What is a Term Sheet?
A term sheet is a (mostly) non-binding agreement that outlines the basic terms and conditions under which an investment will be made. Think of it as the dating phase before you get married—this is where both parties lay out what they expect from the relationship, but nobody's legally committed yet.
We're saying mostly non-binding, because there are usually two binding terms in all term sheets, once they are signed:
- You (founder/startup) agree to not negotiate with other parties
- All information exchanged between parties is confidential.
Despite being (mostly) non-binding, the term sheet is crucial; it sets the tone for the detailed, legally binding documents that will follow.
Here are the main clauses you should know about, grouped by type of clause.
Governance and Control Clauses
Board Composition
Who gets a seat on the board?
It is important to understand if you and your co-founders will have the majority on the board, or if the investors will.
Voting Rights
These define how much say the investor will have in company decisions.
This can range from veto power on certain issues to a mere obligation to consult on certain questions.
Financial Clauses
Valuation
This section discusses pre-money valuation, post-money valuation, and the size of the investment. Knowing your company's worth before and after the investment is critical for understanding your ownership dilution.
Make sure to understand the difference between pre-money and post-money, as well as between non-diluted and fully-diluted valuations.
Liquidation Preferences
The objective of this clause is to align the interests of founders and investors, by dissuading an exit favoring founders but not investors.
It determines the pecking order when the company is sold or liquidated. Who gets paid first?
You will also hear about the order of the waterfall.
Here is how a traditional waterfall will work:
- Carve out: an initial amount (for instance 10%) is distributed to all shareholders based on their share ownership.
- Distribution to preferred shares holders: Owners of preferred shares (i.e. investors) collect the higher of either (i) the value of their investment times a multiple (1x, 2x, …) minus their pro-rata of the carve-out or (ii) their pro-rata post-conversion of preferred shares into ordinary shares.
- Distribution to ordinary shares holders: the remaining funds after the carve-out and repayment of preferred shares holders is then distributed to ordinary shareholders based on their pro-rata share.
Pay close attention to these specific terms:
- Carve out percentage
- Multiple: 1x, 2x, …
- Participating / non-participating
Liquidity Clause
Forces the company and its shareholders to use their best efforts to achieve a sale of the Company or an IPO before the nth anniversary of the closing. **
Ratchet
A ratchet clause is an anti-dilution mechanism protecting investors in down-rounds (i.e. when the company issues shares at a lower valuation than in previous rounds).
The ratchet adjusts the price at which the preferred shares of the investor convert into common shares, to increase their ownership share.
This clause protects investors from being diluted too much if the company has to raise at a lower valuation in the future, at the cost of diluting other stakeholders, usually the founders and employees with stock options.
Pre-emption/Pro-rata Rights
These clauses protect the investor from future fundraising rounds diluting their share. There are different types, like the Right of First Offer or Right of First Refusal, and the devil's in the details.
Securities Transfer Clauses
Several clauses supervise how securities can be transferred.
Drag-along Clause
A "drag-along clause" is a provision that allows majority shareholders to force minority shareholders to join in the sale of a company.
Tag-along Clause
A "tag-along clause" allows minority shareholders to join a sale initiated by majority shareholders, selling their shares on the same terms, conditions, and price.
Founders-related Clauses
Several clauses are related to the founders themselves.
They will govern:
- Exclusivity
- IP
- Non-compete
It is particularly important for you to understand the founder vesting clause.
Founder vesting
This clause determines how and when a founder earns their shares in the company. The primary aim is to align the long-term interests of the founders with those of the company and its investors.
Typically, founder vesting involves a "vesting schedule" and often includes a "cliff."
A common vesting schedule is a four-year vesting period with a one-year cliff. This means that if a founder leaves the company within the first year, they will not own any shares. After the one-year cliff, the founder might vest 25% of their total shares, with the remaining shares vesting monthly over the next three years.
Leaver clauses
These clauses determine what happens if you leave the company, on good terms (good leaver) or not (bad leaver).
Why It Matters
The clause that's the easiest to understand is the valuation.
It's the one that the media and your friends will ask about.
However, there are many other ones that are just as important!
If you have the luxury of having several term sheets, you shouldn't necessarily always go for the highest valuation offer.
While you might be tempted to look only at valuation, other clauses in the term sheet can be equally important for the development of the company and your exit strategy, and they should weigh in the balance.
Key Takeaways
- Non-binding but Important: The term sheet doesn't legally bind you, but it sets the stage for negotiations.
- Know the Terms: Understand each section, valuation is not the only important one!
- Negotiation is Key: This is your chance to negotiate terms favorable to you, so consult experts and don't rush.
Getting a term sheet is a significant achievement, but it's also the beginning of a complex dance!
To Go Further
Read “Venture Deals” from Brad Feld and Jason Mendelson: https://www.venturedeals.com/
The Galion Project’s Term Sheet: https://thegalionproject.com/en/outils/galion-term-sheet/
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