When evaluating an offer from investors, sometimes the devil is in the details. What appears to be an attractive offer may have serious downsides hidden in the legalese. You should carefully analyze the terms, not just the price, when determining the “best” deal for your startup. A working knowledge of the most important term sheet provisions will help you make the best financing decision for your startup, as you consult with a lawyer and evaluate your startup’s needs.
Term sheets are commonly used by startup investors, such as venture capital (VC) and private equity investors, to communicate the proposed terms of a financing arrangement. Each investor that is interested in making an investment during a funding round submits a separate term sheet and the proposed terms can vary from investor to investor. Only by understanding the various terms of each offer will you be able to truly evaluate the quality of each offer. With each subsequent funding round, you must repeat the analysis as investors will submit new term sheets that may contain different provisions. (For a general overview of term sheets, see our Term Sheets Overview article.)
This article describes some of the most important provisions within a term sheet and provides context for determining whether a term sheet’s provisions are more favorable to investors or founders. Following each provision’s description, the article includes negotiation tips that you can consider utilizing during discussions with potential investors. As you learn about these provisions and prepare for negotiations, keep in mind that the term sheets represent a combination of many interrelated provisions that must be viewed in totality rather than on an individual basis.
Important Provisions (listed in alphabetical order)
The first step to brokering a successful financing is to understand what issues are at stake and what financing options are available. As you learn more about common term sheet provisions, you will be prepared for discussions with lawyers and investors. The various term sheet provisions can be confusing, but with the right preparation and knowledge, you can negotiate a deal with investors that is fair and beneficial to both parties.
- Term Sheets & Valuations by Alex Wilmerding
- NVCA Model Term Sheet
Pro Rata Rights
- Fred Wilson Blog: The Pro-Rata Participation Right
- Strictly Business Blog: Venture Capital Term Sheet Negotiation — Part 12: Preemptive Rights
Pay to Play
- Liquidity Event – an opportunity for investors to sell their stock and get a return for their investment. Acquisitions and IPOs are the most common types of liquidity events.
- Float – the number of shares available for trading on a public exchange. In this context, float refers to the number of shares the company issues during the IPO.
- Market Liquidity – how easily market participants can buy and sell in the marketplace without a significant decline in value. If a company has an IPO without a large enough float, fewer investment analysts follow the stock and trading volume is low. With low trading volumes, investors may not be able to find buyers at the same price.
- Conversion Ratio – determines how many shares of common stock preferred stockholders receive upon conversion.
- Class of Stock – investors from each funding round receive shares from their own class of stock (Series A preferred stock, Series B preferred stock, etc.). Each class of stock carries its own set of investor protections, negotiated separately with the company.
- Liquidation Preferences – these provisions represent a right to receive proceeds from an acquisition before other shareholders. (See liquidation preferences for more information.)
- If some shareholders had decided to sell 1,000 shares and the shareholder with co-sale rights owned 25% of the company, the investor exercising the co-sale right would have the opportunity to sell up to 250 shares (25% of the sale) in place of the other shareholders.
- The rules regarding shareholder approval rights vary based on where the company is incorporated. In California, the majority of each class of stock must approve the sale. In Delaware (home to many corporations), the majority of total shares (on an as converted basis) must approve the sale.
- The original issuance price is the price at which new investors purchase their positions in the company. If an investor bought a stake in the company at $5 per share, the dividend calculation would be a percentage of the $5 original issuance price.
- The actual time period may vary depending on the language in the term sheet, but annual terms are the most common structure.
- In this context, pro rata means that investors will contribute enough capital to maintain their ownership percentage after the financing event.
- A royalty arrangement is a way for a startup to raise capital through a form other than debt or equity. Instead, the startup receives capital in exchange for a specified percentage of the startup’s future revenues. While startups can delay repayment to investors in a debt or equity arrangement (until the terms of the contract require payment), royalty arrangements require systematic payments to investors from cash flows that otherwise could have been reinvested in the business.