What are the standard venture capital terms every entrepreneur should know? A Venture Capital (VC) term sheet is the first formal document between a startup founder and an investor in the startup fundraising context.
The term sheet lays out the terms and conditions of the investment. It finalizes the terms, which a contract subsequently outlines in detail.
The investor prepares the VC term sheet which is usually less than ten pages. A strong VC term sheet balances the interests of the investors and the startup founders. This move is better in the long run for everyone involved (including the company).
Otherwise, a bad VC term sheet pits investors and founders against each other.
The Ultimate Guide To Pitch Decks
At each investment round, a Venture Capital term sheet is generated, which is usually denoted by a letter:
- Pre-Seed and Seed stage: Angel investor or Family and Friends” round
- Early-stage: Series A, B
- Expansion stage: Series B, C
- Late-stage: Series C, D, etc.
Deal volume has favored earlier stage investments. However, in recent years, there has been a clear shift toward larger-scale transactions.
As one might assume, the average deal size for later-stage investments is substantially greater. Yet early-stage venture capital investments have been rising across the board.
The Common Sections of a Venture Capital Term Sheet
Each term sheet may differ based on the circumstances of the startup and the needs of both the startup and the investor. However, there are a few topics that any Venture Capital term sheet should cover.
You have to know what you’re negotiating about before you can negotiate terms. While determining the value of an early-stage startup can be challenging, there are common valuation methods that you can use.
You’ll include both pre-money and post-money valuations on a Venture Capital term sheet.
The difference between pre-money valuation and post-money valuation:
- Pre-money valuation: The value of a company before a funding round
- Post-money valuation: The new investment(s) after the financing round will be accounted for in the post-money valuation. The newly raised funding amount will multiply with the pre-money valuation to arrive at the post-money valuation.
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The following are included in the Offering Terms section:
- Investor names
- Closing date
- Price per share
- Amount raised
- Pre-money valuation
The Offering Terms section often establishes a new class of Preferred Investor shares with particular rights that exceed those of common shareholders (e.g., dividends, investment protection, and liquidation rights).
Every entrepreneur should do their research on what are the standard venture capital terms and understand them carefully.
The Charter displays the dividend policy, protective provisions, liquidity preference, etc.
- Dividend policy: The timing, amount, and cumulative nature of dividends are all clarified.
- Anti-dilution protection: In the occurrence of a down round, Venture Capitals are protected so that their conversion ratio to common stock remains the same as new investors.
- Liquidation preference: One of the most significant clauses in a term sheet is the liquidation preference, which reflects the sum that the startup will have to pay at the time of exit (after trade creditors, secured debt, and other company obligations). While most entrepreneurs are concerned with valuation, venture capitalists are concerned with the liquidation preference structure.
- Pay-to-play provision: Unless preferred shareholders buy in the next round at a lower price (“down round”), they can lose anti-dilution protection. In this situation, preferred will generally convert to common.
Two Types of Dividends
- Cumulative: Cumulative dividends favor preferred stockholders (i.e., investors) and disadvantage common stockholders (i.e., founders and employees). Every year, the company calculates the dividend. If the company cannot pay it, it carries forward (accrued) the dividend dues into the following year until it pays the sum or cancels or the right to dividends.
- Non-cumulative: A non-cumulative dividend requires a company’s Board of Directors to declare the right to a dividend for that fiscal year. If this does not occur, no one is entitled to a payout for that year. For holders of common stock, this is an excellent deal.
Two Types of Anti-Dilution Rights
- Full-ratchet: This is great for preferred stockholders and worst for common stockholders. It permits the preferred stock’s conversion price to be determined based on the cost of the new round of shares rather than the number of new shares issued.
- Weighted average: Holders of common stock benefit more from weighted average anti-dilution rights than from full-ratchet anti-dilution rights. Weighted average anti-dilution rights are based on a method that considers both the share price and the number of new stocks issued. The price at which preferred stock converts to common stock gets calculated using this formula.
As a startup owner, take the time to understand what are the standard venture capital terms and what they signify.
Stock Purchase Agreement (SPA)
For the Stock Purchase Agreement, the SPA includes initial clauses on foreign investment regulatory stipulations, representations and warranties, and legal counsel designation.
VC term sheets generally include a section concerning investor rights. Because the rights listed here can vary considerably, it’s a good idea to contact a lawyer to make sure you’re getting the best deal possible.
Investor rights typically refer to specific activities that investors are entitled to take or expect.
Registration rights, information rights, lock-up provisions, the opportunity to participate in future rounds, and employee stock option specifications get highlighted in the Investor Rights section.
- Registration rights: The right to register shares with the Securities and Exchange Commission (SEC) so that investors can sell them on the open market
- Information rights: The access to a copy of quarterly and annual financials for preferred shareholders
- Lock-up provision: Defines the time limits for selling in the event of an initial public offering (IPO)
- Right to participate: Existing investors have the option to purchase shares in future financing rounds
- Employee option pool: The percentage of shares reserved for key employees (both current and new hiring) and the vesting schedule for option grants
Ownership Percentage of Share Classes
While a company’s Board of Directors often makes major decisions, some will get decided by a shareholder vote. A portion of your term sheet describing ownership percentages of share classes — that is, what percentage of the startup each person/group owns — should be included.
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Right of First Refusal / Co-Sale Agreement
The right of first refusal (ROFR) clause allows the startup and/or the investor to buy any shareholder’s shares before any other third party.
A co-sale agreement allows shareholders to sell their shares simultaneously as another group under the same conditions. Explore what are the standard venture capital terms and other legal jargon.
This establishes the future Voting Agreement, including the composition of the Board of Directors and drag-along rights.
- Composition of Board of Directors: 4-6 individuals on average, with a mix of founders, Venture Capitals, and outside advisors.
- Drag-Along Rights: If the board of directors and/or most shareholders agree, all shareholders must sell.
Board of Directors
While a Board of Directors’ idea may seem absurd to a startup, it is an essential component of any company’s growth. As a result, most term sheets will have a section dedicated to the Board of Directors.
Even if you and a co-founder are the only ones in your startup right now, the goal is to expand. Equal participation of founder-friendly and investor-friendly members on a Board of Directors is the most equitable provision.
Some startups may want to have one “independent” member, someone from the business community who is well-liked by everyone.
When it comes to investing, investors prefer certainty. One of the risks is that you become dissatisfied with the startup as the founder and decide to leave.
As a result, investors are constantly looking for ways to reduce the risk of losing founders. Founder share vesting does this by making it difficult for a founder to leave the company by placing their stock at risk.
Furthermore, the returned shares enable the organization to incentivize a suitable successor to the departing founder. You should not be treated as an employee if you’re a founder.
Where an employee share option plan is in place to incentivize future work, you have already accomplished a great deal and should be recognized.
As a result, work out a vesting schedule that works for you. Excluding a portion of your holding from this arrangement is not unreasonable.
Single vs. Double Trigger
What happens at the time of a sale is a crucial aspect of any vesting system. The simplest option is for all shares to vest immediately at the time of sale.
This also gets referred to as a “single trigger.” When understanding what are the standard venture capital terms, expect to see these on the list.
The other option is for the founder’s shares to vest after being a good leader (e.g. 12 months). This gets referred to as a “double trigger.”
While a single trigger may appear to be the most appealing option for a founder, the double trigger has benefits.
When a potential buyer considers purchasing your startup, they will almost certainly want some assurance that you would stay for at least the company’s integration.
As a result, it is not uncommon for founders to waive their single trigger at the time of the deal to facilitate the transaction.
Once you’ve decided on your lead investor from among your available possibilities, a no-shop agreement is usually included in the final VC term sheet.
Accepting to commit to getting a deal done is a part of the process of negotiating the final term sheet with this investor.
To make the commitment mutual, founders may want to tie the no-shop rule to a period of 30-60 days. The founder commits not to shop the deal, and the Venture Capital investor pledges to complete the transaction promptly.
When you’re ready for some more detailed information about what is a term sheet, check out this video. I have talked about some in-depth nuances that you’re sure to find helpful.
The term sheet’s expiration date and a copy of the Pro-forma cap table are examples of other terms.
Investors with redemption rights have the option of getting their money back. This will not be an issue whether your startup succeeds or fails because the investor will receive a return in the former scenario, and no one will receive anything in the latter.
However, redemption rights might be a concern if a startup is going through a hard patch and a wary investor requests their money back, thus sinking the startup.
“Board fees” and “monitoring fees” are two fees that may appear and may be fought. The investor will charge you for their attendance at board meetings or the responsibility of monitoring their investment in both situations.
Milestone-Based Financing / Tranched Round
With milestone-based financing, everyone agrees that another financing piece will follow an initial portion (tranche) of funding if the startup meets specific milestones.
If the startup fails to meet specified milestones, the investor may amend the terms of the agreement. In other cases, founders only get given a percentage of the money if they fulfill specific milestones.
This is why it is critical that you understand what are the standard venture capital terms and what they mean.
Multiple Board Seats Per Investor Per Round
It’s standard practice to provide each investor with one board seat per round. Allowing a greedy investor to take more than that dilutes your stake and control in the company and may limit future funding rounds.
Non-Binding vs. Binding
While most term sheets are non-binding (the purpose is to lay down terms to enter into a legally binding agreement hopefully), there are several exceptions.
If the term sheet expressly specifies that it is non-binding, then it is such. If it contains a phrase requiring the parties to “negotiate in good faith,” neither party can back out simply because their views have changed.
Some provisions in other term sheets are non-binding, while others are not.
The conclusion here is that you should carefully examine all of the material on your Venture Capital term sheet to see if the structure is appropriate for you and your startup.
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