Term sheet, a non-binding agreement that outlines the basic terms and conditions under which an investment will be made in a startup, serves as a critical milestone in the investment process. Even though the term sheet isn’t legally binding except for certain clauses like confidentiality and exclusivity, it shows that the investors and the startup have reached a preliminary understanding.
For others, it suggests that a funding round is imminent, generating excitement and anticipation in the sector or segment the startup operates. It also provides insight into the startup’s valuation. While the exact terms might not be disclosed by the company, experts refer to the pre-money valuation, post-money valuation, or the investment amount to decipher the business’s future growth.
However, reading a term sheet can be complex for several reasons, especially for founders who may not be well-versed in legal or financial jargon. Breaking down those jargons, here are the key components of a term sheet for startups explained with example:
Valuation: Pre-money valuation of the company is the valuation before the new funding and determines how much of the company the investors will own after their investment. On the other hand, post-money valuation includes the total value with the newly added capital.
For example, a startup with a pre-money valuation of $5 million raises $1 million. Post-funding, the post-money valuation becomes $6 million. The investor putting in $1 million will own approximately 16.67 per cent of the company.
Equity Structure: Investors often receive preferred shares, which provide them with certain rights over common shares. These can include special voting rights, liquidation preferences, and dividends while common shares, typically held by founders and employees, are subordinate to preferred shares in terms of payout hierarchy.
Liquidation Preference: This defines the order in which investors get their money back in the event of a sale, liquidation, or exit. It usually comes in forms such as liquidation preference wherein investors get back 1x of their original investment before other shareholders receive payouts.
Then there are participating preference shares which mean investors receive their liquidation preference and then share in the remaining proceeds while non-participating preference shares mean they only get either their preference amount or their share of proceeds—whichever is higher.
For example, in liquidation preference, if investors have a 1x non-participating liquidation preference on their $1 million funding and if the startup sells for $3 million, the investor would receive $1 million before the remaining $2 million is distributed to other shareholders.
In the case of participating shares, the investors would receive $1 million first and then their 16.67% share of the remaining $2 million, which would be $333,333, totalling $1.33 million.
Voting Rights: These include the extent to which investors can influence decisions made by the company. They may include rights to approve certain major decisions like new funding rounds, changes to the company’s structure, or sale of the business.
Anti-Dilution Provisions: These provisions protect investors in the event of a down round (a future round of funding at a lower valuation than previous rounds). They include full ratchet wherein investors’ previous shares are adjusted to reflect the new lower price. Another is weighted average which adjusts the price per share of previous investors more proportionally to the size of the new round.
For example, in full rachet, if a startup initially raised funding at $5/share and later raises a down round at $2/share, the full ratchet anti-dilution would adjust the earlier investor’s price per share from $5 to $2, giving them additional shares to maintain their ownership.
With a weighted average anti-dilution provision, the adjustment would be more moderate, reflecting the proportionate difference rather than a full adjustment.
Pro Rata Rights: These rights allow investors to maintain their percentage ownership in subsequent financing rounds by participating in those rounds proportionally. For instance, an investor who owns 10 per cent of a startup at the Series A round might have the right to maintain 10 per cent ownership in the Series B round by investing additional capital, ensuring their percentage isn’t diluted by new investors.
Founder Vesting: Investors often require founders to have a vesting schedule, even if they already own shares. A typical vesting schedule may have a 4-year vesting period with a 1-year cliff which means that if founders leave within the first year, they get no additional shares.
Drag-Along and Tag-Along Rights: Drag-along enables majority shareholders to force minority shareholders to join in the sale of a company under the same terms while tag-along allows minority shareholders to sell their shares if a majority shareholder is selling theirs, ensuring they get the same deal.
Exclusivity Clauses: These clauses prevent the startup founder from soliciting or negotiating with other investors for a certain period while the term sheet is being finalized. It ensures that the investors have the first right to proceed with the investment.
Conversion Rights: These are for investors who may want the right to convert their preferred shares into common shares under certain conditions, such as an IPO or sale of the company.
For example, an investor holding let’s say Series A preferred Shares may have the right to convert their shares into common shares at a 1:1 ratio during an IPO, allowing them to benefit from the liquidity and public market prices.