Learn what a term sheet is and which key clauses to negotiate. This article explains the financial and corporate clauses you can negotiate with investors for everyone’s benefit. Specifically, it covers the following topics:
- What is a term sheet?
- What is a capital increase?
- Equity rounds vs. raising capital with convertible instruments
- Term sheet clauses
- Financial clauses
- Corporate clauses
Before getting straight to the point, it’s important to stress that, in most cases, a term sheet is presented to a startup when it raises an equity round—that is, a “priced round” in which shares are issued to new investors and holders of convertible instruments. But what exactly is a term sheet?
What is a term sheet?
Also known in Spanish as a hoja de términos, a term sheet is a document negotiated by an investor and a startup during an investment process. It sets out all the rights and obligations both parties agree to in order to become part of the startup receiving the investment. These rights and obligations are laid out in clauses, which we’ll review below.
Also, remember that all term sheets are intended to facilitate the purchase of preferred stock, not common stock.
Types of term sheet clauses
There are 2 common types of clauses in a term sheet: financial and corporate. In general, financial clauses cover how money is managed in the startup, while corporate clauses cover the startup’s management and control.
Below, you can learn more about each type.
Financial clauses
As the name suggests, these clauses refer to all the rights and obligations an investor may acquire when joining the company they invest in. Below are the most common financial clauses for startups in their seed and Series A rounds.
Price per share (valuation)
The price an investor is willing to pay for a preferred share in the startup. This price per share depends directly on the pre-money valuation agreed upon by the investor and the founders.
Price per share = Pre-money valuation / Fully diluted capitalization
Liquidation preference
The amount of money, expressed as an “X” multiple, that an investor is entitled to receive ahead of anyone else if the entity is liquidated or dissolved. Put as a question: How many times the invested capital will be returned to the investor?
The standard for this clause is 1X.
For example: If an investor put in US $100K and the company is about to be sold for US $1M, the investor will be entitled to a 1X return—that is, to get back the amount they invested.
Participating or non-participating preference
Once the money has been returned, a second question to consider is whether the investor also receives their percentage ownership of the remaining amount to be distributed. In other words, in addition to receiving their money back X times, can the investor also exercise their ownership percentage in the company to receive more money?
The standard for this clause is 1X + non-participating.
Otherwise, the investor would receive their 1X plus the amount corresponding to their ownership percentage in the company. Returning to the example above, in addition to the US $100K recovered by the investor, they would be entitled to their percentage of the remaining US $900K.
It’s worth noting that this “extra” would come out of the founders’ pockets.
Anti-dilution protection
An adjustment to the price per share if shares are later sold at a lower price (also known as a down round) than the price the investor paid. In other words, the valuation in a subsequent round is lower than the current valuation.
There are various protection mechanisms. We recommend watching the video starting at 27:09 and consulting your trusted lawyers to determine the best strategy for this clause.
Pay to play
An obligation for the investor to invest a certain amount of money, or a minimum percentage of the next round, to retain the rights acquired in the current round. If the investor does not meet this requirement, they lose their special rights.
Preemptive rights and right of first refusal
A right that gives the investor the opportunity to be the 1st to invest again in the startup in a subsequent round, and, at the same time, to be the first to accept or pass on the investment opportunity before it is offered to a 3rd party.
Corporate clauses
Also known as control clauses, these give the investor various rights that allow them to exercise a degree of control over certain important aspects of the company. These clauses may be offered to both smaller investors and lead investors at different levels.
Veto right
A right that gives the investor the power to block a decision, regardless of the opinions of the other members of the entity. In other words, certain types of decisions require the investor’s approval to proceed; otherwise, they will not go ahead.
Some situations in which this right may be exercised include borrowing, the sale of intangible assets, a radical change in the business model, and the sale of shares at lower prices, among others…
Board member
A right that allows the investor to join the board of directors and have a voice and vote on it. As a standard practice, this right is always granted to the lead investor in a Series A round.
Forced-sale rights
Forced-sale rights protect the investor’s interests when they seek to make their investment liquid—that is, to achieve an exit. They are usually summarized as drag-along and tag-along rights, both of which are standard.
Drag-along
Also known as the right of drag-along. A right that requires founders to participate in a sale led or initiated by investors, even if a founder does not wish to sell their stake.
Tag-along
Also known as the right to join a sale. A right that requires founders to invite investors to participate in a sale led or initiated by the founders themselves.
Information and inspection rights
A right that allows the investor to request information and stay informed about the company’s results and performance in different areas. At a minimum, information would be expected to be shared annually; however, quarterly reports are also standard.
Conversion rights
The investor’s right to convert preferred shares into common shares at any time. This right is commonly used during a liquidity event, when the investor chooses to convert based on their ownership percentage to maximize their return, rather than exercise their liquidation preference and receive 1X their invested money.
For example: If an investor invested US $100K and owns 10%, and the company is about to be sold for US $10M, instead of requesting a 1X return, the investor exercises their conversion right to access the 10% at US $10M.
The standard ratio of preferred shares to common shares is 1 to 1. Also, once a preferred share is converted into a common share, there is no going back.