For any founder, whether a first-timer or a serial entrepreneur, it’s an exciting moment when you receive a term sheet from a venture capital fund for your company’s first preferred stock financing round. Excitement aside, it’s important to digest, understand and negotiate the key provisions of the term sheet. It can be overwhelming to understand what’s key when you haven’t negotiated numerous term sheets, but it’s vital to stay focused and diligent as many of these terms can have a lasting impact on your company, even if the term sheet is only a page or two. This is where trusted advisors – like lawyers – come in handy.
I’ve summarized a few of the most common provisions that should be negotiated below. In true lawyer fashion, I’ll caveat this post by saying that this list isn’t intended to be a complete summary of all relevant provisions; consult with trusted advisors before negotiating and executing a term sheet.
Valuation and Percentage Ownership
This is one of the core business items of any term sheet – what is the pre-money valuation as compared to the size of the investment? Put differently, what stake in the company will the investor(s) receive. Not only will this reflect the ownership percentage of the company that you are willing to give away to the investors, but it will have a lasting effect on the company’s capital raising efforts with respect to later financing rounds, anti-dilution provisions and option grants. It is important to always give careful and thorough attention to the valuation, and to keep in mind that a higher valuation is not always a “better” valuation. Pro tip: review and finalize a pro forma cap table before signing a term sheet to make sure you understand the various moving pieces and dilutive effect of a round.
Board of Directors
Yes, this is “your company”, but the term sheet will reflect the amount of control and power you will give to the venture capital investor – both in the boardroom and through stockholder protective provisions (discussed below). Generally, an investor’s term sheet will propose a 3-person board that’s comprised of two common stock representatives (usually the founder and/or founding team members) and an investor representative. However, there are numerous ways this could play out, like having a larger-sized board, using an “independent” director for one of the common stock seats, mandating there always be a “CEO” director, etc. To complicate matters a tad further, while the default rule is that the vote of a majority of the members of the board is required to take action, it’s important to understand (i) quorum and written consent rules, as the interplay of these rules with the makeup of the board may have a bigger impact on board dynamics than you’d expect and (ii) any proposed preferred director approval rights. Beyond the black and white of the term sheet and legal documents, a key driver for any company’s success is a healthy, balanced and efficient boardroom – so it’s important to keep this in mind when entertaining term sheet offers and provisions from potential investors. Early discussions with a potential investor about boardroom dynamics and board composition is never a bad thing because it will allow you to fully evaluate an offer and ensure that the parties involved are aligned.
A typical term sheet will include a list of “protective provisions” in favor of the investor (or holders of a majority of the shares of preferred stock to be issued to the investors). What does this mean? This means that there are certain company actions that the investor is saying cannot be taken without obtaining that investor’s consent. There are definitely some “industry standard” protective provisions, but all of these (whether standard or not) should be given careful thought and consideration before executing a term sheet. An interesting discussion point here that often comes up is understanding the applicability or inapplicability of fiduciary duties to members of a company’s board and/or preferred stock investors.
At the end of the day, an early-stage investor is investing in both the company and its founders and founding team members – sometimes more of the former, sometimes more of the latter and sometimes all things are equal. All that said, investors value the founders and other core members of the team and will want to ensure that these key members are incentivized to stick around and continue building the company. Long story short, even if your equity was issued at formation without any vesting terms or with vesting terms that are well underway, many investors will “reset” or modify vesting terms to ensure key members stick around. Beyond the length, it’s important to understand (and often negotiate) related vesting terms like what, if anything, happens to your equity upon termination (with or without cause) and/or a sale of the company (is there single-trigger acceleration or double-trigger acceleration)?
This is a core economic and legal term for sure, and definitely one that it is important to wrap your head around and negotiate (if necessary) as it not only will impact the amount of sale proceeds that could go to the holders of common stock in an exit, but it will have a lasting impact on subsequent fundraising efforts. The typical construct is a 1x non-participating preference, but sometimes you’ll see references to accrued (or other types of) dividends, replacing a non-participating preference with a participating preference, and other terms. While some of these words and phrases can seem like legalese, the liquidation preference is a core business term that has an economic impact on the deal, so it is important to fully understand the liquidation preference provisions of a term sheet. More importantly, while you may think that the liquidation preference in a “small” Series Seed or Series A financing round may not have a large economic impact on you as a founder and holder of common stock due to the dollars at stake in that “small” round when you model things out, it’s vital to make sure that you can “see the forest through the trees” here when negotiating the liquidation preference. Put differently, this matters, and it matters a lot on a go-forward basis. Read more on the basics of founder liquidation in venture financing.