In the early stages of a venture capital deal, the important details about the financing will be documented by the VC in a term sheet and presented to the founder.
The term sheet will typically cover everything from the valuation given to the company by the VC to the control and post-closing rights that the VC will have over the company.
Founders often get excited by the arrival of a term sheet and are tempted to gloss over the finer details—usually on page 3—that can cost them greatly in the future. The term sheet is the most important document to negotiate with investors so the terms and the potential consequences of those terms should be considered carefully by founders before signing.
This chapter details some of the terms that may be included in a VC term sheet:
VCs will often want the right to appoint a designated number of directors to monitor their investment and have a say in how the business is run. Board seat allocation is aligned with share ownership. In the beginning, investors may own 25% of the company’s stock and have 20 to 40% of the seats on the board. However, in future investment rounds, they can own the majority of the stock and take majority control of the board—effectively leaving founders out of key decisions in the direction of their company.
After a Series A financing round, typical board scenarios might include:
- A three-person board, with two chosen by the founders, and one chosen by the VC
- A three-member board, one chosen by the founders, one chosen by the VC, and one independent director
- A five-member board, two chosen by the founders, two chosen by the VC, and one independent director
Founders may be able to negotiate that the VC takes board observer rights in lieu of board seats.
Liquidation Preference of Preferred Stock
The term “2X liquidation preference with participation” is commonly used—but do you really know what that means or how that may affect the flow of cash when you sell your company?”
VCs often insist on a liquidation preference to protect their investment in downside scenarios.
A liquidation preference refers to the amount of money the VC (as the preferred investor) will be entitled to receive on the sale of the company or other liquidation event before any proceeds are shared with the common stock.
The liquidation preference is typically expressed as a multiple of the original invested capital, usually at 1x. So in the event of a sale of the company, the investor will be entitled to receive back $1 for every $1 invested, before any other shareholders get paid. In situations where the company is particularly risky or the investment climate has turned adverse, investors may insist on a 1.5x, 2x, or 3x liquidation preference.
When the VC first invests, at a small amount, this liquidation preference may not seem so bad, however, after multiple rounds of VC investment layered on top of each other, it is very common for common shareholders to be buried below $50M of liquidation preferences.
This means that if the company is sold for $49M, then the common shareholders get 0% of the proceeds on exit.
Participating Preferred Stock
Participating preferred stock is a frequent request from VCs. It means that, upon a sale of the company, the participating preferred would receive back its liquidation preference (typically 1x of the original investment), before the remaining proceeds are shared by the common and preferred according to their relative percentage share ownership.
This is also referred to as a “double-dip” because the VC first gets paid their liquidation preference and then also gets paid a pro-rata percentage of the remaining exit proceeds. This is a very expensive one-word add-on to VC terms.
For example, if the exit sale price of the company is $30 million, and the VCs had invested $3 million in preferred stock at a 1X liquidation preference with participation:
- The first $3 million goes to the preferred holders to satisfy the 1X liquidation preference, and the remaining $27 million is split 50-50 (assuming the preferred and common shares owned equal percentages of the company). So, in total, the founders/common would receive $13.5 million and the preferred would receive a total of $16.5 million.
- If the preferred is non-participating, the $30 million in proceeds would be split 50-50 and the founders/common would receive $15 million from the sale.
Founders can try to resist participating preferred on the theory that it will hurt the Series A investors down the road if later financings also incorporate that term. If founders are forced to accept participation, they can often negotiate for the participating feature to go away if the VCs have received back some multiple (for example, 3x) of their investment.
Warrants represent an option to purchase a certain number of shares (common or preferred) at a future date at a fixed price, which can be the price of the current round of financing or set at a premium to the current price per share. They tend to be used in earlier-stage deals to compensate an investor helping you to raise startup financing (in lieu of or in addition to cash). Warrants can also be used in later-stage deals or strategic rounds to provide upside potential value to investors to encourage participation in a round of financing.
Unlike stock options, warrants tend to provide an option to purchase the most recent class of shares (rather than common shares). Warrants can also be issued to third parties while stock options are limited to employees, directors, consultants and advisors engaged in the business.
VCs will typically insist on protective provisions or veto rights on certain actions by the company that could adversely affect their investment or their projected return. VCs may invoke veto rights in scenarios such as:
- The amendment of the company’s charter or bylaws to change the rights of the preferred, or to increase or decrease the authorized number of shares of preferred or common stock
- The creation of any new series or class of shares senior to or on parity with the preferred
- Redeeming or acquiring any shares of common, except from employees, consultants, or other service providers of the company, on terms approved by the Board
- The sale or liquidation of the company
- Incurring debt over a specified dollar amount
- Payment of dividends
- Increasing the size of the company’s board
The most sensitive of these veto rights is the one granting the venture investors a blocking right on a sale of the company. Founders sometimes try to mitigate this veto right by arguing that it should not apply in situations where the VC receives a minimum return on its investment (often 3x-5x).
VCs often obtain protection against the company issuing stock at a valuation lower than the valuation represented by their investment.
The most common is weighted average anti-dilution protection, which reduces the conversion price, inversely increasing the conversion rate of the preferred stock held by earlier investors if lower-priced stock is sold by the company. With weighted average anti-dilution, the more shares that are issued, and the lower the price of the shares, the greater the adjustment to the earlier preferred.
Founders will want to avoid the more severe full ratchet anti-dilution clause, which reduces the conversion price of the existing preferred to match the price of the new stock (no matter how many shares are issued). This term is commonly referred to as a “death spiral” term, as it leads to a near endless amount of dilution.
Investors will typically agree to specifically exempt from anti-dilution protection certain types of equity issuances, such as incentive equity for employees and other service providers, equity issued in acquiring other companies, and equity issued in connection with bank financings, real estate, and equipment leases, etc.
These rights are very rarely exercised, rather they are used as a bargaining chip in negotiations when follow-on rounds are done at lower valuations, usually to punish the founders/common shareholders for perceived underperformance.
Right to Participate in Future Financings
VCs will normally receive a right to purchase more stock in connection with future equity issuances to maintain their percentage interest in the company.
These participation rights are usually reserved for major investors who own a certain amount of stock and typically terminate on a public offering. As with anti-dilution protection, these rights are typically designed to apply only to true financings and are drafted to exclude employee equity, equity issued in acquisitions, or kickers issued to lenders, landlords, or equipment lessors.
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Stock Option Issues
VCs will want to ensure that the company has a stock option pool for future equity grants, typically 10% to 20% of the company’s capitalization, with later-stage companies having smaller pools. The options are used to attract and retain employees, advisors, and board members.
VCs will almost always insist that this option pool be included as part of the pre-money valuation of the company, and it is standard to do so. However, founders should realize that any increase in the option pool will come at their expense, reducing their percentage ownership of the company. If the size of the pool becomes an issue in the term sheet negotiation, it is a good idea for the founder to produce a grounds-up budget for future options, estimating the options that will be needed for future hires until the next round of financing.
Occasionally, VCs request a provision allowing them to cash out of their investment through a redemption feature (assuming the company has the cash). A typical redemption provision would say that the investors may, by majority vote at any time starting five years after their investment, elect to be redeemed (repurchased at their original purchase price), with payments made over a three-year period in equal installments.
Series A investors will not typically push for a redemption feature, knowing that such a provision may show up in future rounds of financings to the detriment of the Series A investors. This is rarely exercised but is instead used a bargaining chip in future negotiations between the VC and the company, as well as between VCs.
The company may be obligated to maintain directors’ and officers’ liability insurance, covering the officers and directors of the company in connection with litigation with respect to duties they are performing for the company. The term sheet will specify the dollar amount of coverage (often $2 million to $10 million).
Venture investors occasionally also require the company to acquire and maintain life insurance policies on the lives of the key founders that will provide the company with cash in the event a founder dies. This insurance policy is usually used to redeem the preferred shares of the VC investor.
Right of First Refusal
It is common for investors to have a right of first refusal (ROFR) on any stock to be sold by the founders. This will usually require the founders to first offer the shares to the company, and then to the investors (on the same terms as on the proposed sale) before they can be sold. Such a right will allow the company and the investors the opportunity to keep the founders’ shares within the existing shareholder base. Founders are usually able to negotiate exceptions from the right of first refusal, for transfers to family members or trusts for estate planning purposes, and, less often, for the sale of small (5%-15%) stakes.
This mere existence of this right is a deterrent to a founder attempting to sell her stock, as a prospective buyer will be less inclined to put effort into due diligence if a ROFR exists.
VCs will also expect to get “co-sale rights” with respect to founder stock sales. This will give the investors the right to participate (on a pro-rata basis) in a sale by the founders of their shares. (These rights are typically exercised when the founder has negotiated a very high price for his or her stock, too high to warrant a purchase pursuant to the right of first refusal.)
Drag-along rights give the company the right to force all shareholders to participate in and vote for a sale of the company if the sale has been approved by specified groups. For a Series A financing, the drag-along is typically triggered if approved by the board, holders of a majority of the common stock, and holders of a majority of the preferred stock.
In later-stage deals, a drag-along may be structured to give only the venture investors the right to invoke the drag-along right.
Expenses of the Venture Investors
Term sheets will typically include a commitment from the company to reimburse the reasonable legal fees of the investors plus any due diligence or out-of-pocket costs incurred, payable at the closing of the transaction.
This obligation is typically “capped” at a specific dollar amount, but if the deal takes longer or requires more legal work than was expected, the cap is often revised to take that into account.
Typically, VCs also include fees such as quarterly board meeting fees to be paid to the VC fund.
- Never gloss over a term sheet—seek legal advice and ensure you understand every term included.
- Map out the potential consequences of each term in several scenarios (i.e., future funding rounds or an exit event).
- Even small, seemingly insignificant terms in a term sheet may have a dramatic impact on the returns to common shareholders down the line—even if the company is moderately successful.
Have we missed anything on this list? Let us know if you have anything to add. If you’re interested in taking an alternative path on your growth journey, talk to us about our non-dilutive capital options.Back to top