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)
Confidentiality Provisions – Confidentiality provisions usually prevent the startup from disclosing the terms of the term sheet to anyone outside of its officers, members of the board of directors, the startup’s accountants or attorneys, and other potential investors acceptable to the investor who submitted the term sheet. The startup must ask for the investor’s permission to share the details of the term sheet with anyone outside of those explicitly described in this provision. Unlike most of the other terms in a term sheet, the confidentiality provision is legally binding. The no-shop provision (see Item #3) and provisions discussing fees and out-of-pocket expenses resulting from the fundraising are typically the only other legally-binding aspects of the term sheet.
Given the sensitive nature of funding offers and the competitive nature of the VC industry, these provisions usually represent a reasonable request intended to keep competitors from learning a particular VC firm’s strategy.
Negotiating Tips: Nearly all investors include a confidentiality provision and you are unlikely to eliminate this provision during negotiations. If you would like to share the details of the term sheet with a party not listed in the confidentiality provision, you can request that person to be added to the list of permissible individuals or ask for explicit permission from the investor.
Prior to accepting a term sheet, you can still engage in robust negotiations with other investors without breaching the confidentiality provision. Receiving an offer sheet can indicate the market for your startup’s stock and help you re-assess your expectations1[ for a potential financing event. An offer sheet can inform you about whether you should raise or lower your expectations for certain aspects of a proposed financing round, but the terms of a different investor’s term sheet should never enter the negotiation process. Instead, you should remain focused on finding the best deal available by focusing on your startup’s needs and the investor’s willingness to meet those needs. (For more information on term sheet negotiations, see our Term Sheets Overview article.)
Information Rights – Information rights stipulate the amount of information that investors receive regarding the startup’s performance. This provision enables investors to independently evaluate the company’s performance and ensure that management is not misleading investors. A standard set of information rights typically provides access to quarterly financial statements, an annual budget, a quarterly updated cap table2 and the company’s facilities and employees. Some very early-stage companies provide investors with tax returns3 instead of financial statements because they do not have a legitimate bookkeeping function. These requests are usually reasonable given the risk that investors assume, and probably cannot be negotiated out of the term sheet arrangement.
The most investor-friendly information rights include the right to a forensic audit, which allows the investor to inspect any document in the company’s possession. Forensic audits allow investors an unparalleled view into the company, which can be burdensome for the management team. If an investor requests rights to a forensic audit, you should discover why they seek this level of access. For example, some VC firms include this right in all their contracts due to past experiences working with a fraudulent company. Investors are unlikely to exercise these rights unless they suspect fraudulent activity. Without a good reason for this request, however, demanding such access could represent a distrust of the management team.
Negotiating Tips: Although these terms are usually standardized, you should review the information requested by investors and question the inclusion of any unusual or overly burdensome requests. Many term sheets only grant information rights to investors who own a certain percentage of the company’s overall stock (e.g., at least 5% ownership) or who have contributed a certain amount to the funding round (e.g., purchase at least $1m of Series A preferred). By limiting information rights only to major investors, you limit the operational burden of complying with information requests from investors. Also, you should restrict investors’ use of the provided information to prevent the distribution of information to competitors.
Be cautious with granting observer rights, which allow a representative to sit in board meetings without getting a vote. Observers can obtain confidential information that should not be shared openly with all investors and influence board discussions even though they do not have an official vote.
No-shop Agreement – Most term sheets include a “no-shop” clause in which the startup management team agrees to focus on completing an investor’s proposed offer without pursuing better offers from other investors. Before accepting a term sheet, you can “shop around” for the best offers from different VCs and use the various term sheets you have received as negotiating leverage. However, once you agree to a term sheet, investors expect in good faith to have your commitment to the deal. As such, potential investors typically require a period of exclusivity during which you cannot actively seek offers from other investors. The interval between when you agree to a term sheet and when the deal closes provides the potential investor with time to evaluate the business at a more detailed level4 before committing to the funding round. This period also provides time for you and the potential investor to finalize the details of the arrangement and proceed with drafting the legal documents5.
The “no-shop” agreement usually prevents you from engaging with competing investors for the period of 45 – 60 days. If the deal has not been completed by the end of the allotted time, you are released from your commitment and are free to solicit other funding proposals. Unlike most of the provisions in a term sheet, the exclusivity clause is legally binding. Even more importantly, your company’s reputation is at risk if you break the no-shop clause, which could hinder your ability to raise capital in the future.
Although not common in VC funding rounds, some no-shop provisions require the startup to pay a break-up fee if it breaches the no-shop provision and closes an investment or sale transaction within the exclusivity period. The break-up fee is often included when the potential investor believes the startup is likely to be sold prior to the completion of the funding round.
Negotiating Tips: Nearly all investors include a no-shop agreement and you are unlikely to eliminate this provision during negotiations. However, you can try to negotiate a shorter period during which the investor has exclusivity under the no-shop agreement. A shorter exclusivity period not only encourages a quick finalization of the funding round but allows you to quickly re-engage with other investors if the proposed funding arrangement breaks down during due diligence and final negotiations. Many startups have low cash reserves and negative cash flow, making them reliant on investor funding to finance the daily operations of the business. A delay of even a week in closing a funding round may adversely affect your startup’s ability to make payroll, fund product development, and pay for other essential business activities.
Generally, no-shop provisions are not a major discussion point during negotiations because unlike other provisions, this provision has no effect on the final fundraising agreement. Instead the no-shop provision only influences the startup’s ability to interact with other investors prior to the close of a deal.
Redemption Rights – Redemption rights act similar to a refund by allowing investors to exchange their stock for the amount of their original investment (and possibly accrued dividends) after a pre-determined amount of time. Many startup investors, like VC funds, can only deploy capital for finite time periods (usually 7-10 years) after which they must exit their investments and return capital to their limited partners. (For more information about VC funds see our Venture Capital)
Theoretically, redemption rights allow investors to exit an investment and return capital to their limited partners, even if they did not receive a return on their investment. In practice, investors rarely exercise their redemption rights. Redemption rights aim to allow investors to pull out of companies that are not quite successful enough to go public or be acquired. However, companies in that position can rarely afford to pay out the redemption rights to investors.
The real reason investors insist on having redemption rights is to incentivize management to grow the company. If founders use the investment proceeds to pay themselves a salary without trying to grow the business, investors can threaten to exercise their redemption rights and take cash out of the company.
Negotiation Tips: Nearly all term sheets initially include a redemption right, but you can negotiate to have this provision removed since they are rarely used. If investors insist on including this provision, you should negotiate terms that prevent investors from exercising their redemption rights for at least 5 years after the initial investment. Another compromise that would limit the likelihood of investors exercising their redemption rights would be to require the approval of a majority (or supermajority) of preferred stockholders before investors can exercise their redemption rights. You can also limit the amount that would be paid out to investors if they exercise their redemption rights by negotiating for the redemption of only their initial investment amount, without any cumulative dividends6.
You should also prevent any attempts by investors to include a Material Adverse Change (MAC) clause that triggers the exercise of redemption rights. MAC clauses have vague language that could allow investors to exercise their redemption rights before the agreed-upon timeframe.
Some investors may seek for control of the board of directors if the company cannot fully redeem investors’ stock. You should resist such demands because they could enable certain investors to wrest away control of the company.
Registration Rights – The registration rights provision describes the startup’s responsibility to register the stock held by preferred shareholders as part of a public offering. Only shares of stock that have been registered with the Securities and Exchange Commission (SEC) can be freely bought or sold on public stock markets. During an IPO, investor’s preferred stock automatically converts to shares of common stock, but those shares must be registered with the SEC for investors to sell their shares on the stock exchange.
Theoretically, registration rights could even force a company to go public if investors exercise their registration rights while the company is still privately held. Fortunately, investors rarely exercise their registration rights to force a public offering against management’s will. Instead, investors use their registration rights as negotiating leverage to encourage management to pursue a liquidity event.
If the startup eventually goes public, many of the provisions in the registration rights section may be changed by the investment banker leading the offering. The investment banker is tasked with maximizing the success of the offering, which at times may contradict what investors negotiated in the registration rights years earlier. Investors are usually very accommodating of these changes because the banker’s actions will maximize investor returns.
Investors usually receive both demand registration rights and “piggyback” registration rights. When investors exercise demand registration rights, the company is forced to undertake the process of registering the investor’s shares with the SEC. Registering shares is a costly, time-consuming activity that may expose the company to additional legal liability. Investors who own above a certain percentage of stock can force the company to register its shares after a certain period of time (usually 3-5 years after the funding round or 6 months after an IPO). Piggyback provisions allow investors to participate in the registration of shares requested on behalf of the company itself (in an IPO) or other shareholders (in a secondary offering).
Investors often include another section related to S-3 registration rights for secondary offerings one year after the IPO date. The registration and offering process is much quicker and simpler for public companies than for private companies issuing public shares for the first time.
The registration rights section also clarifies many other details, including whether investors can transfer the registration rights to family members or business partners. For example, the standoff or lock-up clause prevents investors from selling their shares for a certain period after the offering (usually 120 to 180 days), allowing the market price time to stabilize before additional shares are added to the market.
Negotiation Tips: Since registration rights are rarely exercised by investors, these rights should not be the focal point of negotiations. However, startup investors will likely insist on including these rights in the final version of the term sheet. Given the high cost of registering shares and executing public offerings, you should strive to limit the number of times that investors can demand share registrations (typically no more than 2 times). You can also set a minimum size for a registration to prevent trivial registrations wasting inordinate amounts of money and attention.
Voting Rights – The voting rights clause simply states that each share of stock (preferred or common) has equal voting power on an as-converted7 This is important because corporate law in certain states requires approval of each class of stock before amending8 the company’s articles of incorporation. This clause essentially treats all investors as a single class of stock when voting on important issues, allowing the company more flexibility. Without this clause, a minority shareholder who owns all of one class of stock could block any action, even if all the other investors agree.
Note that within the context of the rest of the term sheet, investors do not have equal voting rights on all issues. Many of the other provisions in the term sheet provide investors with special rights of approval, including the selection of board members and other important company decisions. (See the Board Composition and Protection Provisions sections of our Term Sheets Provisions (Part I) article.)
Negotiating Tips: None. The voting rights provision merely streamlines corporate governance procedures and does not favor investors or founders.
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.