The first major milestone for startups in a fundraising process is getting a Term Sheet from investors. A Term Sheet is a short document that summarises the main commercial terms of an investment agreement between the Company and investors. It serves as a basis for lawyers when drafting the extended investment agreements.
Now, the next thing to wonder is: what do all these terms mean and what is market practice?
Founders of startups, in particular at an early stage, might not have any prior experience and it could be their first time receiving a Term Sheet (TS). That being said, founders should get some reassurance by the fact that there is an alignment of interest since investors want to keep founders incentivized, while at the same time reputation is also important for investors.
In this article we will use a template TS – we will go through the terms, give you an indication of what is market practice and highlight what you better watch out (throughout the year and not only during the Christmas season when Santa is coming to town…)
So, let’s get to it!
Term Sheet Template: Summary of Terms for Private Placement of Seed Preferred Stock
|Take Over the World LTD||n/a|
|Pinky and The Brain||n/a|
|1) VentureFriends (VF)|
2) [●] Warner Bros VC
3) [●] Other Bros VC
|The lead investor would typically set the TS to be agreed with the Company. The rest of the investors will enter with the same terms|
Structure of Financing
|The financing will be up to an aggregate amount of € [●] at a debt-free fully diluted pre-money valuation of € [●] including an unallocated employee share option plan (“ESOP”) of the Company’s share capital.||The market practice is to refer to the fully diluted valuation i.e. the sum of already issued shares + any other outstanding instruments that could be converted into shares, such as stock options and convertible bonds|
Conditions to Closing
|(i) completion of confirmatory due diligence to the satisfaction of the Investors and anti-money laundering checks, (ii) all employees have entered into service agreements containing IP assignment provisions, (iii) receipt of all necessary consents (incl. corporate resolutions), (iv) execution of a shareholders agreement||The investors will proceed with the investment after checking that everything is in order. Watch-out, the TS is a non-binding document, hence it is not written in stone|
Type of Security
|Newly issued seed preferred shares (“Seed Shares”)||The market practice is to issue shares that rank above (are preferred) over the existing ones, for every new round of financing|
|In the event of any liquidation or winding up of the Company, the holders of preferred shares issued at Closing shall be entitled to receive a pro-rata amount equal to their proportion of the original capital invested limited up to the amount of cash they invested at the Seed Round (as adjusted for stock splits, stock dividends, recapitalizations reclassifications, combinations and the like) plus any declared but unpaid dividends, in preference to the holders of the common stock.|
After the payment of the Liquidation Preference to the holders of Preferred Shares, the remaining assets shall be distributed first ratably to the holders of common stock, to the extent of an amount equal to the Original Purchase Price per share (as adjusted for stock splits, stock dividends, recapitalizations, reclassifications, combinations and the like) plus any declared but unpaid dividends, and shall be distributed second to all Shareholders on a pro rata basis.
A merger, acquisition, sale of voting control (excluding sales of equity securities for primarily capital raising purposes), consolidation or sale of all or substantially all of the Company’s assets will be treated as a liquidation or winding up.
|This is a clause to watch out. Market practice for Liquidation Preference is to be 1x (one-time). Liquidation Preference is the right of preferred shareholders to have priority and be the ones who get their capital back before any other shareholders in case of a liquidity event (such as a sale of the company). If the Liquidation Preference is more than 1x then fewer funds are left for Founders and common shareholders if the exit happens at a valuation lower than the one in the respective round of investment.|
Something else to watch out is if the Liquidation preference is Non-Participating or Participating. Market practice is to aim for Non-Participating. Participating Liquidation Preference (also known as “Double Dipping”) is the right of preferred shareholders to also get their pro-rata payoff on top of the Liquidation Preference, before other shareholders catch-up.
|Holders of Seed Shares vote together with holders of ordinary stock on an as converted basis.||A standard term that gives the right to investors to vote in general meetings|
Reserved Matters Important Decisions
|Certain important actions of the Company shall require the consent of the holders of a [60%] majority of the Seed Shares (a “Seed Majority”), to include amongst others, actions to: (i) alter the rights, preferences or privileges of the Seed Shares (ii) create any new class or increase the number of shares (iii) redeem or the selling of any shares (iv) pay or declare dividends or distributions to shareholders (v) change the number of board members (vi) take any action which results in a Change of Control (in addition to the Seed Majority, no Change of Control to take place without the prior consent of the lead Investor) (vii) amend the constitutional documents (viii) effect any material change to the nature of the business or the agreed business plan (ix) subscribe or otherwise acquire, or dispose of any shares in the capital of any other company (x) grant or receipt of loans or guarantees (xi) merger, dissolution or winding up of the Company, (xii) adoption of the annual budget, (xiii) any borrowing by the (xiv) the entering into any guarantees or executing any instruments creating liens or pledges which are in excess of [€100,000] in any single instance provided that such pledge, commitment or transaction is not authorized in the Annual Budget of the Company and (xv) the conclusion of contracts which entail for the Company a payment commitment of an aggregate value in excess of [€75,000] in any single instance provided that such contract, commitment or transaction is not authorized in the Annual Budget of the Company.||This is a list of important matters that need the consent of a certain % of Shareholders in order to achieve alignment with the management of the Company. Issuing new shares, selling the company or merging with another company are a few examples of such important decisions. Please note that these are just indicative numbers and may vary depending on each case and the stage of the company|
|The Founders shall commit to create an Employees Stock Option Pool in order to allot to key employees (excluding the Founders) a number of shares representing in aggregate [8-10%] of the Company’s total share capital prior to the Investors entry in the Company. The terms of the ESOP will be subject to written acceptance by the lead Investor.||This is a plan designated to allocate stock options to employees, contractors, and consultants. ESOP is used by companies in order to attract talent, incentivize employees and align their interest with shareholders. It is good market practice to have a significant % available as an ESOP|
|Each holder of Seed Shares shall have the right to convert its shares at any time into ordinary shares of the Company (“Ordinary Shares”) at an initial conversion rate of 1:1, subject to proportional adjustment for share splits, dividends or recapitalizations and anti-dilution provisions.||This is a standard clause that allows preferred shareholders to choose what makes sense to do in case of a liquidity event. Depending on the Sale price, amount invested, liquidity preference and their percentage in the Company it might make sense not to convert (if for example they have 1x Liquidation Preference and the Sale price is below the amount they have invested) or convert (if the Sale price covers the Liquidation preference and amount invested)|
|All shareholders will have a pro rata right on a fully diluted and as converted basis, but not an obligation, to participate in subsequent equity issues of the Company (without prejudice to anti-dilution provisions). Any shares not subscribed for may be reallocated among the other shareholders. Investors may assign this right to another member of their fund group.||When new shares of a company are issued shareholders with pre-emption rights have the option to buy those shares before they are offered to new investors. In this way, they can retain their percentage in a company and not be diluted|
Right of First Refusal (ROFR)
|In case that any shareholder decides to sell any of its shares to a third party buyer, the Preferred Shareholders will have the prior right to acquire such shares with the same terms and conditions as agreed with the third party buyer. Any shares not acquired by the Preferred Shareholders will be offered to the common stock holders and if not acquired by the latter, the shares will be transferred to the third party buyer. Exceptions: (i) transfers between family members (ii) estate planning transfers (iii) IPO (iv) transfers to affiliated funds/shareholder/partners.||When a shareholder wishes to sell existing shares, then shareholders who have a ROFR have the right but not the obligation (i.e. the option) to buy those shares, at the same terms, before they are offered to new investors|
Co-Sale (Tag Along)
|Should any shareholder wish to sell all or part his shares held in the Company to a third-party buyer, each Preferred Shareholder will have the right to participate in the transaction with the same terms and conditions and proportionately to the respective shareholding percentages of the selling shareholders. Liquidation preference provisions shall apply. Should the proposed transferee not wish to buy the Investors’ shares, the transfer will be cancelled.||This clause protects minority shareholders. If any of the shareholders has found a buyer for their shares, then the rest of the shareholders can join the Sale|
|If the holders of [50%] of the Shares being (the “Selling Shareholders”) wish to transfer all of their interests in Shares (“Sellers’ Shares”) to a bona fide purchaser on arms-length terms (“Proposed Buyer”), the Selling Shareholders shall have the option (“Drag Along Option”) to require all the other holders of Shares on the date of the request as long as the board and a majority of the investors approve it.||This clause protects majority shareholders, in case they have secured a buyer for the Company (but the buyer is only willing to buy the entire company). This clause ensures that the deal will be completed, and the minority shareholders cannot block the Sale|
|Founders shall not be entitled to transfer any of their shares in the Company for a period of  years as of Closing.||This means that the Founders can’t sell their shares for the first X years after the investment. The purpose of this clause is to keep founders incentivized to grow the business rather than walk away|
Restrictive Covenants and Founders Undertakings
|Each Founder will enter into a non-competition and non-solicitation agreement, and an employment agreement in a form reasonably acceptable to the Investors, and agrees to devote its entire business time and attention to the Company and not to undertake additional activities without the consent of the Investors. A breach of any of the foregoing restrictive covenants or undertakings by a Founder shall result in immediate dismissal for cause of such Founder. Employees and contractors of the Company shall enter into invention assignment agreements and the Founders shall ensure that any intellectual property already developed is transferred to the Company.||This is a standard term to ensure that the founder is a full-time resource to the Company|
|One-year cliff, 4 year vesting period (shares will vest at the end of 6 month periods starting on closing date). If a Founder walks away from the Company within a period of four (4) years as of Closing (either due to cause or by own accord), the Company shall have a call option to redeem the shares owned by such Founder against a minimal consideration linearly and inversely pro rata to the time remaining until the Founders’ shares are fully vested. The shares redeemed by the Company are cancelled.||This term is protective not only to the investors but also to founders themselves (in particular when there are multiple co-founders). The gradual vesting means that co-founders can’t just leave the Company and keep their entire % if they decide to leave before the agreed timeframe. Depending on when they leave they would keep part or the entire %|
Board of Directors (BoD)
|The board of directors of the Company (the “Board”) shall consist of [X number] of members. The Lead Investor may appoint [one] director (“Investor Director”).||It is market practice for the Lead Investor to have a presence in the Board of Directors. Typically the Founders will have control over the BoD in terms of votes, but the Investor Director(s) need to also have enough votes so that there is balance|
Information and Management Rights
|The Investors shall receive monthly reporting and monthly financial information. The Investors will have the right request an audit of the Company. The Company and the Founders acknowledge and agree that, in addition to the Information and Management Rights above, the Investor shall also have the right to carry out controls and audits and to request information and documentation by the Company concerning the same and the Business, provided that such monitoring and audits requirements shall be conducted in a reasonable manner which is not disruptive to the Business.||This is for investors to stay informed about the progress of the Company. The interest of the Company and of investors is aligned and therefore being transparent is helpful for the Company e.g. cash needs will be identified on time by investors who can help, other issues can be picked up etc.|
Documentation and Warranties
|Definitive agreements shall be drafted and executed and shall include customary covenants, representations and warranties of the Company and reflect the provisions set forth herein and other provisions typical to venture capital transactions.||This refers to the assurance by the Company that specific facts or conditions are true, or will happen|
|The Company shall pay the lead Investors’ fees and expenses in the transaction at Closing, capped at € [10,000] plus VAT.||It is market practice for the startup to pay the due diligence expenses. At the end of the day, there is an alignment of interest. Investors are deploying capital to the Company to be used for growth rather than fees, hence the lead investor would try to keep these costs at a minimum|
Exclusivity (no shop agreement)
|In consideration of the Investors committing time and expense to put in place this financing, the Company and Founders agree not to discuss, negotiate or accept any proposals regarding the sale or other disposition of debt or equity securities, or a sale of material assets of the Company for 45 days from the date of the Company’s signature below.||If the Company is happy with the Investor and terms, they will sign the TS. Everybody will put time and effort to complete the deal and therefore this asks from the Company not to start shopping around for a better deal and proceed with completing the one agreed|
|The Company and Founders agree to treat this term sheet confidentially and will not distribute or disclose its existence or contents outside the Company without the consent of the Investors, except as required to their shareholders and professional advisors.||This is a standard Confidentiality clause saying that the TS is not to be freely disclosed|
Governing Law/ Jurisdiction
|English law/ LCIA Rules of Arbitration.||n/a|
|This Summary of Terms is not intended to be legally binding, with the exception of this paragraph and the paragraphs entitled Expenses, Exclusivity and Confidentiality and Governing Law/Jurisdiction, which are binding upon the parties hereto.||Watch-out, the TS is a non-binding document which means that even though these are the initial terms, there are more terms to be agreed (which might also affect the ones initially agreed)|
Hopefully, after reading this article you got a better understanding of what are the key points to focus on, while also got a sneak peek on some standard terms and market practices!
As a concluding point and takeaway, it is important that both founders and investors are happy with the agreement in order to stay incentivised and take over the world (or at least a part of it) 🙂