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Term Sheet: What is it? What Should be on it?

A term sheet is a preliminary, non-binding agreement that outlines the proposed investment amount and crucial details for a potential deal. This document, essential in angel investing and venture capital, acts as a guide for subsequent legal paperwork and mitigates miscommunication risks. In the realm of fundraising for startups, a comprehensive term sheet should cover the following essential elements:

1. Company Valuation:

Company valuation on a term sheet refers to the value of the startup before the investment is made.

It is one of the most important elements of a term sheet and distinguishes it from other investment documents such as SAFEs. The valuation determines the percentage of the company's equity the investor will hold after the investment. It is usually determined by the lead investor and is based on factors such as the startup's financial performance, market potential, and competition. The valuation is typically expressed as a pre-money or post-money valuation, which refers to the value of the company before or after the investment, respectively. It is important for startups to understand the implications of the valuation and to negotiate it carefully, as it can affect the amount of equity the investor will receive and the startup's future funding rounds.

2. Investment Amount:

The monetary commitment an angel investor or VC fund is prepared to contribute to the startup.

3. Percentage Stake:

Percentage stake on a term sheet refers to the portion of the company's equity that the investor will hold after the investment.

It is the amount of the company that the investor will own if the deal goes through and the money is given to the startup. For example, if the percentage stake is 10%, the investor will own 10% of the company. The percentage stake is a crucial item on a term sheet as it determines the level of control the investor will have over the company's decisions. It is often the most debated item on the term sheet, and both parties should take time to carefully decide the percentage stake to ensure everyone is on board.

4. Voting Rights:

The level of influence the investor will exert on the company's decision-making processes.

5. Liquidation Preference (Exit):

Liquidation preference is a clause in a contract that dictates the payout order in case of a corporate liquidation.

It is a key and common part of a term sheet in startup investments. Typically, the company's investors or preferred stockholders get their money back first, ahead of other kinds of stockholders or debtholders, if the company must be liquidated. The mechanics of liquidation preference are based on the preference stack, multiple, and participation rights offered to the investors. The liquidation preference stack, also known as the deal’s “seniority structure,” defines the order in which preferred stockholders are paid back in the event of an exit.

Liquidation preferences meaningfully alter the distribution waterfall for paying out investors, founders, and employees. The more an investor is guaranteed to receive, the smaller the amount available for others on the cap table. Liquidation preferences become more complex as funding milestones progress.

6. Anti-Dilutive Provisions:

Anti-dilutive provisions are clauses built into convertible preferred stocks and some options to help shield investors from their investment potentially being diluted by future issuances of shares at a lower price than the investor paid.

Anti-dilution provisions are usually associated with preferred shares and protect an investor's equity stake from dilution. There are two types of anti-dilution provisions: full ratchet and weighted average. The full ratchet provision adjusts the conversion price of the preferred stock to the price of the new issuance, while the weighted average provision adjusts the conversion price based on a formula that takes into account the price of the new issuance and the number of shares outstanding. The term sheet should spell out the type of anti-dilution provision and how it will be calculated.

7. Investor Commitment:

Investor commitment on a term sheet refers to the investor's obligation to complete the investment, which may include specific milestones or conditions that must be met before the investment is released.

8. Board of Directors Representation:

Board of directors representation on a term sheet refers to the process through which investors secure a seat on the board of directors of a company in exchange for their investment.

This representation is important for both investors and founders, as it can significantly impact the governance and overall trajectory of the company. In a term sheet, the size of the company's board of directors is usually set, and the investors and founders agree on the allocation of board seats.

Different term sheets allocate these seats differently between the founders, the investors, and independent members.

Board representation in term sheets helps balance the power between the different stakeholders and ensures investors have a say in the decision-making process. It also offers founders access to expertise, networks, and industry insights from the investors.

9. Pre-emptive Right:

Pre-emptive right on a term sheet refers to the right of an investor to maintain their percentage ownership in the company by acquiring new shares issued by the company to the extent necessary.

This is an important protection for investors as it allows them to protect their percentage ownership, although they have to pay for it. Pre-emptive rights are typically included in the term sheet for startup investments, and they are important to consider when negotiating the terms of the investment. When considering pre-emption, it is important to consider issues such as the pro-rata entitlements and the flexibility of the statutory provisions. It should be noted that while pre-emption rights are important, very few investments follow the strict pre-emption provisions in the legal documentation.

10. Drag-Along Right:

A drag-along right is a provision in a term sheet that enables a majority shareholder to force a minority shareholder to join in the sale of a company, typically in the event of a merger or acquisition.

This provision is designed to protect the interests of the majority shareholders by ensuring that all shareholders, including the minority ones, are bound by the same terms and conditions of the sale. Drag-along rights are beneficial for majority shareholders as they provide a mechanism to facilitate a sale and can potentially increase the valuation of the company's equity. It is important to note that drag-along rights are usually accompanied by tag-along rights, which protect the interests of the minority shareholders in the event of a sale.

Term sheets are commonly employed during fundraising rounds whether it be early-stage or later rounds. This document not only shapes subsequent funding rounds but can also impact control and payouts during acquisition events, emphasizing the need for a thorough understanding by startups.


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