TERM SHEET FUNDAMENTALS
A “term sheet” is a legal document summarizing material deal points preliminary to a financing transaction. A term sheet is signed before the parties begin due diligence review and start preparing final, definitive documents.
This short article assumes an offering of preferred stock, and addresses three topics:
1. Negotiating a Venture Capital Term Sheet
2. Main Sections of a VC Term Sheet
3. Binding and Non-Binding Terms
(The term, “Term Sheet,” is sometimes used interchangeably with “Letter of Intent”. Click here to read about the differences between Term Sheets and LOI's and why both are important.)
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Negotiating A Venture Capital Term Sheet
The negotiation of a term sheet normally happens by exchanges of documents. In the context of a Venture Capital fund (“VC”) investment in a startup, it is common for the VC's lawyers to prepare the initial draft. The company counsel reviews the proposed term sheet with company management, making desired revisions. This continues until a final version is agreeable, or the parties go in another direction.
Main Sections Of A Venture Capital Term Sheet
There can be any number of formats. But, a general convention has developed by which the term sheet takes the form of a sort-of outline, including the following:
- Overview of the Offering
- Terms of the Offered Securities
- Deal Document Terms
- Additional Matters
Overview of the Offering
This section of a venture capital term sheet summarizes the following points:
- Securities Offered. The class and series of capital stock the company will offer.
- Closing Date. Date by which closing will occur. Alternatively, a statement that closing will be as soon as practicable following satisfaction of all conditions. If multiple closings are anticipated, this will be included.
- Closing Conditions. Conditions that must be met to close the deal. Commonly stated as “standard” or “customary” conditions. Any special conditions should be specified.
- Investors. Identity of individual investors, and/or qualifications of unnamed investors. Sometimes a lead investor will want the right to approve additional investors.
- Round Size. Amount in dollars to be raised. If the company has outstanding convertible securities (convertible notes, SAFE's or other purchase rights), these should be separately stated. If there is a minimum amount to be raised as a closing condition, or a maximum amount permitted, this should be stated.
- Minimum Investment. If applicable, any minimum investment for a given investor should be stated.
- Valuation. The “pre-money” valuation of the company is stated here as the basis for the price of the offered shares. The valuation typically includes the “free option pool” – uncommitted shares allocated for the company's Employee Stock Option Pool. Sometimes, the company's pro forma capitalization table is attached an exhibit to the term sheet.
Preferred Stock Terms
This section of a term sheet summarizes the relevant provisions for the company's certificate of incorporation (“charter”). The company's existing charter will be amended to include the terms of the offered securities, and any other provisions investor and company agree to, including some or all of the following characteristics:
- Dividend Rights
- Liquidation Preference
- Voting Rights
- Protective Provisions
- Conversion into Common Stock
- Anti-Dilution Protections
- Pay-to-Play Obligations
- Redemption Rights
- Certain Rights of Any Investor-Appointed Directors
A term sheet is a road map to preparing the deal documents. So, a VC term sheet commonly highlights their key provisions. Those documents include:
- Stock Purchase Agreement (“SPA”). Effectuates the sale of the preferred stock to the investors. The SPA includes a supplemental Disclosure Schedule, disclosing certain information and any exceptions to company representations.
- Investors' Rights Agreement (“IRA”). The IRA grants rights to investors. These commonly include the right to receive reports on company performance and finances; to sit in on board meetings; to have investor stock registered with the SEC; to participate in future fundraising transactions; and to approve certain company actions.
- Right of First Refusal and Co-Sale Agreement (“ROFR”).The ROFR covers two key things. First, it gives the company and investors the right to purchase shares that might otherwise be sold by founders before being offered to anyone else. Second, it gives certain stockholders the right to sell their shares when other stockholders do.
- Voting Agreement. Requires investors (and holders of converting securities, founders, and other key holders) to vote their shares in certain ways.
- Other Agreements. Other agreements may include a legal opinion from company counsel to investors; an agreement granting investors certain management rights; company's agreement to indemnify investor-appointed directors under certain circumstances; and other agreements that may be required or desired.
Term sheets commonly include a non-disclosure provision; a statement that each party is responsible for its own term sheet-related expenses; an exclusivity provision (restricting the company from seeking other offers); a requirement that founders' stock vest over time; and a governing law provision.
In addition, if the deal closes, the company normally reimburses the lead investor a certain amount of its legal and/or due diligence costs. Companies should ensure this is triggered only on closing and funding.
Finally, if applicable, the term sheet will require that any existing preferred stock be amended to conform to the new deal (implicating the need for consent from existing preferred stock holders).
Binding And Non-Binding Provisions
While a venture capital term sheet is typically a non-binding document, there are certain provisions that are commonly binding and enforceable. These provisions include confidentiality (non-disclosure) and exclusivity, which ensure that the parties involved maintain the confidentiality of sensitive information and commit to negotiating exclusively with each other for a certain period. Additionally, provisions related to governing law, dispute resolution, and jurisdiction are usually binding to establish the legal framework for any potential disputes. And, it is common for the parties to be bound to the provisions in the term sheet relating to legal expenses and no-shop provisions. It's important for both the startup and the venture capital firm to carefully review and understand these binding provisions to ensure a smooth and mutually beneficial investment process.
In conclusion, a venture capital term sheet serves as a critical document in the negotiation and structuring of a venture capital deal. It outlines the key terms and conditions to govern the relationship between the startup and the venture capital firm. While the term sheet is typically non-binding as to the deal itself, it sets the foundation for the final investment agreement and serves as a roadmap for both parties to navigate their investment journey together. Understanding the key components of a term sheet, such as the investment amount, valuation, ownership structure, and exit strategy, is essential for entrepreneurs seeking funding and for venture capital firms looking to make strategic investments. By carefully reviewing and negotiating the term sheet, both parties can align their interests, establish a solid foundation for the partnership, and work towards mutual success.
Term sheets are important legal documents, especially for startups. There are numerous legal, related tax, accounting, and business issues implicated in them. Contact an experienced corporate lawyer / securities attorney if you have been presented with a term sheet, or are contemplating negotiating a venture capital financing transaction. Make an appointment now for a free consultation.
This article is not legal advice, but is provided for general information purposes only: see the disclaimer in the footer of this site, and read my Legal Notices here.