The term sheet is a legal document negotiated between startup/scaleup companies and their potential investors as part of the process for raising money. By its legal nature the term sheet is somewhat similar to a letter of intent or a memorandum of understanding. This is so because the term sheet is a non-binding agreement that also predicates a form of future partnership which may or may not happen. Unlike the other two instruments, the focus of the term sheet is not on the cooperation of the parties in the strict sense of doing business together but on the potential making of an investment against, typically, equity ownership.
The term sheet has a non-binding nature in the sense that it outlines the framework for the specific terms of the future investment. This future investment will ultimately be specified in other legal agreements with binding character (such as the agreement for purchase of equity).
At the same time, there is a limited territory to renegotiate the clauses of a term sheet once it is signed by both parties. This is so because the startup founders usually have less bargaining power and they cannot easily make significant deviations from the provisions of the term sheet without negative repercussions. Moreover, abrupt requests for significant changes could lead to erosion in the perceived reliability of the startup and eventually the investor may not follow up on the deal.
Additionally, if a party tries to significantly renegotiate a huge chunk of topics that are deemed already agreed or just leaves the negotiations without good cause, this could be a failure of the duty to negotiate in good faith and could have legal consequences in terms of pre-contractual liability.
Therefore, either party to the term sheet should be confident that it can follow up on the agreed terms before signing the document. This is especially important for startup founders as usually they are the party with less bargaining power and less domain expertise as compared to venture capital firms who are going through such documents on a regular basis. Hence, founders should make sure that they fully understand the specific lingo used in a term sheet and have total clarity if those terms align with their vision.
Finally, it must be mentioned that there are some provisions in a term sheet that are usually binding on their own and enforceable against the other party.
First, this is the case with the confidentiality provision. Based on this provision, the startup cannot disclose any information related to the term sheet and the specific terms outlined in the document to anyone other than its directors, officers, legal counsel and advisors involved.
Second, most term sheets come with a “no-shop clause” that also has a binding effect. Under this provision, for a certain period of time (typically between 30-60 days) the startup cannot solicit or accept offers from any other sources of financing. This is a provision that is impactful for the startup because when the “no-shop” period is unreasonably long it effectively takes the company out of the market for potential investments. As the “no-shop” is quite common in term sheets, typically what founders could do is try to limit the period to no more than 30 days.
When negotiating a term sheet, tech founders must be vigilant to ensure that they are protecting their interests and the long-term viability of their startup. Below are 8 key risk areas to watch out for during term sheet negotiations:
- The liquidation preference
Risk: High liquidation preferences can leave founders with little to nothing in the event of a sale or liquidation.
Mitigation: Aim for a 1x liquidation preference, which means investors will get the invested amount back before any other distributions. Try to avoid participating liquidation preferences, which would allow investors to double-dip. If not feasible, at least aim for a participating preference with a cap.
- Board composition
Risk: Losing control over the board might lead to decisions that are not in the best interest of the founders.
Mitigation: Ensure that founders retain a majority on the board so that they exert control over key decisions (normally, in a Series A round the investor should get one seat on the board while the founders should retain the other two).
- Anti-dilution provisions
Risk: Anti-dilution clauses can significantly impact founders’ ownership percentage in future funding rounds as their aim is to protect the early investors.
Mitigation: Try to avoid a “full ratchet” provision as it could have a devastating impact on the founders’ equity in a down round. Instead, aim for a weighted-average anti-dilution provision.
- Vesting schedules
Risk: Unreasonable vesting schedules can demotivate founders and key employees.
Mitigation: Focus on established market standards – a typical vesting schedule would be 4 years with a 1-year cliff and monthly vesting afterwards.
- Voting rights
Risk: Special voting rights for investors can influence major decisions and limit founder control.
Mitigation: Understand the voting rights associated with the preferred shares being issued. Negotiate to reasonably limit the areas where approval from the preferred stock majority would be required.
- Dividends
Risk: Dividend provisions may impact the cash flow of the company and limit reinvestment opportunities.
Mitigation: Avoid cumulative dividends (i.e. a situation where the annual amounts owed to the investors, if unpaid, will be carried across fiscal years producing a snowball effect)
- The option pool
Risk: The option pool always dilutes the founders’ equity.
Mitigation: Try to negotiate an adequate pool that is not excessive but still sufficient to attract and retain talent (between 10 and 15%) and aim for a post-money option pool set-up so that investors share the dilution with the founders.
- Drag-along rights
Risk: Drag-along rights could force founders to sell their shares in the company if the majority shareholders decide to sell. Effectively, if the majority shareholders agree to a sale, the founders and other minority shareholders will have to sell their shares on the same terms.
Mitigation: Founders should aim to limit the scope of drag-along. This may include setting a higher threshold for the percentage of shareholders required to trigger the drag-along rights or ensuring that the sale price would meet a certain minimum valuation.
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