What to look out for in VC Term Sheets

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What to Look Out For in VC Term Sheets

Fundraising for your start-up can be a tricky and lengthy process. There are a million things to consider, and seemingly endless funding options (read our guide to early-stage fundraising here).

Venture Capital (VC) is often a well-aligned and suitable option for high growth businesses, although do note that not all start-ups are suited for Venture Capital. The nature of the portfolio approach typically leads VC's to hunt for outsized returns, or in other words the next multi-billion dollar opportunity.

Ahead of any first round of funding, all founders/CEO's should be familiar with the terms on which VCs will invest - as this will stand them in good stead when it comes to negotiation and setting expectations.

The different types of financing:

Angels — Business Angels are typically high net-worth individuals, seeking exposure to early-stage business opportunities. In the UK this is typically through the EIS/SEIS schemes, which offer favourable tax incentives for private investors. They are typically priced round (with a set share price) although some angels will also invest through SAFE structures (convertible notes) that turn to equity at the subsequent round of financing.

VC Funds — Venture Capital funds will typically invest in specific sectors in which they are experienced and have industry connections. A VC fund has it’s a commitment to its LPs, whose money they are investing. Due to this, they will more often than not implement additional measures to protect their capital - such liquidation preferences and anti-dilution terms.

Venture funding can be very beneficial if you find the right type of investor, a great tip is to always do background research on a VC before even considering them as a source of funding to understand whether they’re the correct fit.

Accelerators and Incubators — Accelerators and Incubators are organisations that are focused on helping your start-up grow from an idea into a proper business. They assist by providing mentorship, advice and in some cases, funding. They typically have large networks of investors to support the start-ups within the cohorts and have some have corporate partnerships to accelerate the growth of the start-up. Whilst only some provide funding beyond co-working space, an accelerator or incubator is a great step to formalising your idea and putting your start-up's name on the map (see Y-Combinator, Techstars and 500 Startups).

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Now that you know some of the options available and how they may differ, we will dig deeper into what you can expect from a Term Sheet:

What is a Term Sheet?

A term sheet is essentially a ‘letter of intent’ detailing the terms which will be agreed upon the transaction. It is the first major step in completing a funding transaction. This provides lawyers with a roadmap or wireframe from which they will draft long-form documents that are then signed by both parties (Investor and Company).

Despite popular belief, a term sheet is not a binding legal agreement. It is subject to provision of long-form documents, due diligence, and other closing conditions (e.g. legal opinion). This being said, it is unusual for a deal to vary significantly from a term sheet and once you have one signed you are well on your way to securing funding.

There are typically some binding rules such as confidentially and exclusivity when it comes to term sheets, preventing a company from shopping for better terms and using it as leverage. This period typically lasts around 30 days.

What a typical VC Term-Sheet includes:

(Remember, most things can be negotiated on the term-sheet, this is just some guidance to realise what to expect from a VC term sheet.)

Valuation

One of the first things a term-sheet will agree on is the transfer price of shares. Valuation is often a sensitive subject, and this is the time to negotiate. Overall, you must remember that your business will hopefully raise multiple future funding rounds, and you will be diluted at each of these stages. Be careful not to give too much equity away too early - no more than ~20% at each round. E.g. When raising £1 million pounds, you might expect a £4m pre-money valuation to be a fair ballpark figure...new capital would own 20% of your business.

Overall It's a balancing act: More money raised at the same pre-money valuation = results in additional dilution for founders. Also a smaller raise at a lower valuation could lead to additional dilution. E.g. Imagine you raise £500k, but at a £2m valuation - you are still giving away 20% of your company, but now you only have £500,000 to reach your milestones for the same amount of dilution.

However, there is an issue when pricing the valuation of your company too high earlier on as it might put later stage investors off the next round. Thus, it's important to remember that your goal is to grow the company for the long term. Having a high valuation early on is meaningless if you cannot hit your targets and scale quickly once you reach product market fit.

Option Pool

VCs will expect you to set up an optional pool during the financing round if there isn't already one in place. The purpose of this is to help incentivise early employees joining the company, and to align long-term interests. Standard practice is a minimum of 10% of the companies shares to be allocated to the option pool. The Option Pool is usually 'topped-up' at each new funding event in order to reward long-standing employees and also to anticipate personnel growth following the financing.

Conditions to Close

A term sheet is a letter of intent. Thus, before signing the paperwork and transferring the money, A VC will have to do some basic due diligence on the company and also on you, the founders. This includes anti-money laundering checks. Due diligence includes seeing that all of the company’s relevant employees and freelancers have signed employment or similar contracts which make it clear that the company owns all of the intellectual property that’s been created for the business.

Closing Date

Once everything is in order and legally binding documents are signed, the money will be sent to the company bank account. This date is a target, not a fixed moment, of when terms should be agreed, money transferred and the investment concluded.

Warranties

Documentation and Warranties have to be signed by the founders in order to make sure that you are who you say you are. This provides the investors with assurances that the information provided to them is accurate or at the very least, to the best of the founders’ knowledge.

Good Leaver/ Bad Leaver

This is typically established in the term sheet, protecting both the founders and investors. These set out the process by which a founder can depart the start-up and how their shareholdings are treated. In the event of an unfavourable departure of a founder, the shares will be vested/redistributed in accordance with this term.

Pre-Emption

Pro-rata rights are typically given to investors who back companies early, giving them the right to participate in subsequent rounds (without further dilution) . Investors may also assign this right to another member of their funding group.

Right of First Refusal & Co-Sale

Shareholders will have the right of first refusal to acquire the shares of shareholders wishing to sell or transfer their Ordinary Shares before they’re proposed to be transferred or sold to a third party.

Observer Rights

The lead investor as well as other VC investors will expect the right to appoint a Board Member or at least a board observer to your company. This is usually in order to monitor and report back to the wider fund partnership on progress, or to help where possible. Board observers don't have voting rights.

Investor Consent

VC Investors will require investor consent rights in order to safeguard their investment (especially on behalf of their LPs). Requiring investor consent for a range of things that the company may occasionally need to do:

Drag and Tag Rights

Drag along means that if the shareholders with a majority equity stake - say, 50.1% - want to sell, they can ‘drag’ the other shareholders into the sale. Investors might insist on terms that mean they can only be ‘dragged’ if they are then given a defined proportion of the sale proceeds. Drag along rights are used to ensure majority shareholders have flexibility and an easy exit route. Tag along rights are the converse of drag along rights: if a majority shareholder has triggered a sale, then a minority shareholder can ‘tag’ their shares along to the sale. The threshold at which this right is triggered is often a lot higher e.g. 90%

Cap Table Example

The basic outlines of this cap table are:

  1. It shows all the major stockholders of the company listed down the left side. it also shows the major option holders and buckets of option holders
  2. It shows all of the classes of stock and how much was paid for them across the top of the columns
  3. For each investor, you show how much of each class was bought and how many shares of that class they own as a result
  4. You total up the cost and shares and then calculate ownerships on a fully-diluted basis (which means you include the options, whether issued or non-issued or vested or non-vested).

Key Terms to be aware of:

Investors: Those who are investing money into the business.

Amount Raised: Total amount raised to date.

Price Per Share: Price of each share.

Pre-Money Valuation: Value of the company before investment.

Capitalisation: Company’s shares multiplied by share price.

Dividends: Distribution of company’s profits or reserves to its shareholders based on a percentage rate of the purchase price when declared by a predetermined group like the Board of Directors (typically not declared in early-stage companies until liquidation event).

Liquidation preference: The order of funds returned to a particular class of stock ahead of other classes of stock in the event of a liquidation event, such as the sale of the business.

Voting rights: The grouping of stockholders, typically preferred stock as one group and common stock as another group, when it comes to a vote on core items as defined in the term sheet.

Protective Provisions: Veto rights that investors have on certain actions by the business.

Anti-Dilution Provisions: Protects an investor from dilution resulting from later issues of stock at a lower price than what the investor originally paid.

Mandatory Conversion: Conversion of preferred equity into common stock based on a public offering and/or consent of preferred stockholders.

Pay to Play: Requires preferred-stock holders to buy the firm’s new stock issues or else lose certain benefits like anti-dilution protection.

Redemption Rights: A feature of preferred stock that allows investors to require the company to repurchase their shares after a specified period of time.

Representations and Warranties: Provides guarantees and assurances about the state of the business between the company and investors.

Conditions to closing: Tasks that must be fulfilled before the deal agreement is closed.

Registration Rights: A restricted stock investor’s right to require a business to list the shares publicly so that the investor can sell them.

Demand Registration: Entitle an investor to force a company to register shares of common stock so the investor can sell them to the public.

Piggyback Registration: Allows a business’s shares to be sold in conjunction with a new public offering.

Lock-up: Restricting the sale or transfer of shares post-transaction.

Right to Participate Pro Rata in Future Rounds: An investor’s right to continue to participate in future rounds so they can maintain their percentage ownership.

Matters Requiring Investor Director Approval: Identifies critical business decisions that would require consent from the investor representative on the Board of Directors.

Non-Competition and Non-Solicitation Agreements: Neither party is allowed to enter into or start a similar business.

Non-Disclosure and Developments Agreement: Agreement to not pass along confidential information to an external party about the business or its products or services.

Employee Stock Options: A security which gives the employee the right to purchase company stock at a set price for a fixed period of time.

Key Person Insurance: Life insurance on the key management team member(s), such as the CEO, that are critical to driving the value and success of the business.

Right of First Refusal/Right of Co-Sale (Take-Me-Along): Defines the right of an investor to buy or sell shares in the future prior to an offer going out to another party.

Board of Directors: Body of elected or appointed members who jointly oversee duties that are outlined in the company’s charter.

Drag Along: A right that enables a subset of shareholders to force all other shareholders to agree to the sale of the company.

Founders’ Stock: Shares of common stock that are issued to founders at the formation of a new business.

No Shop/Confidentiality: Requires business not to solicit any offer of an investment in the company by a party other than the venture capital investor for a certain period.