I got a Term Sheet — Wait what’s a Term Sheet
I saw my first term sheet in 2017. It was intimidating. I remember stumbling across Charles Yu’s Medium article “The Ultimate Guide to Liquidation Preferences” which definitely helped. Recently (Aug 2024), Chris Smith of Playfair published their term sheet, which is adapted from policies set by the British Private Equity & Venture Capital Association ([BVCA]) which makes sense because Playfair is in the UK). They published an article shortly thereafter which has some very helpful terms.
There is no substitute for having an attorney review a term sheet. Even this article, while informative (I hope), is not enough to negotiate a term sheet on your own. Here are some key terms & what to look out for, but please, have an attorney who does this type of work for a living review your deal:
Employee Share Option Pool (ESOP): Investors often require startups to create an employee pool. Where founders should be aware is that in future rounds these pools may be fully or partially re-set to certain rates (often 10% to 15%). Accepting a higher-than-industry-standard rate too early can impact future rounds as these pools dilute the founders’ ownership.
Conditions to Closing: Lists range from short (only legal conditions—the investor needs to check that the company is correctly set up and agree long form documents before closing) to long (where other conditions may be added to create an option for investors to get out of the deal if they want to. Playfair recommends pushing back on investors to negotiate out other conditions or agree on exactly how they will be satisfied and the timeline for doing so.
Exit Provisions and Distributions: These are usually worded in terms of liquidation preferences and participation.
Simply put, liquidation preferences determine who gets how much of the company when it is sold. The industry has settled on 1x. Founders are unlikely to negotiate less than 1x with institutional investors and should pass on anything greater as this is now seen as predatory.
Participating Liquidation Preference: With a participating liquidation preference, preferred shareholders receive their original investment back but also a percentage of the remaining proceeds after the original investment has been repaid. For example, in a 10M exit, an investor with 10% ownership and a 1x preferred return on an investment of 2M would receive their original 2M back and then 10% of the remaining 8M, so they would get 2.8M and the founders would get 7.2M.
Non-Participating Liquidation Preference: When liquidation preferences are non-participating, the investor is entitled to receive the higher value of their preferred amount (usually 1x) or their pro rata share of the remaining proceeds. In the prior exit example (10M exit, 2M initial investment and 10% ownership, the 1x pays back 2M while the 10% would pay back 1M, so the investor would cash out with 2M.
Drag Along / Tag Along: Drag-along rights allow a majority shareholder to force minority shareholders to sell their shares. This facilitates an exit strategy, can maximize sale value (100% ownership could be worth a premium), and can reduce negotiating friction—“Don’t worry, nobody can throw a wrench in this transaction”. But Tag-along can be different. Whereas drag-along allow a majority to force a minority, Tag-along rights allow minority shareholders to sell their shares for the same price and terms as the majority shareholder when the majority shareholder sells to a third party.
You may like Tag-Along rights because minority shareholder protection may be seen as attractive to investors
You may not like Tag-Along rights because if a major shareholder wants to sell their stake, the process can become more complicated if multiple minority shareholders also want to exit. And, tag-along rights can limit the flexibility of major shareholders in negotiating sales because they have to consider minority interests.
Important Decisions: External investment limits founder control. A list of decisions requiring either investor director or investor majority (shareholder) consent is set out in the Appendix. Common sense dictates founders avoid signing a term sheet without seeing a list of these requirements, but Playfair goes even further to explain how significant it is to do reference/background checks on your investors at this point if you haven’t already started. You can’t do too many references.
Board of Directors: Playfair views boards as a positive thing, even at the early stages, citing getting together on a regular basis as a good practice. Founders should ask - do I want this person on my board when vetting possible investors. It’s also important not to bloat the board early on so ‘one director per round’ is a sensible yardstick (with the exception of co-leads who may each put in the same amounts or some other round-specific detail). Tying observer rights to a certain shareholding % is also prudent as it could help you shed the weight if over time, their ownership falls below threshold.
Founder Vesting: When co-founders breakup, vesting creates an equitable process which is good for all parties involved—a co-founder voluntarily leaving in the first year with 50% of the shares—eek! Playfair recommends founders fully understand the Bad Leaver / Good Leaver definitions (in the UK). In the US, we might refer to voluntary termination (an employee leaving), without cause (no misconduct), involuntary (terminated with or without cause).
Restrictive Covenants and Founder Undertakings: Investors want total focus on the creation of shareholder value, so the starting point is usually to prohibit any kind of work outside. There are exceptions, especially where it may make sense to maintain some relationships (access to prospects, it’s germane to the startup etc.), so this should be negotiated with the investor to see a carve out is relevant and can be agreed upon.
Documentation and Warranties: the whole process around warranties and disclosure feels stressful for founders, but remember: (1) investors just want to make sure they know everything they can about the company around key topics like employment, IP and disputes and this is the legal process to do that; and (2) investors are very, very unlikely to ever sue the company they have invested in.
Expenses: This is a good one. Founders should expect to pay for the legal fees of a lead investor, with other investors covering their own costs. No other expenses or fees should be charged by the investor as every dollar should be invested in the company. Founders should push back on all but the legal fees and for everybody but the lead in each round.
Expiry/Expiration: It’s reasonable to ask for a week to finalize and sign a term sheet. Shorter time periods are not uncommon, but this is where you should absolutely work with an attorney and determine what’s right for your business.
Exclusivity: This is exactly what it sounds like — it locks you in with the investor you sign with, which can be good or bad (if the deal isn’t what you’d hoped for). Even worse, in some cases, investors hook founders with a short/abbreviated term sheet that includes exclusivity, but leaves out many of the details explored here. It’d be a shame to lock yourself into exclusive negotiations without having seen a fully fledged term-sheet. Playfair also recommends checking whether further Investment Committee approvals are required so as not to be bogged down in administration (a deal may fall through but if you’re tied to the investor throughout the process, you’d like to know what other administrative hurdles exist outside of the terms themselves).
Non-binding Effect and Jurisdiction: a reminder that term sheets are not binding and we do hear about term sheets being pulled after founders have invested considerable time in a process. Protect yourself by doing your reference checks and ensuring you negotiate out or have absolute clarity on any conditions as mentioned above.
Anti-dilution provisions: Playfair saved this for last in their blog post. They highlighted investors who include anti-dilution provisions to protect themselves in the event of a down round. This is a toughie, but I like the fact that Playfair doesn’t include them in their term sheets. To quote Chris Smith, “If things aren’t going well, we’ll figure out the best financing options together rather than relying on a contractual right to put ourselves first.”