number of shares (see below)
Security types
As highlighted in the previous section, it is not uncommon to create a different kind of security type for an investment.
Now, as the cap table needs to be comprehensive and complete, we will list the most common security types with links to their definitions. For the rest of the article, it is more than adequate if you remember common stock, preferred stock and stock options.
Share counts
Share counts are important as they are the denominator for various aspects of the cap table analysis.
- Authorized Shares - Before issuing any shares, they need to be authorized by the company’s board. Authorized shares refer to the number of shares that is authorized for current and future issuance (this amount should be adequate for future issuances; for example for issuance of options).
- Outstanding Shares - This is the total number of shares that have been issued (thus a subset of authorized shares). It does not include options that have not been granted, nor does it include options that have not been exercized, as the shares are only issued when exercized (hence there need to be enough authorized shares).
- Fully Diluted Shares - This is a calculation which models all the granted options, restricted stock, warrants, and the remainder of the option pool itself, into a number of shares that represents a theoretical count, as if all of these outstanding items were granted and exercized.
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Understand the key term sheet clauses
Most people will tell you that an investment is dictated by two key terms: valuation and investment.
But as investors are trying to minimize their risk while setting themselves up for the best return, a number of additional clauses will be added. These have a huge impact on the deal.
A deal with a lower valuation but with better terms can often be the better deal. 👈
The key clauses of a term sheet can be grouped into four categories; deal economics, investor rights and protection, governance management and control, and exits and liquidity.
1. Deal economics: who gets what?
The logic behind taking outside investment is often that you would rather have a smaller part of a bigger pie, instead of a big part of a small pie.
Now, in order to protect this piece of the potentially big pie, you need to watch the deal economics closely. 🧐
Beyond valuation, conversion, and option pool, investors also use special clauses to limit their downside and guarantee a certain return, such as a liquidation preference, participating preferred, and dividends.
Be careful with these types of terms and don’t forget that your latest term sheet will also be driving your next round of financing.
a. Total size of the round
One of the first and most important items on the term sheet is the investment amount.
Typically the term sheet specifies the amounts per investor (lead, non-lead).
b. Valuation
The next item on the list is the valuation.
The start of any negotiation is making sure that you are both talking about the same thing. This is not always as straightforward when it comes to pre- and post-money.
Pre-money and post-money valuation
The key difference between pre and post is timing.
Pre-money refers to the value of your company excluding the funding that you are raising.
Post-money refers to the value of your company directly after you receive the investment.
Now, let’s say you are looking for a $500,000 investment in your company and decide that your company is worth $1,000,000. If this $1,000,000 refers to the pre-money valuation, it means you will hold two thirds of shares after the investment. If it, however, refers to the post-money valuation, you will only hold half of the shares post-investment.
In the below table, the pre-money and post-money valuations are indicated in bold.
c. Conversion
Preferred stock is more valuable than common stock as it grants certain rights. One of which is a conversion right.
A conversion right is the right to convert shares of preferred stock into shares of common stock.
The rate at which this happens is the conversion rate (e.g. 2:1).
There are two types of conversion rights: optional and mandatory.
Optional conversion
Optional conversion rights allow the holder to convert her shares of preferred stock into shares of common stock (initially on a one-to-one basis).
Let’s assume that an investor has a $1 million non-participating 2x liquidation preference representing 25% of the outstanding shares of your company. If the company gets sold for $50 million, the investor would be entitled to the first $2 million due to its liquidation preference.
If the investor, however, chooses to convert its shares using her optional conversion rights, it would receive $12.5 million. 😯
Optional conversion rights are typically non-negotiable.
Mandatory conversion
Mandatory conversion rights oblige the holder to convert her shares into shares of common stock at pre-defined events, such as an IPO. This happens automatically, that is why it is sometimes referred to as “automatic conversion”.
d. Option pool
Up next is the option pool size, as it is directly linked to the valuation.
A key tool to attract talent in the startup world is by sharing equity with your employees. Investors know this and often ask you to organize a pretty sizeable option pool before their investment.
By forcing you to do this prior to investment, it will not be dilutive to the investors.
In fact, as it is coming out of the pre-investment cap table, it will have a dilutive effect on your shareholding as a founder, similar to a price change.
In this example, we show the difference between a $1m investment at a $3m pre-money valuation and no option pool and the same investment with a 15% option pool established pre-money.
As you can see, by establishing the option pool pre-money, it comes directly out of the share of the founders.
e. Liquidation Preference
The liquidation preference sets out who gets paid first and how much they get in the event of a liquidation, a bankruptcy or a sale.
By including liquidation preferences, venture firms try to protect their investments from downside risks, by making sure that they get their investment back before any other shareholders.
Now imagine that an investor invests $500,000 in preferred shares with a liquidation preference of 2x in the company.
Now if the company gets sold for $2,000,000 the investor will receive $1,000,000 (2x $500,000) and the regular shareholders (common share) will divide the remaining $1,000,000 amongst themselves.
If the investor had, for example, invested $500,000 as a preferred (2x) and additionally invested $500,000 in regular stock representing 50% of the common shares. The investor would have received $1,000,000 due to the liquidation preference and 50% of the remaining $1,000,000 due to her ownership of the common shares. Thus at the sale there only remains $500,000 for the other shareholders despite selling at $2,000,000. 😖
This shows the impact of a liquidation preference on the preferred.
f. Participating preferred
With regular preferred equity, the preferred holder gets paid out first. Afterwards, the remainder of the sale price goes to the common shareholders.
If the preferred is a “participating” there will be a “double dipping” as the participating preferred also receives a pro-rata share of the remaining proceeds, as if it were holding an equal amount of common shares as well (like in the above example).
Say your company has $10m of preferred participating equity and $40m of common equity. In this example, 20% of the capital structure is preferred and 80% are common shares. If your company gets sold for $60m the participating preferred shareholders first receive $10m. Now of the remaining $50m they will also receive 20% of $50m, so in total $20m. This in comparison to just $10m if there was no “participating” clause.
In the case of common dividends, a participating preferred also receives a proportion following the same principle.
g. Dividends
One way to guarantee a certain return is by asking for a dividend (or an interest).
In the case of startups, this dividend is often not paid on a regular basis. Instead, the investor allows you to accumulate your dividends by growing the preferred in size over time. At the end of the investment (sale/IPO), the preferred will have grown and the investor will benefit from the fixed return.
Basically, the liquidation preference grows over time. 📈
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2. Investor rights and protection: protecting their investment
When discussing deal economics, we’ve already seen how investors optimise their upside in the deal. Now we will look into clauses that are used to protect their investment.
The most important clause of this category is the anti-dilution provision.
Dilution happens as a company issues more shares and the existing shareholders’ ownership decreases.
a. Anti-dilution rights
With an anti-dilution provision in place, the company is prevented from diluting investors by selling stock to someone else at a lower price than the initial investor paid.
There are two key varieties; weighted average anti-dilution and ratchet based anti-dilution.
Let’s assume for now that we are in a Series A round negotiation.
Full-ratchet anti-dilution
A full ratchet means that if a company issues new shares in the future at a price below the price of the Series A, the Series A price is reduced to the lower price.
This effectively means (for a full ratchet) that if the company issues one share at a price below the price of the Series A that all of the Series A gets reprised.
What does that mean? 🤔
If the Series A gets repriced, the ownership or the conversion rate will change.
Say you originally have a company with 100,000 shares and a share price of $10 per share. You now issue 100,000 shares in your Series A at the price of $10 per share representing an investment of $1,000,000. At the end of the Series A, you will hold 100,000 shares out of a total of 200,000 representing 50% of the company.
If the Series A price gets repriced to $9 per share, the investment remains $1,000,000 but they now represent 111,111 shares your ownership is decreased to 100,000 / 211,000 or 47%.
Weighted average anti-dilution
A more commonly used variety is the weighted average anti-dilution. Here the number of shares issued at the reduced price is considered in the calculation of the new price of the Series A.
NCP = OCP * ( (CSO + CSP) / (CSO + CSAP))
- NCP = new conversion price
- OCP = old conversion price
- CSO = common shares outstanding immediately prior to the new issue
- CSP = common share purchased if the round was not a down round (at Series A pricing)
- CSAP = common shares actually purchased because the round is down
Weighted average anti-dilution is much more friendly to the founders than full-ratchet, as it takes into account the number of shares issued in the new round. 👈
Generally, it comes in two versions: broad-based and narrow-based. Broad-based weighted average anti-dilution counts the amount of share according to the fully diluted capitalization of the company. The narrow-based version only counts common stock. In-between options are often negotiated, where the broader the base the smaller the anti-dilution adjustment, hence the more founder friendly.
b. Pre-emptive or pro-rata rights
Pro-rata or pre-emptive rights give investors the right, but not the obligation, to maintain their level of ownership throughout subsequent financing rounds.
This by allowing the holder of the rights to participate proportionally (pro-rata) in any future issues of common stock prior to non-holders.
They are also called pre-emption rights, anti-dilution provisions or subscription rights.
Say you have 100 shares and you sell 10 shares to an investor with pre-emptive rights. If you now issue 500 additional shares, the investor will have the right to buy 50 shares (at the same pricing) before others.
The danger in granting them is that in later rounds you might find investors that are only willing to come into your company if they can acquire a sizeable portion of equity.
If at that time you have a lot of pro-rata and pre-emptive rights, you might not be able to offer this sizeable portion to the new investor.
Pro-rata rights are highly sought after in hot startups. This even leads to some investors selling those rights. As this might lead to you getting unwanted investors as shareholders, it is not uncommon to include language that prevents investors from doing so.
c. Right of first refusal (ROFR) and Co-sale rights
The pre-emptive rights and pro-rata rights protect the investor in the case of a primary offering (new stock issuance) by offering the right to buy more stock directly in the company.
The ROFR and co-sale rights protect investors in the case of a secondary offering. This refers to stock offerings where existing shares are sold.
In the event that an existing shareholder tries to sell her shares, the ROFR offers the investor the right to buy the stock before it can be sold to a third party.
Generally, the ROFR also states that, if the investor wants to sell the stock, the company has the right to buy the stock before it is offered to a third party.
With co-sale rights, the holder of the rights has the ability to join any secondary transaction, such as a sale of shares by other shareholders.
This means that if one of the larger shareholders has negotiated a sale of their shares at a certain price, the holder of the rights can opt in to add their stock to the package that is being sold, at exactly the same deal terms.
It is done in order to protect the smaller shareholders, as they often do not have the same ability to negotiate an attractive deal as the major shareholders.
d. No-shop clause
The no-shop clause included on the term sheet is there to prevent the company from asking investment proposals from other parties.
This gives the investor leverage, as it prevents you from shopping around for better terms.
The no-shop is pretty standard, but it is important to look out with the timing. 🕚 You don’t want to have a too long no-shop clause, as it could allow the investor to take a long time for her due diligence and to potentially drop out at the last moment (don’t forget that a term sheet is non-binding).
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3. Governance management and control: who’s in control
When setting the rules of the investment through the term sheet, one of the key aspects is who’s in control of the company.
The key terms to look out for are the voting rights, board rights, information rights and founder vesting.
a. Voting rights
Voting rights are the rights of a shareholder to vote on matters of corporate policy.
This clause of the term sheet points out how voting rights are divided across different instruments (A, B, Preferred). It also defines for which corporate action a voting majority is required.
This can amongst other items include:
- Changes to the share instrument
- Issuance of securities
- Redemption or repurchasing of shares
- Declaration or payout of dividends
- Change of the number of board directors
- Liquidation of the company including a sale
- Closing material contracts or leases
- Annual spending budgets and exceptions
- Changes to the bylaws or the charter
Depending on how the voting majority on this topic is defined, it allows the holder of the instrument to block any of the above actions.
Let’s clarify by an example. 🤓
Say that the term sheet for a preferred share deal stipulates that approval of a preferred majority is required for the above actions.
That would mean that your preferred shareholders have a veto on issuing new securities, changing the number of shares, paying out dividends, selling your company, etc.
The voting rights can also stipulate that a “common” majority is required, which puts the power to decide in the hands of the common shareholders (preferred shares often also have common voting rights).
b. Board rights
Another major potential loss of control is the composition and mandate of the board.
A board of directors is a group of individuals chosen to represent the interests of the shareholders in the company. Its mandate is to establish policies for corporate management and oversight and make decisions on major corporate decisions.
The key corporate decisions that a board can decide on are:
- Hiring/firing senior executives
- Dividends and option policies
- Executive compensation
- Setting broad goals
- Assuring adequate resources are at its disposal
The structure of the board and the number of meetings can be set by the company in its bylaws. It is here that investors might choose to make adjustments in order to take a bit more control over the board.
An example of a founder-friendly board structure is 2-1 with two founders on the board and one investor. A riskier example would be 2-2-1 with two founders, two investors and one independent board member. Because if you lose control over the board, you effectively lose control over your company.
Other dangerous practices can be specific provisions that stipulate that the investor board member’s approval is required for an action. This can go from approving the annual budget to very operational items, such as opening business lines or markets.
Make sure that you fully understand the importance of the board’s decision making and the impact of the proposed structure and provisions.
This is also were investors show their trust in you and your senior team. The more control the investor is trying to gain through the board, the more they are trying to minimize the risk of mismanagement. And effectively putting you on a leash.
c. Information rights
Paired with board rights are so-called information rights. These require the company to share the company’s financial and business condition with its investors on a regular basis.
In most cases, the information rights will oblige you to provide quarterly management reports with some financial or management dashboard data. They can also oblige you to provide detailed annual financials, within a certain period after closing the fiscal year.
d. Founder vesting
Investors like to have certainty when investing. One of the potential risks is that you, as the founder, get fed up with the business and decide to walk away.
Therefore investors are constantly looking for mechanisms to minimize the risk of losing founders.
Founder share vesting does just that, by making it painful for a founder to leave the company by putting shares at risk.
Additionally, the returned shares allow the company to incentivize a fitting replacement for the departed founder.
While this seems logical, the devil is in the details. As a founder, you are obviously not to be treated the same way as an employee. Where an employee share option plan is in place to reward future work, you already have done a lot and should be rewarded for it.
Therefore negotiate a vesting program that works. It is not unreasonable to exclude part of your holding from this arrangement.
Single vs double trigger
An important detail to any vesting scheme is what happens at the moment of a sale. The easiest solution is that at the time of the sale all shares vest immediately. This is also called “single trigger”. 🔫
The other approach is that the founder’s shares vest after being a good leaver after a period of time (e.g. 12 months). This is called a “double trigger”.
While a single trigger is an attractive solution for a founder, there is merit in considering the double trigger. When a potential buyer is considering buying your company, they probably want to have a form of guarantee that you are staying for at least the integration of the company.
It is therefore not uncommon that, at the moment of the deal, founders still forego their single trigger in order to make a deal possible.
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4. Exits and liquidity: what happens when it’s cashing time
a. Drag-along and tag-along rights
In the event of a sale, the buying company typically wants to acquire all shares. While the majority shareholder can decide to sell her shares and the whole company, she can not force minority shareholders to do the same without a specific clause or a lengthy legal process.
Say now that you as a founder have 51% of the remaining shares following your Series A and would like to sell your company to SearchEngine Inc., but your minority VC shareholder would like to see more upside, blocking the sale.
That is where drag-along rights come in. They prevent any future situation in which a minority shareholder can block the sale of a company that was approved by the majority shareholder or by a collective representing a majority.
Drag-along rights are also good for the minority shareholder, as they ensure that the same deal is offered to all shareholders.
In order to protect the minority shareholder even further, there are also tag-along rights. These rights give the minority shareholder the right, but not the obligation, to join in any action with the majority shareholder. This because majority holders are often more capable of finding favourable deals from which the minority shareholder would be excluded without this provision.
Comment: Drag-along and tag-along rights typically end at an IPO, as they get replaced by security laws for public markets.
b. Redemption rights
A term with potentially devastating impact is the redemption clause.
With this clause, investors have a right to demand redemption of their stock within a specific window of time.
This is great for a structured venture fund, as they have a set time (10-12 years) at which they need to return the funds to their limited partners. This allows them to do so.
The way it is done however can create a time bomb that creates a liquidity crisis for a fast-growing company like a startup.
As management is forced to redeem the funds, it is either forced to sell the company in a rushed way, or get remaining shareholders to come across with the money in a hasty financing round.
Typically the company will pay the redeeming party the greater of fair market value and the original purchase price plus an interest rate (of around 5% - 10%).
The time window can be set to certain events or set to start x years out (typically 5 years). The clause also stipulates how much time the company has once the event has happened to complete the redemption and if it relates to a fraction or the complete investment.
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If you've been reading all the way here, you're now ready to go into term sheet negotiations.
We wish you a lot of luck closing that investment round! 👊
Let us know if you have any questions left; we’ll be happy to elaborate! Also, don’t forget to tune in next week for Part Ten (the final one!) in our Startup Funding Masterclass: Where to Get it & What to Look Out for - Full Guide! It'll be a wrap up of all we've discussed so far, so make sure not to miss it.
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