Anatomy of a Term Sheet

A term sheet is simply a non-binding document outlining the terms of a proposed investment. If accepted, it becomes a guide for the lawyers who will draw up the actual legal documents required to complete the financing. As with anything, all of these terms are negotiable. Let’s dive in and understand what the terms mean.

This example is for a venture capital Series A (first equity financing) for our awesome new startup, Fitaco. Remember that venture capital investors are buying stock in your company (it’s not a loan), with the expectation that they will sell the stock at a large profit in the future, either when the company is acquired (by another company), or has an Initial Public Offering (an IPO, when the stock is sold to the public). They also want some protection if things don’t work out and the company has to be wound-down and the remaining assets sold-off. Here are the items on a typical venture capital term sheet, followed by an explanation of each:

Issuer: Fitaco, Inc., a Delaware corporation (the “Company”)

This is your startup, issuing stock that will be purchased by the investor(s).

Securities: Series A Preferred Stock (the “Series A Preferred”)

This simply refers to a series of stock certificates issued with each financing round. 

Valuation of the Company: $2,000,000 pre-money

In order to calculate what percentage of the company the new investors will own, both parties need to agree on the company’s current value before the financing (the pre-money valuation). Once the financing (new money) has been received, the new valuation is calculated (post-money valuation). New Money + Pre-Money Valuation = Post-Money Valuation. New Money divided by Post-Money Valuation = the percentage of the company that will be owned by the new investors.

Amount of the offering: Up to $3,500,000

Number of securities: 3,500,000 shares

Price per share: $1.00

I’ve kept the math simple for the sake of this example. The actual numbers will be computed based on your company’s current cap table, how many new shares will need to be issued, etc. In this example, with a pre-money valuation of $5M and investors putting in $3.5M worth of new money, this means the post-money valuation will be $8.5M, and the new investors will own 41% of the company ($3.5M divided by $8.5M).

Dividends: Dividend rate: 8%

This means that the investors will be “paid” a dividend each year on their stock. Typically they don’t actually expect to be paid in cash, but they do expect these unpaid dividends to accrue (and they’ll get them at some future liquidation date). So, for example, if the investors put in a million dollars and then a year later the company is sold, their liquidation preference (see below) will be one million dollars plus eight percent of that in accrued but unpaid dividends. 

Liquidation preference: Amount: Original purchase price plus accrued dividends. This means that when the company is liquidated, either by being sold or by being wound-down, VCs will get their investment back (plus accrued dividends) before any money goes to any founders or employees. This is an extremely important provision for you to understand. As described in this book, I once founded a company and when it was eventually sold, after all the liquidation preferences were paid, my remaining share of the proceeds was eighty-six dollars.

Conversion: The Series A Preferred may be converted at any time, at the option of the holder, into shares of common stock. The conversion rate will initially be 1:1, subject to anti-dilution and other customary adjustments.

Automatic conversion: Each share of preferred stock will automatically convert into common stock, at the then applicable conversion rate, upon (i) the closing of a firmly underwritten public offering of common stock (a “Qualified Public Offering”), or (ii) the consent of the holders of a majority of the then outstanding shares of the preferred stock. Investors want to hold preferred stock (and get the benefits of that) until the IPO, at which time they want to convert to common stock so that they can sell them on the open market. 

Anti-dilution: Adjustments. The conversion price of the Series A Preferred will be subject to adjustment, on a broad-based weighted-average basis, if the Company issues additional securities at a price per share less than the then applicable conversion price. The investors want to avoid getting unfairly diluted if there’s a future financing at a lower valuation (a “down round”). This provision protects them in that scenario.

Voting for directors: The holders of Series A Preferred will be entitled to elect two directors. The holders of common stock will be entitled to elect three directors. Any additional directors will be elected by the holders of preferred stock and common stock voting together. This defines the initial Board of Directors as having two seats chosen by the investors and three seats chosen by the founders. This should map closely to the percentage of stock owned. In this example, the investors will hold 41% of the company and have 40% of the board seats.

Information rights: Each holder of at least 10,000 shares of Series A Preferred will have full information rights. 

This sets a threshold as to who can call you up anytime and ask for financial statements and other information.

Proprietary information agreements: The Company will have all employees and consultants enter into proprietary information and inventions agreements. Very standard. They want to make sure that all the IP created belongs to the company, not the founders and employees.

Purchase agreement: The investment will be made pursuant to a stock purchase agreement which will contain, among other things, appropriate representations and warranties of the Company and the investors and appropriate conditions of closing. There will be a very long legal document prepared by the lawyers where you represent that you’ve disclosed everything you know, there is no pending litigation you haven’t told them about, etc, etc, etc.

Legal fees and expenses: The Company will pay the reasonable fees and expenses of counsel to the investors if the financing closes.

That’s right! You get to pay your lawyer and their lawyer for handling the transaction! This may seem bizarre, but it is considered standard.

Conditions precedent: The investment will be subject to customary conditions, including but not limited to completion of due diligence to the satisfaction of the investors. This means the deal won’t close (and funding won’t happen) until and unless they complete due diligence to their satisfaction on everything about the company. Every skeleton you have in the closet will come out, so be prepared for that.

These are the typical items you will find on a standard term sheet for a Series A venture capital financing. I’m providing this simply in the hope that it will be helpful to you to be familiar with some of these terms as you pursue your own startup venture. But I ain’t no lawyer, and I don’t intend any of this to be legal advice. 

Now, go forth and prosper.  Solve problems, take care of customers, and make the world a better place. Let the lawyers review your term sheets, while you spend your time doing the actual hard work of building a great business.