This article discusses common term sheet provisions that rarely become the main focus of negotiations. Most of these provisions are industry-standard requests that investors insist on receiving. Although founders should not concentrate their efforts on negotiating these provisions, understanding these provisions improves your ability to converse intelligently with lawyers and investors. Also, being able to prioritize the various term sheet provisions in negotiations can help you to direct the legal team and limit legal fees!
This article also provides context for determining whether the provisions are more favorable to investors or founders. Each provision includes a section with negotiation tips you can consider using during discussions with potential investors. Note that each round of financing will result in a separate term sheet. (For a general overview of term sheets, see our Term Sheets Overview article. To learn more about other term sheet provisions, see our Term Sheets Provisions (Part I) article.)
Important Provisions (listed in alphabetical order)
The first step to brokering a successful round of financing is to understand what issues are at stake. 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, you are more likely to negotiate a deal with investors that is fair and beneficial to both parties.
- Term Sheets & Valuations by Alex Wilmerding
- NVCA Model Term Sheet
- VentureBeat: Demystifying the VC Term Sheet: Redemption Rights
- Brad Feld Blog: Term Sheet - Redemption Rights
- Brad Feld Blog: Information and Registration Rights
- Morgan Lewis: Preparing a Venture Capital Term Sheet
- Brad Feld Blog: Term Sheet - No Shop Agreement
- Rubicon: Key Legal Documents for a Series A Financing Round
- VentureBeat: Demystifying the VC Term Sheet: The Investors’ Option to Walk
- WilmerHale: Know Your Limits: Understanding Your Term Sheet’s Exclusivity Provision
- Founders usually have expectations about a few key characteristics of a potential funding round, including the valuation, the size of the funding round, and the rights given to preferred shareholders.
- A capitalization table (or cap table) displays the ownership structure of the company, including issued shares as well as restricted stock units, warrants, and stock options. For more information on cap tables, see our Dilution and Stock Option Pools article.
- In some cases, tax returns are more reliable than financial statements because there are serious legal consequences for falsifying tax returns.
- Before finalizing a funding round, investors review various aspects of the company to ensure that they have a complete understanding of a startup’s position. This process, known as due diligence, includes (among many other activities) meeting customers, contacting references of the management team, reading employment contracts for key employees, examining deeds and titles to property, inspecting lease contracts, reviewing legal agreements, assessing technological capabilities, analyzing financial information, and studying key supplier and vendor contracts. Investors who identify a serious problem during this process can withdraw their term sheets, cancelling the proposed funding transaction.
- To finalize a funding arrangement, the proposed terms included in the term sheet must be incorporated into legally-binding documents such as a Preferred Stock Investment Agreement, an amended and restated Certificate of Incorporation, and an Investors’ Rights Agreement. Written consents from the shareholders and board of directors must also be drafted to evidence their approval of the financing arrangement.
- In a cumulative dividend arrangement, any unpaid dividends accumulate over time and must be paid out in full before other shareholders receive dividend payments. Upon liquidation, an outstanding cumulative dividend balance is included as part of a preferred stockholder’s claim on the liquidation proceeds.
- Some preferred shares might convert into more than one share of common stock, so voting rights are distributed among the stockholders relative to the number of common shares they would have if all the preferred stock converted to common stock.
- Many actions, including issuing additional shares of stock, require the company to amend its articles of incorporation.