How To Make Sense Of An Investor Term Sheet

During the last 6 months, you’ve spent so much of your precious time pitching investors and finally it’s time to get down to business. When the money hits the account you can start executing on all of the things you haven’t been able to do until now. Exciting times! But hold on, first comes the fun part. Before any money exchanges hands you have to do a few classes in legalese.

Trying to comprehend the incomprehensible clauses set out in Term Sheets for first time entrepreneurs can be a pretty intimidating task. As legalese isn’t designed for us speakers of the ‘common tongue’, it’s essential to have good legal advice on board who can run you though every clause to make sure you don’t get caught with your pants down.

I’m far from an expert at raising capital nor am I a lawyer, however I’m going to attempt to explain the ‘terms’ in a Term Sheet in a fashion akin to the common tongue spoken in the street. With some much appreciated help from Mr. Ignacio Lacasa of Across Legal hopefully this might make your first time going over a Term Sheet a little easier.

Please bear in mind that every investor/VC/lawyer is going to be used to a different style of Term Sheet, especially for different rounds, so below is just a rough guideline of what you can expect.

Financing terms

Company’s purpose

What does your business do?

Financing

We are offering (X)€ investment for this seed/angel/series A etc round. This equates to a (X)% ownership of the company and (X) shares. The shares will be the Ordinary Shares (most likely the one’s you have) or Preferred Shares (with special rights such as liquidation preference/anti-dilution etc).

Goal of the financing

What is the money to be used for?

Valuation

The pre-money valuation of your company. Pre-money valuations are based on a variety of factors, from market consensus, stage of the business, to calculations based on revenue. Check out this article for more details on the subject matter.

Stock to be issued

What type of shares are you offering the investors? Ordinary Shares (most likely the ones you have) or Preferred Shares? Preferred shares means investors will have certain rights and privileges such as receiving their liquidation before everyone else – this is explained in more detail in the liquidation preferences section.

Capitalization 

The capitalization table of the company. Usually included in the annex. A list of the shareholders and what amount of shares/percentage they have in the company. A fully diluted cap table means taking into account stock options, warrants, convertible loans and any other instrument that may end up converting into shares.

Voting Rights

Investors rightly want to be able to block any decisions that could be detrimental to them. More often than not, investors will require the consent of a certain % of shareholders to allow the company to engage in certain decisions. Shareholders voting rights are based on the amount of shares they hold and the class of the shares (if the company has any preferred shares). If there are only ordinary shares, the more shares you have the more sway you have when it comes to making these decisions.

Liquidation preference

Although more prominent in the States and the UK than in Spain, most VC’s will expect a liquidation preference of 1x in a Series A round or any later round. This means that if the company is sold, then the holders of the preferred shares will get their money back before holders of ordinary shares at a particular multiple. In some cases the liquidation preferences can go as high as 3x although a preference of 1x is generally accepted as fair. Usually liquidation will refer to when the company is sold, acquired or merges with another company. Liquidation preference may become more complex as investors may propose to have a participating vs non-participating liquidation preference. Check out more on that here.

Dividends

Whether you will be offering Dividends to investors or not and the conditions you will offer. Preferred Shares may also have preference in case of distribution of dividends.

Stock Options (SOP)

Usually investors expect your company to have an existing Stock Option Plan in place however this isn’t always the case.  The SOP is generally used for new management and senior people and will be included in the fully diluted cap table in the annex. The pot of stock available for new employees can range anywhere from 5-20%. If you already have it in place before the round then this will not dilute investors unless it needs to be refreshed (new options created).

Pre-Emption

All shareholders, even the founders, have the right to invest in further rounds to prevent further dilutions. In Series A rounds, preference may be limited to certain shareholders.

Right of First Refusal 

If any shareholder wants to sell their shares to a third party then the rest of the shareholders have the option to purchase the shares on the same terms. In Series A rounds, preference may be limited to certain shareholders.

Drag along 

Drag along allows shareholders to essentially ‘drag along’ other shareholders when it comes to time to sell the company. This stops smaller shareholders preventing the sale. Usually a 50% vote is sufficient for the Drag Along to come into place although varying versions of the drag along provision exist. Investors may be reluctant to be forced to a drag sale if they are not supportive to the transaction.

Tag along

Designed to protect the minority shareholders. If a majority shareholder sells their stake, then the minority shareholder has the right to join the transaction and sell their minority stake in the company. If change of control occurs, all minority shareholders need to be able to sell all their shares.

Non-compete

The investors cannot have shares nor operate on the board of your competition. Pretty standard. However, Investors with a large portfolio may not accept this restriction.

Conditions to Close

Before everything is signed, investors will expect to do a certain amount of due diligence on your company and also you as founders. They will most likely want to check the accounting, employee contracts, who owns the IP, make sure there has been no money laundering etc.

Documentation and Warranties

Documents guaranteeing the investors that the company they are investing in is actually what you say it is. 

Expenses

Investors pay for their legal costs and you for yours. Usually the company pays the notary fees when signing final documents. If you agree to pay the Investors fees, make sure it only happens if the round closes and also and include a limit on the amount.

Company governance and minority shareholder protections

Board of Directors

A typical board can be anywhere between 3-8 members split between the founders and investors. Investors are generally elected to the board depending on how much stock they own in the company. It’s important to cap the board as bigger boards can cause more problems. Boards have the power to fire top management and take drastic decisions on the company’s behalf. That’s why it’s important to have founders on the board!

Information Rights

Investors expect to be kept in the loop with what’s going on so expect to be sending quarterly financial reports of how the company is performing.

Important Decisions

A list of certain decisions that will need to be approved by the majority of the shareholders and investors, i.e. issuing new shares, changes to material sections of the company bylaws, adding new board members etc.

Key executives provisions

Key executives

Who are the key executives?

Non compete

Pretty standard; founder’s cant go working with the competition for a certain period of time after leaving the company.

Salary

Investors will want to know and approve what salary the key executives will be receiving.

Permanency/Founders Shares

Investors are betting on you for the company to be successful so if you leave then they are up shit creak without a paddle. Again there are 1001 different stipulations but the overall idea is that if you don’t stay for a predetermined period of time, you will be penalized. A model quite popular in the States is to to use reverse vesting. For example, if you own 30% of the company, your shares would be reverse vested over a period of say 3 years. So you start with 0% and every month you get your shares back. In this case, if you were to leave after 1 year you would only go away with 10% of your shares. In most cases the penalizations are applicable to your shares.

Confidentiality

States that you won’t tell every man and his dog about the details of this round until it us publicly finalized.

Exclusivity

You are bound to secrecy once you have signed the Term Sheet. You shouldn’t be contacting other investors nor trying to find investors to replace other investors.

Non binding effect

Explains that his agreement isn’t legally binding but expresses the interest the investors have in working with you. Confidentiality, exclusivity and costs will often be binding.