Navigating Termsheets

Termsheets are (1) used by founders raising capital and (2) investors looking to deploy capital. Most all termsheets are different in some slight way (unless you’re using a SAFE or KISS note), they usually require lawyers, and all are time-consuming where neither party usually gets 100% of what they want. For a founder, it’s about obtaining capital without giving up too much control of their company, and for an investor, it’s about both how much control they can obtain and what the economic upside looks like. If you’re a founder, it’s best to get legal representation when executing these financings and understand what levers can be pulled with preferred stock. It’s also important to pick your fights when negotiating: for example, ask yourself if you care about registration rights more-so than liquidation preferences and which terms you want to put effort into.

I wanted to cover some of the main sections a term sheet, why it matters, and an example as a founder.

Please note that there are many pieces I won’t cover below: voting rights, option plans, key person insurance, piggyback rights, asset purchase rights (M&A), drag-along rights, and voting thresholds to name a few. One great way to familiarize yourself with termsheets is just to read a dozen of them in a similar place you’re operating at. You’ll be able to google your way to them. I’ll also put some books and template material at the end of this post since there are a lot of great resources are out there to get educated on the topic.

Terms and their meanings (in no particular order):

The Round:

  • Normal rounds follow these titles: pre-seed (otherwise known as soil or angel), seed, series-A, series-B, C, D, E, F (etc.) to IPO, acquisition, or continuing to stay private. The amount of capital varies widely depending on the industry the company is in, the opportunity at hand, the current marketplace, and wouldn’t be fair to talk about a template. For example, Outreach (CRM tech) closed a series-F round of $50m at a $1.3bn valuation while Megvii (deep learning) closed a series-E round of $750m at a $4bn valuation. It quickly becomes alphabet soup and somewhat meaningless.
    • Example: we’ll do a series-A round in this example

Amount raising:

  • After understanding how much cash on the balance sheet you want over the next 24 months, you’ll need to understand what you have in the bank currently and what amount of revenue you can expect. The gap should be targeted as your round (with some buffering for safety). You’ll likely include your pre-money valuation (for this purpose lets say it was at $10m).
    • For example, after calculating you believe you’ll need $4,500,000, but want some cushion in your balance sheet and a buffer if landing clients take another month or two, so you raise $5,000,000.
  • Understand that the investors will want preferred stock. You’ll need to choose the aggregate number of shares to be sold and at what price: for example, 2.5m shares at $4 per share.
    • Typically your price per share is the pre-money valuation divided by the fully-diluted shares outstanding. Fully-diluted should mean that it’s the number of all outstanding stock on an as-converted basis (common, preferred, and even warrants or convertible securities).
  • Understand the type of payment – and that it’s cash you want.
  • You’ll also want to do some due diligence into what other rounds have happened and what they’ve looked like for other private companies. Some reports on this get published from Pitchbook to Wilson Sonsini’s quarterly financing trend report.
    • Example: we’ll raise $5m on $10m pre-money 

Warrants:

  • Warrants will either be issued or not (binary). A warrant will grant the holder an option to purchase shares at a particular price during a chosen duration. These would increase in value as the underlying share increases with the exercise price. You may structure warrants in your series A financing for an investor to sweeten the deal: for example, you expect your company to grow 75% YoY and the investor you want to be on your cap-table plans to help your company grow, thus wanting the option to get a higher percentage of the company in another 18 months. This is where warrants would come in. Conversely, as a founder you may not want to issue warrants given the cap-table you want to have, the control you desire, the funds you need, or the need to at all.
    • Example: we will have no warrants

Dilutive Financing:

  • You’ll need to choose with the next round investors if the financing will be dilutive to the existing capitalization structure in your company beyond the issuance of the new shares. Sometimes there will be a pay-to-play provision where investors must continue to invest or become diluted, or even harsher where current preferred holders must convert to common shares. The latter will require negotiations and be time-consuming.
  • Depending on if your company has been increasing in value, or decreasing, the investors may want it to be dilutive and to restructure the capital structure. For example, if the company has decreased since earlier rounds (your soil and seed round) then they may want it to be dilutive and have a ‘wash-out’ event. This usually wouldn’t happen for a series A, but could in later rounds.
    • Example: we will not have dilutive financing beyond the issuance of new preferred shares

Preferred Stock Rights – Liquidation Preference:

  • Liquidation preference – a very important topic – comes into play when the company has an event either along the lines of going out of business or a sale of the company. As a founder, you’ll have common stock and your investors are likely to all hold preferred (remember this). You game planning is important, as IPOs frankly don’t matter in these situations as it wouldn’t come into play. But the likelier scenario is that your company is purchased in the middle-market, where liquidation preference matters.
    • It’s likely that the terms will be senior-to-common and would be a bit rare if preferred did not have a preference over common.
  • The first point of negotiation will be around ‘purchase price’ or a multiple of that. The most common occurrence will be equal to the purchase price. But some investors may perceive the investment to be risker, asking for a multiple (say of 2x). If you have it at purchase price, it’ll reassure the investors that they’ll at least get their money back before amounts are distributed to common stockholders
    • Example: liquidation rights @ purchase price
  • The second point of negotiation is ‘participation right’. Which can be seen by some as investors ‘double-dipping’. For example, with non-participating, the investors holding preferred shares would only receive their liquidation preference (noted above, where our ‘takeaway was the purchase price’). The remaining would go to the common stockholders. But if investors have participation rights, they would normally receive an additional amount after the liquidation preference is paid out. This could be structured when a later stage company raises a financing round and expect to be sold in the next 12 months given their new investors want to ensure they can receive a premium on the capital deployed.
  • There will usually be an amount in multiple fashions. Normal levels are 1.5-3 depending on the round, company, and investors. For what it’s worth in today’s market, 3 is very aggressive, and depending on the situation, 2x can be as well.
    • Example: participation rights capped at 2x.

Preferred Stock Rights – Conversion to Common:

  • Normally the number preferred shares convert to common shares is a 1:1 basis. There are some important rights to holders of preferred shares, and one of them is the ability of the holder to convert to common stock of their choosing. Holders of preferred may choose to convert their shares to common stock if after calculating they’d receive more capital back than just receiving both their liquidation and participation preferences.
    • Example: conversation to common is 1:1

Preferred Stock Rights – Anti-dilution:

  • As we talked about above with dilution from the next rounds, investors will likely want protection and will request it. The normal term will be set on a weighted average (broad-based). Weighted averages are the most common and take into consideration the new financing and the number of already outstanding shares. Broad-based takes into account all shares into the average, where a narrow-based usually doesn’t consider options, warrants, or notes. Investors would likely want a narrow-based weighted average given the total pool being calculated.
  • Full-ratchet. This is not used as much any longer (similar to ROFRs). But the term takes into account a conversion to reflect the new lower price of the issued securities and does not take into account the number of shares to be issued or outstanding. Full-ratchet provisions are much more dramatic than the broad or narrow-based weighted average options.
    • Example: broad-based weighted average

Preferred Stock Rights – Redemption Rights:

  • It’s not normal for an investor to act on their redemption rights, but investors look to see a return on their invested capital. If that doesn’t happen (there’s no liquidity event in sight), this could be an outlet for them. It’s important to note that this could hurt your company because it may not have the cash on hand to pay and could be used as leverage by the investors to influence the founders’ decisions. It’s considered founder-friendly if you don’t have them and is a binary decision (yes or no).
    • Example: none

Preferred Stock Rights – Dividends:

  • Dividends are usually not paid out and in normal circumstances only be allowed to be paid out if is declared by your board. The percentage is usually a percentage of the purchase price and reflects some points above the prime rate. It’s not uncommon to see a range between 8-12%. Additionally, dividends are usually not cumulative; meaning they don’t accrue and accumulate whether or not declared by the board. Usually what will happen is that if an investor exercises their redemption rate clause, they’d be paid then, or in a likelier scenario when the preferred shares convert to common, those dividends would be used to convert to more common stock.
    • Example: 8%, priority is Senior-to-common, are not cumulative and common receives dividends after preferred payments

Preferred Stock Rights – Pay to Play:

  • This term applies to the current and future financings, doing exactly what the term implies. Brad Feld has a great blog post on this which I linked below. It’s quite common for this to be included as a requirement these days. Having this clause helps to ensure that investors continue on your company’s journey by continuously investing to continue receiving the same rights and ownership.
    • Example: Includes pay-to-play requirement applied to all future financings

In a pay-to-play provision, an investor must keep “paying” (participating pro ratably in future financings) to keep “playing”(not have his preferred stock converted to common stock) in the company. Sample language follows:

Pay-to-Play: In the event of a Qualified Financing (as defined below), shares of Series A Preferred held by any Investor which is offered the right to participate but does not participate fully in such financing by purchasing at least its pro-rata portion as calculated above under “Right of First Refusal” below will be converted into Common Stock.

Registration Rights:

  • This is a rarely used clause that’s usually embedded into every term sheet. It allows investors to have an ability to liquidate their holdings by making the company register those shares through ‘demand’, ‘S-3’, or ‘piggyback’ rights. By doing so it allows investors shares to be resold under certain circumstances. You’re likely to have this in your term sheet, but put a limit as to the number of shares and also the duration due to the costs, time, and importance of it all.
    • Example: Investors will have registration rights, with a minimum of 500k shares to transfer registration rights with a 2-year term following the closing of an IPO.

Market Stand-Off:

  • This clause ensures that if your company does one day have an IPO, investors don’t sell immediately and possibly shift the market in doing so. It’s normal for bankers to also ask or have a rule in place ensuring this doesn’t happen which is usually called a lock-up agreement.
    • Example: market stand-off of 180 days with IPO only to where it is conditioned only if directors, officers, and/or 1% stockholders agree similarly. 

Information Rights:

  • As a founder, you’ll need to give some sort of information rights to investors. Companies will typically agree to provide some sort of financial information rights and also an ability to inspect the records if desired. This can be annual, quarterly, monthly, and also encompass annual operating plans and usually has some form of a timestamp and signature on them (for example, 120 days after each fiscal year stamped by the CFO). Typically investors will want quarterly depending on the stage of the investment. This is so they can simply track the health of the performance. Be wary to provide monthly statements if you’re sub-series-A. You’re more about building and there’s not much to report then anyways – this type of ask usually doesn’t happen as it’ll just take up more time of the founders to create and distribute.
    • Example: annual and quarterly financials certified by the CFO. Annuals must arrive 120 days following the fiscal year, and 45 days after each quarter. The annual operating plan must be delivered 30 days after the fiscal year and the investors do not receive inspection rightsThese rights will terminate following an IPO. 

Right of First Refusal:

  • ROFRs (and ROFOs) can allow investors to participate in future financing (and/or sales). If you’re going with an investor who you believe you want to lead or partake in the next round you’ll do, this isn’t a hard topic to think about. But it is if you are unsure if you’d want the same money next time and providing someone with an ability to continue. Let’s pretend you’ve got a good relationship with your investor and this is something they want – you’ll likely let this go so you can negotiate other items which you find more pressing.
    • Exampleinvestors will have the right of first refusal on future company issuances but will be limited to stockholders without significant holdings of X shares. This applies to any new offering of securities and will not require the purchase of all the securities being offered. 
  • Moving to a future sale of the company, sometimes investors will require a founder that intends to sell to a buyer, instead offer the ability directly to the company and the investors. This provides the company and the investors to keep the stock in the existing ownership group and is usually considered to be used for strategic reasons – ensuring control does not go to a non-strategic or even hostile party. Although this term isn’t used as frequently as it was even 5 years ago. A lot of founders do not agree to have a ROFR for a sale as it turns off potential bidders knowing that term is there any whoever is within that clause can choose before them.
    • Exampleno, sales by founders or other stockholders are not subject to a ROFR. 

ROFR provides the non-selling shareholders with a right to either accept or refuse an offer from a selling shareholder after the selling shareholder has received a third party offer for its shares. A ROFO provides the non-selling shareholders with the right to make an offer for the selling shareholder’s shares before the selling shareholder can solicit for third party offers for its shares.

From the link above. 

Co-Sale Rights:

  • This clause allows existing investors to participate in a sale of the company’s stock by founders or other large shareholders. This can be asked by investors to protect their ability to generate liquidity. For example, if the founders want to exit the company by selling their shares to another, some of the existing shareholders may follow as they see what could be a transfer of controlling interest pass hands, strategy changing, and perhaps a closure of future ability to sell (against their current time horizon).
    • Examplethe sale by founders or other stockholders will be subject to co-sale rights, and shareholders must have a minimum of X shares to participate; it will terminate following an IPO. 

Vesting of Founders Shares:

  • This topic is usually pretty straight forward given industry trends. For example, most founders are put on a vesting schedule that has a standard four year period, with 25% vested after year one cliff followed by month-to-month vesting. This clause is usually instituted because if not, it could in theory allow the founder to raise this round, then 12 months later decide that they no longer want to be part of this journey, selling all their shares to another and leaving the company rudderless. You can look at this as investors’ insurance that the founders will continue to stay and build.
    • Example: all founders are subject to a vesting schedule of 4 years equally (25% per annum) and will commence after the closing of the round.

Legal Fees:

  • It’s normal to have investors usually ask that the company pay their fees in full or at a capped amount following the close. This is more of a reimbursement.
    • Example: the company will be required to pay the legal fees of one attorney to the investors, payable at closing, at a capped amount of up to $30,000.

No-Shop Restrictions: 

  • This clause is used to have companies agree to an exclusive negotiation period. Depending on the company (your balance sheet), the round, investors, and the current market; deals can close in weeks or months. As a founder, agreeing to this no-shop restriction too early could hinder your ability to get a better opportunity and investors still have no obligation to follow-through. If you do one, it will likely have terms around the period, the types of restrictions (an inability to participate in other discussions, etc.), to having to notify them of another proposal. It’s important to note though that this is a very relationship-driven industry. If you’re shopping deals behind investors’ backs, they’ll likely discover it at some point (when you close and with whom). This can hurt a reputation and also your network connections.
    • Example: no, there will not be an exclusivity period.

Resources:

Books: two books I liked are by Alex Wilmerding. One titled, “Term Sheets & Valuations: A Line by Line Look”, and a second of, “Deal Terms: The Finer Points”

Templates: NVCA model documents

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