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)
Anti-dilution Protection – When a startup issues additional equity to outside investors, the existing shareholders are diluted, meaning that their ownership percentage has decreased. If the valuation for the company falls relative to the previous valuation in what is known as a down round, investors often suffer even larger losses in ownership percentage. Anti-dilution clauses limit the amount of ownership preferred shareholders lose in the event that a subsequent round of funding results in a lower valuation. (For additional information about dilution, see our Dilution and Stock Option Pools)
Anti-dilution clauses protect investors by shifting much of the dilution to the common stockholders (usually held by founders and employees). If a down round occurs, anti-dilution provisions increase the rate at which preferred shareholders can convert their stock into common stock. This adjustment essentially provides additional shares of stock to the preferred stock investors, offsetting the dilutive effect of the down round.
There are many ways to structure anti-dilution provisions, with full ratchet and weighted-average anti-dilution protections being the most common. If subsequent funding rounds result in a cheaper price per share, full ratchet provisions provide extra stock to earlier investors, as if they had invested at the lower price. Weighted-average protections, meanwhile, do not provide investors as much extra stock as full ratchets.
(For more detailed information about anti-dilution provisions and different anti-dilution structures, see our Anti-dilution Provisions article.)
Negotiation Tips: Anti-dilution provisions are one of the most important provisions within the term sheet, and you should carefully review the terms in this section. Investor-friendly terms can be extremely detrimental to your personal holdings in the company. Common stockholders have a fixed number of shares and receive no dilution protections. Any additional shares issued to preferred shareholders via an anti-dilution provision directly diminish your ownership percentage.
If an investor presents you with a term sheet with anti-dilution provisions that generously favor the investor (such as a full ratchet), you should consider negotiating to replace them with less onerous provisions (such as a weighted-average provision). Alternatively, some founders pursue funding strategies that result in minimal dilution to founders, such as debt financing or bootstrapping. (For more information on the range of startup financing options, see our Convertible Preferred Stock and Convertible Debt, Types of Startup Investors, and The Stages of Startup Financing articles.)
Board Composition – This provision specifies the size of the board of directors (the “board”) and describes the incoming investor’s rights to board representation. Most major investors will require the right to select one or two of the company’s board members. Investors who have significant capital invested in the company want to ensure that they have a voice on the board and some influence over the company’s key decisions. Since different classes of stock can have different voting rights, some shareholders may be able to exert far greater influence over the composition of the board of directors than their ownership percentage would indicate.
The board composition usually reflects the ownership percentages of the different shareholders. In early funding rounds, founders often maintain control of the board of directors. As more and more equity is raised and additional investors add their representatives to the board, founders often lose direct control over the board. Since both investors and founders desire control over the board of directors, some companies compromise and elect an independent board member (not a shareholder) as the deciding final vote.
Negotiation Tips: This is one of the most important provisions within the term sheet because of how much influence the board of directors can exert on the direction of the company. All levels of management, including the CEO, operate under the guidance of the board of directors. The board has the power to fire and replace the CEO and other company executives. The board also oversees a company’s strategic decision-making, which usually entails mandatory board approval for any proposed acquisitions or investments. To avoid creating a fractured or antagonistic board of directors, make sure that you select investors that work well with you and share your vision for the company.
You can often negotiate both the size of the board and the number of board seats provided to incoming preferred stockholders. Investor-friendly terms provide more board seats to preferred shareholders, while founder-friendly terms would provide fewer board seats to preferred shareholders.
Conversion Rights – Nearly all startup investors insist on receiving convertible preferred stock in exchange for their investments. Investors prefer the additional protections that preferred stock provides, but often must convert to common stock to fully capitalize on the upside of their investment during a liquidity event1. The conversion rights provision articulates how and when preferred stock converts to common stock. (For more information on conversion features, see our Convertible Preferred Stock and Convertible Debt)
Preferred shareholders usually receive both automatic and voluntary conversion rights. Automatic conversion provisions are triggered when the company undergoes a qualifying public offering that meets certain thresholds for valuation and public float2. Investors include a valuation threshold to ensure an adequate return on their investment and a float threshold to guarantee that the IPO will generate enough liquidity3 for investors to sell their stock. If the IPO meets these criteria, the preferred shares automatically convert to common stock according to the stated conversion ratio4, adjusted for the effect of anti-dilution provisions. Preferred stock also automatically converts to common stock if a certain percentage of shareholders for that class5 of stock (usually over 50%) vote to convert.
Voluntary conversion rights allow preferred stockholders to convert their shares to common stock at any time. Investors usually exercise their voluntary conversion rights during a sale of the company. Investors will determine whether they will get a better return by keeping their preferred stock (considering their liquidation preferences6) or by using the voluntary conversion right to obtain common stock. (For more information about this decision, see our Liquidation Preferences article.)
Negotiating Tips: All investors will insist on including both automatic and voluntary conversion rights in the term sheet, but you may still be able to negotiate several aspects of these provisions. For example, you may be able to negotiate a lower valuation threshold for a qualifying IPO, thus providing the company additional flexibility with regard to future exit opportunities.
Co-sale Right – Co-sale rights (also known as a “Take-me-along” or “Tag-along” provision) provide preferred stockholders the option to participate along with common stockholders in a sale of stock. Common stockholders (usually founders and employees) are not allowed to sell, transfer, or exchange their stock unless preferred stockholders can also sell their shares under the same terms proportional7 to their ownership percentage.
Investors include co-sale rights to prevent common stockholders (founders and employees) from liquidating their shares and leaving the preferred stockholders without an exit opportunity. This provision allows investors the opportunity for a partial exit if a favorable opportunity presents itself. Note that a sale of over 50% of the company may trigger “change of control” provisions relating to liquidation preferences. (For more on this topic, see the liquidation preferences section.)
Co-sale rights work in tandem with the right of first refusal, and most term sheets will include both clauses. If investors decide not to exercise the option to purchase the common shares up for sale via the right of first refusal, they still have the option to participate in the sale via the co-sale right. (For more on this topic, see the right of first refusal section.)
Negotiation Tips: Co-sale rights are a standard part of most investment agreements. You may be able to disqualify certain types of transactions (such as transfers to family members) from the co-sale and right of first refusal provisions. Without such an exemption, transfers of stock to your family members may not be permitted unless the recipients of the stock also purchase a proportional number of shares from investors with the co-sale right. As many family members can rarely afford to purchase such large amounts of stock, the co-sale right may limit or entirely prevent transfers of stock to your relatives.
Drag-along Provision – Drag-along provisions allow investors to force the other shareholders to consent to a sale or merger. With this provision, majority shareholders can complete an acquisition even if minority shareholders oppose the sale, thus “dragging them along.” This provision provides investors the flexibility to exit their investments, while leaving other shareholders at the mercy of those with drag-along provisions.
Since founders and investors are both trying to maximize the startup’s value, both parties will usually agree on decisions to sell the business. Sometimes, however, founders and investors have misaligned incentives, leading to disagreements about acquisition offers. For example, venture capital (VC) and private equity funds usually operate under a mandate to provide returns to their limited partners 8-12 years subsequent to the fund’s creation. As the deadline to liquidate the fund approaches, investors may seek an accelerated exit, contrary to the wishes of the founders. (For more information on this topic, see our Venture Capital article.)
Another potential disagreement may occur if the offered exit price is below the preferred shareholders’ liquidation preferences. In this circumstance, founders are likely to oppose the transaction because preferred shareholders would receive all of the transaction proceeds, leaving common stockholders empty-handed. With the drag-along provision, founders cannot prevent a sale if the majority of preferred stockholders agree to the deal. (For more on this topic, see the liquidation preferences section.)
For most companies, the majority of shareholders must approve8 a proposed sale of the business. In startup companies that award drag-along rights to investors, the necessary approval for a sale rests entirely on the opinion of the outstanding preferred stockholders. All other shareholders must support the deal if the majority of outstanding preferred stockholders are in favor of the transaction.
Negotiation Tips: Your ability to negotiate the terms of the drag-along provision depends on your ownership in the company. If you hold only a small stake in the company, your opinion is unlikely to change the outcome of a shareholder vote, even without a drag-along provision. However, if you hold a considerable equity stake, you have more negotiating power to lessen the effect of the drag-along provision. Below are some common amendments that you can bring up during negotiations:
- Preferred Stockholder Approval – You can negotiate the percentage of preferred stockholders needed to trigger the drag-along provision above a simple majority of 50%.
- Approval by Common Stock – You can require a majority of common stockholders to also approve of the transaction instead of or in addition to the preferred stockholder approval. Preferred stockholders can still convert their shares into common stock to trigger the drag-along provision, but this would at least decrease the amount of outstanding liquidation preferences.
- Approval by Board of Directors – You can require the approval of the board of directors in addition to the preferred stockholders. Because board members have a fiduciary duty to protect the rights of all shareholders, this amendment increases the likelihood that the company will get a fair price in the sale.
- Minimum Purchase Price – To guarantee some type of payout for common stockholders, you can try to restrict the drag-along provision to situations where the company sales price exceeds investors’ liquidation preferences. Investors may be reluctant to agree to this amendment, but you should at least consider this alternative.
Dividend Provisions – Dividends represent payments or distributions from a company to its shareholders, usually on a recurring basis. Companies are not legally obligated to pay dividends to their shareholders until the board of directors announces, or declares, a dividend. Most startups do not pay cash dividends to investors because all available capital is needed to grow the business. Nevertheless, some preferred stock agreements allow investors to accumulate (accrue) dividends over the course of their investment and receive payment in the form of stock instead of cash.
The dividend provisions in a funding agreement dictate the preferred stockholders’ right to these payments and play an important role in the board’s decision to declare dividends. These provisions include four main components that detail the economics of the proposed dividend arrangement:
- Rate – The dividend provision specifies a rate at which the company will pay dividends to preferred shareholders if the company decides to pay a dividend. The rate is expressed as a percentage of the original issuance price9 for that investor. An investor with a 5% rate on a $1 million initial investment would receive a $50,000 dividend.
- Cumulative or Non-cumulative – In a cumulative dividend arrangement, preferred stockholders have a right to receive a specified amount of dividends each year10 (based on the rate—see above). If the company does not pay out this amount, the unpaid dividends accumulate over time until the company either makes the payment or enters liquidation. The entire balance of the cumulative dividends must be paid out during a liquidation event. Under non-cumulative dividend provisions, preferred stockholders do not have a right to receive a dividend, unless the board of directors explicitly declares a dividend. If no dividends are declared, stockholders do not accrue dividends from year to year and investors do not receive any additional compensation upon liquidation.
- Compounding or Simple – The structure of a dividend provision (compounding or simple) determines what happens when a dividend is declared (or accrued in the case of cumulative dividends) but not paid to investors. In a compounding dividend arrangement, the unpaid dividend accrues dividends in future periods, according to the specified dividend rate. For the purposes of calculating dividends, the unpaid dividend is treated as though it were part of the investor’s initial equity investment. In a simple dividend arrangement, on the other hand, unpaid dividends remain constant over time and do not accrue additional dividends.
- Preferred Stockholder Preference – Most agreements require that preferred stockholders receive preference over common stockholders. With this feature, common stockholders do not receive any dividends until preferred stockholders have been paid their dividends in full (either cumulative or non-cumulative). Some agreements do not give preferred shareholders dividend preferences, treating common and preferred stockholders equally.
A board of directors considering a dividend to shareholders must consider the preference clause to determine the dividend amount each type of shareholder will receive. If a large cumulative dividend is owed to preferred shareholders that have preference, the company may be less likely to declare a dividend.
Negotiating Tips: Investors will likely require dividend provisions, but each of the main aspects of the dividend provision may be negotiable. One common compromise is to disallow any cumulative dividends to be paid out until a liquidity event and to require that any unpaid dividends be forfeited upon conversion to common stock. A founder-friendly provision would feature a low dividend rate, non-cumulative dividends, and no dividend preference. If investors receive large cumulative dividend payouts, the value of your equity stake may be diminished during a liquidity event.
Liquidation Preferences – Investors include liquidation preference clauses within term sheets as downside protection in case the startup’s exit is below expectations. Liquidation preferences represent a right to receive proceeds from a liquidation event before other shareholders.
Term sheets indicate how many multiples of their initial investment preferred shareholders receive before other shareholders receive any liquidation proceeds. A 1x multiple means that preferred stockholders have the right to recoup 100% of their initial investment before other stockholders receive anything. Using similar logic, a 2x multiple guarantees that preferred shareholders will at least double their investment before other shareholders receive any of the transaction proceeds. The higher the multiple, the more favorable the terms are to investors (and harmful to founders). Many VCs structure deals with a 1x multiple, but some deals include multiples of up to 3x.
Investors sometimes receive a percentage of any proceeds remaining after the liquidation preferences have been paid. In these situations, preferred shareholders participate in the residual value of the firm, as if they had converted their shares to common stock. Full participation provides preferred shareholders with the right to a liquidation preference and a percentage of all residual proceeds. Participating liquidation preferences are very generous to investors, allowing them to receive the downside protection of a creditor and the upside potential of an equity holder.
Negotiating Tips: Nearly all investors require at least a 1x liquidation preference, but you can petition for a preference multiple no higher than 1x. You can also negotiate for investors to receive capped participation or no participation, instead of full participation. Providing generous liquidation preferences to investors can significantly diminish the return for founders and employees. (For more detailed information on liquidation preferences, see our Liquidation Preferences article.)
Pay-to-play Provisions – Unpredictable economic forces, inconsistent company performance, and changing investor sentiment can make raising financing difficult for even the best-run startups. Pay-to-play provisions help ease some of these concerns by requiring investors to participate in future funding rounds. If existing investors do not contribute additional capital on a pro-rata11 basis, they can lose investor protections like anti-dilution protections, liquidation preferences, and voting rights. Pay-to-play provisions benefit startups by providing a very strong incentive for investors to contribute more capital in the future, increasing the startup’s ability to raise financing.
Pro-rata rights also relate to an investor’s ability to participate in future financing rounds, but they aim to help investors, not founders. (See the pro-rata rights section to learn more.)
Negotiating Tips: An investor’s initial term sheet usually won’t include a pay-to-play provision because these are founder-friendly clauses. You should consider requesting a pay-to-play provision in the contract as part of the negotiation process. As a compromise, some agreements include pay-to-play provisions that only go into effect when certain events occur, such as a down round.
Milestones – Some investors structure their capital contributions contingent on the startup achieving specific goals or milestones (also known as tranched investing). The investor may put in a certain amount of money upfront, with future payments scheduled to coincide with the achievement of certain company milestones.
For startups with an unproven but highly promising product offering, a financing arrangement involving milestones may prove helpful. The company can test out its strategy with an initial investment and then investors can provide even more capital if the initial efforts are successful. However, for early-stage startups that are still unsure about their product offering, setting milestones may hinder management’s ability to pursue new growth opportunities. Financing structures incorporating milestones or royalty arrangements12 may restrict the amount of available capital during a startup’s nascent years, hampering its future growth.
Many in the startup community believe that milestone financing arrangements are unnecessary because the startup financing process already provides incremental yet increasing access to capital over time. They argue that instead of using milestones, startups could use smaller, more frequent funding rounds and avoid the problematic process of setting and achieving milestones.
Negotiating Tips: If an investor offers you a term sheet with milestones, you should consult with a trusted, experienced advisor to ensure that these milestones will not hinder your company’s development. Early-stage startups often need to adapt their business model and/or product offerings multiple times before arriving at the right strategy. If you agree to a deal with milestones and then significantly change the direction of your business, it may be extremely difficult or impossible to access the capital attached to milestones.
Protection Provisions – These provisions provide preferred stock investors with the right to veto certain company decisions. Entrepreneurs prefer to have no protection provisions, allowing them greater control over the direction and strategy of their startup. Investors, meanwhile, would like additional veto-level control, especially on decisions that affect the value of their investment.
Some of the activities investors desire to specially oversee include:
- Amendments of investor rights
- Increases in the authorized number of common or preferred stock
- Redemption/repurchase of shares of common stock
- Merger or sale of the business
- Increases to the size of the board of directors
- Declaration of a dividend
- Issuance of debt above a desired threshold
- Hiring of company officers
- Compensation programs for employees
- Creation of employee stock option programs
- Creation of annual budgets, business plans, and financial plans
- Large real estate leases or purchases
- Entrance obligations or commitments
Note that protection provisions do not preclude the company from pursuing any of the actions listed above. They simply require the approval of a class of shareholders before doing so.
Whenever startups raise new rounds of financing, the new investors must decide whether to receive the same protection provisions as previous funding rounds or to receive a separate set of protective provisions. Investors who feel that their interests do not align with prior investors will often insist on a separate set of protective provisions. To streamline decision-making, founders usually prefer to give the same protective provisions to all classes of stock. Otherwise, each class of stock with its own set of protective provisions would represent an additional approval (and potential veto) that management must obtain before taking action.
Negotiation Tips: You can try to convince board members that their influence on the board of directors makes the need for additional investor protections redundant. However, in response, some investors may argue that board members have a duty to look out for the best interests of all shareholders, not necessarily the best interests of their particular class of stockholders. Protective provisions allow investors to act in their own self-interest rather than in the interest of all stockholders.
Pro-rata Right – The pro-rata right (also called preemptive right or participation right) provides founders with the option to maintain their ownership percentage in the startup by participating in future financing rounds. These rights do not let investors increase their ownership percentage in the startup but do permit the opportunity to buy additional shares in future financing rounds to prevent the dilution of their ownership positions. (For more information on dilution, see our Dilution and Stock Option Pools)
Investors like this clause because it allows them to avoid dilution in successful companies that are raising additional capital. Early-stage VC investors make many investments, few of which will lead to successful exits. VCs want to capture large returns on their successful investments by retaining as much of the company ownership as possible. Pro-rata rights allow investors to capitalize on a startup’s upside potential by participating in future financing events if the startup performs well without the downside risk of needing to invest more if the startup performs poorly.
Unlike pay-to-play provisions which force investors to participate in future financing rounds, pro rata rights provide investors with the option but not the obligation to participate. Whereas pay-to-play provisions are designed to help the startup secure future investment, pro-rata rights are designed for the benefit of investors.
Negotiation Tips: VC-backed deals almost always include pro-rata right provisions, and most VCs will not accept a deal without them. From a VC’s perspective, this clause is an essential part of any investment. Although you probably cannot negotiate for large investors to forgo pro-rata rights, you can try to withhold these rights from smaller investors.
Right of First Refusal – This clause provides preferred stockholders with the option to purchase existing shares of stock that other shareholders have put up for sale. Preferred stockholders have the opportunity to purchase stock that is being put up for sale before any outsiders can purchase the shares. This right helps investors exert additional control over the company’s ownership structure by increasing their equity positions.
If a founder or company employee wants to sell some stock, preferred stockholders would have the first opportunity to purchase a portion of the stock, according to their ownership percentage in the company. Depending on the language of the clause, investors may be able to purchase more than their ownership percentage if not all the shares up for sale are purchased by other investors. If the preferred shareholders decide not to purchase some of the stock, the founder can then sell any remaining shares to an outside party. The pricing offered to the outside party cannot be superior to the pricing offered to the existing shareholders.
Note that the right of first refusal gives investors the option to buy existing shares while the pro-rata right relates to the issuance of new shares. (For more on this topic, see the pro-rata rights section.)
Negotiating Tips: Almost all startup investors will insist on including a right of first refusal clause in the final term sheet. This clause may not be important enough to spend significant amounts of time on during negotiations. If you do feel strongly about this provision, however, you can attempt to negotiate two points within this clause:
- Qualifying Investors – Often, you can negotiate restrictions on which investors receive the right of first refusal, based on their overall ownership percentage or participation in the equity round.
- Purchasing Ability – Investor-friendly terms allow preferred shareholders to purchase more than their pro-rata percentage of the stock up for sale. (If no other investors are interested, a single investor could potentially purchase all of the stock available for sale!) If you feel strongly about this issue, you can attempt to restrict investor purchases to their ownership percentage.
Exception for Family Members – Investors sometimes grant exceptions to the right of first refusal for transfers of stock to family members, either through a direct transfer or indirectly through estate planning. Without these exceptions, founders may have difficulty transferring shares to loved ones because investors would have the opportunity to halt the transfer and purchase the shares for themselves. Some founders have negotiated a specified, maximum number of shares they can transfer to family members each year.
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
- Shake Law: VC Term Sheets: Liquidation Preferences and Participation
- Fred Wilson Blog: Milestone Based Investing
- 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.