The Investment Term Sheet
You’ve impressed a number of venture capital firms, and now it’s time to sit down face to face with these potential partners, find out what they can do for you, and discuss terms. The terms of an investment agreement are spelled out in what is called the term sheet. To help prepare you for this discussion, here are some brief definitions of terminology found in term sheets.
Negotiating the terms of the agreement is part of establishing a close working relationship with your venture partner.
Understanding Term Sheets
Here are the standard sections of an investor term sheet along with a brief description.
Valuation is a highly contested issue between entrepreneur and venture capitalist. It’s not something you have to figure out on your own. Simply put, the value of a company is what drives the price investors will pay for a piece of the action. The information used to determine valuation comes out of the due diligence process, and has to do with the strength of the management team, market potential, the sustainable advantage of the product/service, and potential financial returns. Another way to look at valuation is how much money it will take to make the company a success. In the end, the value of a company is the price at which a willing buyer and seller can complete a transaction.
Ownership and valuation is typically calculated on a fully diluted basis. This means that all securities, including preferred stock, options and warrants, that can result in additional common shares, are counted in determining the total amount of shares outstanding for the purposes of determining ownership or valuation.
Type of Security
Investors typically receive convertible preferred stock in exchange for making the investment in a new venture. This type of stock has priority over common stock if the company is acquired or liquidated and assets are distributed. The higher priority of the preferred stock justifies a higher price, compared to the price paid by founders for common stock. “Convertible” means that the shares may be exchanged for a fixed number of common shares.
When the company is sold or liquidated, the preferred stockholders will receive a certain fixed amount before any assets are distributed to the common stockholders. A “participating preferred” stockholder will not only receive the fixed amount, but will also share in any additional amounts distributed to common stock.
Dividends are paid first to preferred stock, and then common stock. This dividend may be cumulative – so that it accrues from year to year until paid in full, or non-cumulative and discretionary.
Preferred stock may be redeemed or retired, either at the option of the company or the investors, or on a mandatory basis, frequently at some premium over the initial purchase price of the stock. One reason why venture firms want this right is due to the finite life of each investment partnership managed by the firm.
Preferred stock may be converted into common stock at a certain conversion price, generally whenever the stockholder chooses. Conversion may also happen automatically in response to certain events, such as when the company goes public.
The conversion price of the preferred stock is subject to adjustment for certain diluting events, such as stock splits or stock dividends. The conversion price is typically subject to “price protection,” which is an adjustment based on future sales of stock at prices below the conversion price. Price protection can take many forms. One form is called “ratchet” protection, which lowers the conversion price to the price at which any new stock is sold no matter the number of shares. Another form is broad-based “weighted average” protection, which adjusts the conversion price according to a formula that incorporates the number of new shares being issued, and their price. In many cases, a certain number of shares are exempted from this protection to cover anticipated assurances to key employees, consultants, and directors.
Preferred stock has a number of votes equal to the number of shares of common stock into which it is convertible. Preferred stock usually has special voting rights, such as the right to elect one or more of the company’s directors, or to approve certain types of corporate actions, such as amending the articles of incorporation, or creating a new series of preferred stock.
Right of First Refusal
Holders of preferred stock typically have the right to purchase additional shares when issued by the company, up to their current aggregate ownership percentage.
Founders will often enter into a co-sale agreement with investors. A co-sale right gives investors some protection for investors against founders selling their interest to a third party by giving investors the right to sell part of their stock as part of such a sale.
Registration rights are generally given to preferred investors as part of their investment. These rights provide investors liquidity by allowing them to require the company to register their shares for sale to the public — either as part of an offering already planned by the company (called piggyback rights), or in a separate offering initiated at the investors’ request (called demand rights).
Vesting on Founders’ Stock
A percentage of founders’ stock, which decreases over time, can be purchased by the company at cost if a founder leaves the company. This is a protection for the investors against founders leaving the company after it gets funded.
VC Self Defense 101
A fool and his company are soon parted. – Anon
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Very helpful. I have been looking at samplle term sheets and explanations all day. Your explanations were useful.