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A Startup Founder's Introduction to Term Sheets
Newsletter
Shoumik is working at 10 Minute School, an edtech startup based in Bangladesh as a General Manager. He manages the finance team and takes care of management accounting, financial reporting, FP&A, and fundraising-related matters for the company.
Raising funds for a startup can be an intimidating task for any founder. The fundraising journey of a founder gets formalized upon receiving the term sheet which serves as the foundation of any startup investment deal. In this article, I will discuss the key segments of a typical term sheet.
What is a Term Sheet?
A term sheet is a document outlining the terms and conditions of a deal to facilitate mutual agreement among all parties involved. It is non-binding and covers a broad range of discussion points.
Why Do We Use Term Sheets?
- Building a common ground: It helps all parties involved to align on the most important details of the deal fostering mutual understanding, especially during fundraising.
- Setting the stage for formal agreements: The term sheet outlines the terms that will be included in the binding contracts. This helps prevent any surprises or disagreements about the deal.
- Showing seriousness: When parties agree on a term sheet, it shows they're serious about moving forward with the transaction.
Some Key Segments of Term Sheet
1. Valuation
This segment covers the pre and post-money valuation which determines the investment from the investor(s). Pre-money valuation refers to the company’s valuation before the investment, while post-money valuation is the pre-money valuation plus the new funding.
2. Liquidation Preference
Liquidation preference discusses the order and the amount in which investors are paid out in the event of a liquidation. There are two key negotiation pointers in liquidation preference -
- Multiple: This is usually set at 1x or 2x the initial investment. At 1x, the investor gets their initial money back before anyone else gets a dime. At 2x, they get double their investment back first.
- Participation: This can be either participating or non-participating. In a non-participating scenario, once the investor gets their chunk (like that 1x we talked about), whatever is left goes to the other shareholders based on their ownership percentage in the company. On the other hand, in a participating scenario, the investor gets to take a slice of the remaining pie in addition to their initial chunk (such as that 1x previously mentioned).
3. Dividend Right
Dividend rights set the conditions under which dividends will be paid to shareholders. The two most discussed types of dividends are -
- Cumulative Dividends: Cumulative dividends ensure that if dividends are not paid in any year, they are accrued and must be paid out in future profitable years before any dividends can be paid to common shareholders.
- Non-Cumulative Dividends: These are more like a "use it or lose it" situation. If dividends aren’t declared in a particular year, preferred shareholders just miss out for that year and there’s no catching up in future years.
4. Conversion Right
Conversion rights specify when and how investors can convert their initial investment form (such as convertible notes or preferred shares) into common shares. Common types of conversion rights are -
- Automatic Conversion: This is like setting an automatic trigger for investments. For eg - if a company hits predetermined targets, an investor’s investment automatically converts into equity.
- Optional Conversion: Here investors can decide when to convert their securities into equity.
5. Anti-Dilution
Anti-dilution refers to protections for investors against dilution of their ownership percentage in a company, particularly when new shares are issued at a lower price than the investor previously paid. There are different types of anti-dilution provisions:
- Full Ratchet: If the company issues new shares at a price lower than what the original investor paid, the conversion price of the original preferred shares will be adjusted downward to match the price of the new shares. This increases the number of shares the original investor would receive upon conversion of their preferred shares, maintaining their percentage ownership.
- Weighted Average: It adjusts the conversion price based on the weighted average price of all shares sold before and during the new issue. This formula considers both the new lower price and the number of shares previously issued at the higher price.
6. Founders’ Lock-In
The "founders’ lock-in" refers to clauses that restrict the founders of a company from selling or transferring their shares for a certain period. Here are two key areas typically covered in founders' lock-in clauses:
- Vesting Period: Founders' shares are often subject to vesting over a specified period, which means that the founders earn a percentage of their equity incrementally over time.
- Cliff Period: This refers to the initial period during which no shares vest. The cliff is typically one year and is intended to incentivize founders to stay at least this long.
7. Tag Along
Tag-along rights ensure that if a majority shareholder sells their shares to a third party, the minority shareholders have the right to join the transaction and sell their shares under the same terms and conditions as the majority shareholder. This protection helps prevent minority shareholders from being trapped with a new majority owner that is not desirable or from being stuck in a potentially less liquid and less valuable investment. However, it is important to note that it is a right, not an obligation for investors.
8. Drag Along
Drag-along rights allow majority shareholders to force minority shareholders to participate in the sale of a company. The primary purpose is to enable a smooth transaction process, allowing the majority shareholder(s) to sell the entire company without opposition from minority holders, which can be crucial in negotiating a sale to a buyer who wishes to acquire 100% of the company.
9. Voting Rights
Voting rights refer to the powers granted to shareholders to vote on various corporate matters. These rights are critical as they influence the direction of the company and how it is managed. These are generally divided into board-reserved matters and shareholders-reserved matters.
10. Information Right
Information rights allow investors the right to receive regular updates about the financial health, operations, and plans of the company. Some key expectations in information rights are access to - financial statements, annual budget, and material event notification.
11. No-Shop Clause
No-shop clauses prohibit the company and its representatives from engaging in discussions or negotiations with any third party regarding the sale of the company, investment, or other similar transactions during a specified period.
12. Exit
Exit strategies detail how and when investors can exit their investment, usually through events that enable them to sell their shares, such as a public offering, a sale of the company (acquisition), or a buyback of shares. The purpose of designing exit strategies is to give investors a clear path to realizing a return.
13. Option Pool
An option pool is a portion of a company's equity that is reserved specifically for issuance as stock options to employees, and other key contributors. These stock options represent the right to purchase shares of the company at a set price, typically called the exercise or strike price, usually based on the valuation of the company at the time the pool is created.
14. Conditions Precedent
Condition Precedent refers to a set of requirements that must be met before the formal closing of a financial transaction, such as an investment or acquisition. This ensures everything is legally, financially, and operationally sound; reducing risks for the investors before they go all in.
15. Redemption Right
Redemption rights grant investors the right to ask the company to repurchase their shares after a specified period. This allows investors to exit their investment, ensuring liquidity if other exit opportunities do not materialize.
These are some of the key terms where mutual agreement between the parties plays a decisive role in successful fundraising. It’s important to note that every term sheet is unique and tailored to the specific needs and expectations of both the investor and the startup.