The Climb: A Law Blog Designed to Help Entrepreneurs Chart and Stay the Course

Breaking Down a Venture Capital Term Sheet

Once you have decided to raise money from third-party investors, the next step is typically to prepare a term sheet summarizing the terms on which your company will issue equity to such investors. The content of the term sheet will be driven by the type of security your company is going to issue to investors in exchange for the money invested by such investors. Here is a separate article where we discuss the different types of securities a company can issue in exchange for raising money from third-party investors. This article focuses on a term sheet for a typical venture capital financing transaction in which a company that is a corporation is issuing shares of stock to investors. For an overview of the key terms of a Simple Agreement for Equity Financing (SAFE), please check out this article.

In most venture capital equity financings, a company will issue preferred stock to the investors. Preferred stock has certain rights, preferences, and privileges over the common stock of such company. These rights, preferences, and privileges are set forth in a number of different documents including the company’s Certificate of Incorporation, Bylaws, and then either a Stockholders Agreement or a suite of documents, which typically include an Investors Rights Agreement, Right of First Refusal and Co-Sale Agreement, and Voting Agreement. The actual shares of preferred stock are sold and issued to the investors by the company pursuant to a Stock Purchase Agreement. Below is a summary of the key terms in these documents assuming the investment documents consist of a Certificate of Incorporation, Stock Purchase Agreement, Investors Rights Agreement, and Stockholders Agreement, which includes the provisions typically found in a Right of First Refusal and Co-Sale Agreement and Voting Agreement:

Offering Terms
Securities to Issue: The company needs to approve and authorize a new class of preferred stock to issue to the investors. This requires amending and restating the company’s Certificate of Incorporation to include the new class of preferred stock. Traditionally, a company’s first class of preferred stock is referred to as “Series Seed Preferred Stock,” the preferred stock issued in the next financing is referred to as “Series A Preferred Stock,” the preferred stock issued in the following financing is referred to as “Series B Preferred Stock,” and then onward in successive alphabetic order for each new financing. Ultimately, the naming of each class of preferred stock is arbitrary, but it is always best to stick with a naming convention that investors will be familiar with.
Closing Date: The company needs to decide whether it will have a single closing for all investors or whether there will be rolling closings, where there is a separate closing as each investor is ready to close. The advantage of the former is that the company gets all the money it is raising at once and doing a single closing typically helps cut down on ongoing legal fees. The advantage of the latter is that the company can take money from investors as it becomes available, therefore, reducing the risk of losing any investors while waiting to complete a single closing with everyone.
Round Size: The round size is the total amount of money that the company wants to raise through the financing. The company should be able to explain how it generally plans to use the invested capital and how such capital will contribute to the growth in the company’s value. The company should strive to raise enough capital to either get the company to (a) a place where its own cash flow will support the company’s ongoing operations or (b) the next financing round.
Price Per Share: The price per share is equal to the quotient of the pre-money valuation of the company divided by the pre-money shares. The pre-money valuation is the value of the company prior to the financing. The pre-money valuation is a negotiated point. The company should try to get a lead investor (or a group of investors) to agree to the pre-money valuation early to minimize this number moving too much during negotiations, because uncertainty around the pre-money valuation can throw off the whole negotiation because it shows a lack of consensus among prospective investors about the company’s value. The pre-money shares typically are all the outstanding shares of the company plus any shares reserved for issuance under the company’s equity incentive plan.
Certificate of Incorporation
Dividends: The company should push to only pay dividends on the preferred stock on an as‑converted basis when, as, and if declared by the company’s Board of Directors and only if an equivalent dividend is paid concurrently on shares of the company’s common stock. This type of dividend is referred to as a non-cumulative dividend. A company may also agree to pay non-cumulative dividends at a predetermined rate (e.g., $1.25 per share of preferred stock). In either case, the payment of the non-cumulative dividends is not guaranteed over time and the company has no obligation to pay such non-cumulative dividends. Alternatively, a company could agree to issue cumulative dividends. Cumulative dividends are typically based on a percentage of the capital invested by an investor and payable on a liquidation event of the company. Cumulative dividends can be thought of as interest on a loan. Even if the company is not paying the cumulative dividends over time, they are still accruing, and the company will need to pay all accrued and unpaid dividends on a liquidation event.
Liquidation Preference:

The preferred stock will typically have a liquidation preference, which is primarily intended to provide the investors with downside protection (e.g., where the company has failed and needs to wind up). The liquidation preference also determines the liquidation waterfall in an upside scenario where the company is being sold for a profit, so founders should be careful not to give away value when negotiating the liquidation preference for the preferred stock. There are three primary types of liquidations preferences. First, and most common, is the non-participating liquidation preference. With a non-participating liquidation preference, the holders of preferred stock will receive, to the extent the company has adequate funds, the greater of (a) the amount they paid for such preferred stock and (b) the amount that they would receive if the preferred stock were converted to common stock immediately prior to the liquidation event. Second, is the full participating liquidation preference. With a full participating liquidation preference, the holders of preferred stock will receive, to the extent the company has adequate funds, the amount they paid for such preferred stock plus their pro rata share of any dividends made to the holders of the company’s common stock. Third, is the capped participating preferred liquidation preference. With a capped participating preferred liquidation preference, the holders of preferred stock will receive, to the extent the company has adequate funds, the amount they paid for such preferred stock plus their pro rata share of any dividends made to the holders of the company’s common stock up to some predetermined limit (e.g., up to three times (3x) the amount investors paid for such preferred stock).

In all the foregoing types of liquidation preferences, investors can negotiate a multiple of their invested dollars back as part of the liquidation preference. The company should resist a liquidation preference that is greater than the amount each investor invested in the company unless it is a really investor favorable market. Any liquidation preference will also include the payment of any declared but unpaid dividends, if the preferred stock has non-cumulative dividends, or any unpaid accrued cumulative dividends, if the preferred stock has cumulative dividends.

Voting Rights: Typically, each share of preferred stock will carry a number of votes equal to the number of shares of common stock then issuable on its conversion to common stock. The preferred stock will generally vote together with the common stock and not as a separate class, except for negotiated protective provisions, which are discussed below, or as otherwise required by law.

 

Protective Provisions:

The company’s Certificate of Incorporation typically will include customary protective provisions which shall require the approval of the holders of some percentage of the outstanding shares of the preferred stock. It is in the company’s and founders’ interest to (a) minimize the types of actions that require the approval of the holders of the preferred stock and (b) keep the percentage of outstanding shares of the preferred stock that is needed to approve such actions low. Actions that are often subject to the protective provisions include: (i) liquidating, dissolving, or winding up the company; (ii) amending the company’s Certificate of Incorporation or Bylaws; (iii) creating or authorizing the issuance of a class of preferred stock that has rights and priorities equal to or ahead of the existing class of preferred stock; and (iv) issuing dividends or redeeming outstanding shares. Typically, the actions that are subject to the protective provisions will require the approval of the holders of at least a majority (i.e., more than 50%) of the outstanding shares of preferred stock.
Board of Directors: Typically, investors will request the right to designate a member to the company’s board of directors. If the holders of preferred stock will have the right to designate a member of the board of directors, then that should be set forth in the term sheet.
Optional Conversion: The shares of preferred stock will typically initially convert 1:1 to common stock at any time at the option of the holder, subject to adjustments for stock dividends, splits, combinations, and similar events and as described below under “Anti-dilution Provisions.”
Anti-dilution Provisions: The conversion price of the preferred stock will typically be subject to an anti-dilution adjustment to reduce dilution of the ownership percentage of the holders of the preferred stock if the company issues additional equity securities at a purchase price less than the applicable conversion price for the preferred stock, subject to standard exceptions. There are three primary types of anti-dilution adjustments. First, there is a broad-based weighted-average adjustment, which adjusts the conversion price of the preferred stock pursuant to a predetermined formula that takes into account the fully diluted shares of the company (i.e., it includes the shares reserved under the company’s equity incentive pool and possibly other unissued shares). Second, there is a narrow-based weighted-average adjustment, which is the same as a broad-based weighted-average adjustment, but it typically only takes into account the outstanding shares of the company. Third, there is a full rachet adjustment, which results in the conversion price for the preferred stock changing to the price being offered in the down round. Broad-based weighted-average adjustments are by far the most common[1] and the most favorable to founders. Narrow-based weighted-average adjustments are more investor favorable and full rachet adjustments are the most investor favorable.
Mandatory Conversion: In addition to the optional conversion rights discussed above, shares of preferred stock are typically also subject to mandatory conversion into shares of common stock on the occurrence of certain events. These events include: (a) the closing of a firm commitment underwritten public offering with a price of some multiple of the price originally paid by the holders of the preferred stock for the preferred stock and net proceeds to the company of not less than some predetermined amount, or (b) upon the written consent of the holders of two-thirds of the preferred stock.
Stock Purchase Agreement
Representations and Warranties: Investors will require the company to make some representations and warranties with respect to the company, its business, and the preferred stock financing. For early-stage investments, the representations and warranties should be minimal because (a) the business likely has not operated for long and therefore has nothing to make representations and warranties about and (b) the investors recourse against the company is limited, because the company likely has little to no assets other than the money it is currently raising, which the company will spend on its business shortly after closing the financing. That being said, the company should be prepared to make standard representations and warranties regarding the capitalization of the company, financial statements (if the company has more than a year of operating history), and approval of the preferred stock financing.
Conditions to Closing: The investors will also insist that the completion of the closing is subject to standard conditions, including satisfactory completion of financial and legal due diligence, qualification of the shares of preferred stock under applicable Blue Sky laws, and the filing of the company’s Certificate of Incorporation establishing the rights and preferences of the preferred stock.
Investors Rights Agreement
Registration Rights In later stage financings (i.e., financings other than series seed financings), investors will often require that the company grant them registration rights. Registration rights give the investors the ability to have their shares of preferred stock converted to common stock and then registered in connection with a public offering of the company’s securities. There are two primary types of registration rights, demand registration rights and piggyback registration rights. Demand registration rights give a predetermined number of investors the right to request the company to publicly list its securities on a publicly traded securities exchange. Piggyback registration rights give investors the right to participate in any public offering of the company’s securities.
Information Rights: Stockholders of a corporation have statutorily defined information rights. Investors will often request additional information rights. The company should push to limit these additional information rights to only investors that own a sizeable number of the shares of preferred stock. Such additional information rights often include: an annual budget, and unaudited annual and quarterly financial statements. The company typically does not need to comply with its obligation to provide such information if an investor is or becomes a competitor of the company.
Preemptive Rights: To help preserve their percentage interest ownership of the company, investors will often require the company grant them preemptive rights, which entitle each investor to purchase their pro rata share of any future equity financing rounds of the company. We often counsel clients to expand this right to include all stockholders so that founders can benefit from it as well. The company should consider whether the preemptive rights should include a right of overallotment, which entitles holders of preemptive rights to purchase any offered securities that are not purchased by the other holders of preemptive rights. To preserve flexibility in future financings and to help ensure one investor does not gain too much control of the company without the consent of the founders, the company may want to omit overallotment rights.
Stockholders Agreement
Right of First Refusal/Co-Sale:

The transfer of any shares of capital stock of the company will typically be subject to a right of first refusal benefiting the company and a right of second refusal benefiting the stockholders if the company does not exercise its right of first refusal. Investors often also require co-sale rights, which entitle stockholders to participate, on a pro rata basis, in any transfers of the company’s shares of capital stock over which the company has not exercised its right of first refusal and the stockholders have not exercised their right of second refusal.

The stockholders’ right of second refusal and co-sale right is based on the number of shares of the company’s capital stock held by each stockholder compared to the shares of the company’s capital stock held by all stockholders.

In early financing rounds the right of first refusal, right of second refusal, and co-sale right should apply to the transfer of all shares. In later financing rounds, institutional investors will typically resist having their shares subject to these transfer restrictions. The right of first refusal, right of second refusal, and co-sale right should be subject to customary exclusions relating to transfers for estate planning purposes and transfers to family members. Similar to preemptive rights, the stockholders’ right of second refusal may be subject to overallotment rights.

Drag Along: To help ensure no one stockholder or small group of stockholders can block a sale of the company, investors will typically require all stockholders to be subject to a customary drag-along agreement including a proxy, which is triggered by the approval of (a) a majority of the Board, (b) the holders of some percentage of the preferred stock, and (c) the holders of some percentage of the common stock. If the following people approve the sale of the company, then the drag along provision will require all other stockholders to cooperate and participate in the sale, subject to common protections and exceptions for minority stockholders.
Other Matters
Confidentiality: The company and any prospective investors should agree to keep the term sheet and any related discussions and correspondence confidential (other than disclosures to legal counsel, the accountants, and the beneficial owners of the company (i.e., its existing stockholders) and the investors to the extent reasonably necessary for such persons to render advice in connection with the proposed transaction).
Expenses: Sometimes a lead investor will require the company to cover such investor’s legal expenses relating to the financing of the company. The company should resist such fee shifting because the company is typically not in a position to cover such expenses. The company should push to have each investor cover its own legal and other expenses with respect to the financing.

 

The company can often cut down on legal expenses by reaching agreement on each of the above items at the term sheet stage with the lead investors participating in the financing round. If the company has not identified lead investors yet, then consider creating a stripped down term sheet to share with prospective lead investors to get the conversation started on these important negotiating points. No matter how detailed your term sheet is, there will typically be at least some additional negotiations once the parties begin drafting the actual investment documents.

[1] “Enhanced Model Term Sheet v3.0” by National Venture Capital Association (last updated June 2022) (https://www.aumni.fund/reports/new-enhanced-model-term-sheet-v3-0).

 

 

 

Written By:
Jerry Carter

Category: Blog

Published: October 15, 2024

About

The Climb is a blog intended to help entrepreneurs and investors better understand the legal concepts relating to starting and growing a business and investing in startups.

Disclaimer

The materials included on this blog are often legal in nature, but these materials are not intended to be legal advice for your specific situation. If you are an entrepreneur or someone considering taking the plunge into the world of startups, then we highly recommend that you engage legal counsel (whether us or another reputable law firm).

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