Dear Kingsley Napley,
I recently received a term sheet from a venture capital investor for my startup, and I’m feeling a bit overwhelmed by all the terms and provisions in it. I want to make sure I fully understand what I’m agreeing to before I sign anything. Can you provide some guidance on how to decipher the key terms in a VC term sheet and what I should be looking out for to protect mine and my startup’s interests?
Yours sincerely,
Fundraising Founder
Dear Fundraising Founder,
You are right to want to fully understand the provisions of your term sheet. Although a term sheet is not usually a legally binding document (save for specific provisions such as confidentiality), the term sheet will act as the framework upon which legally binding documents will be prepared. It is considered bad form to attempt to renegotiate elements of a term sheet once it is agreed except under exceptional circumstances, so it is important to make sure that you understand what you are signing up to.
Below are some of the provisions you should keep an eye out for when reviewing the VC’s proposed term sheet:
Information Rights
The VC will want the right to receive certain information about the company on a regular basis. As an investor in your company, this will allow the VC to monitor how their investment is performing. It will also allow the VC to satisfy any reporting obligations they may have to investors or partners in their business.
The information that a VC will usually require the company to provide includes regular updates on the financial condition and budgets of the company and a general right to visit the company and examine its books and records. It may also include direct access to the company’s auditors and bankers.
If you have multiple investors, you should ideally try and align their information rights and/or limit detailed reporting to major investors. This will reduce your administrative burden and limit the parties with whom you share confidential information about your company.
Board representation
Typically, a VC investor will also want the right to appoint a person of their choice to the company’s board of directors. This is another mechanism that allows the VC to monitor its investment and ensure that they are aligned with the strategic direction of the company. Although it dilutes the founder’s control over the company, it can also be a positive experience for the company, which may benefit from the board member’s investment or sector expertise.
Alternatively, a VC may choose to appoint a board observer. A board observer has the right to attend all board meetings, but does not participate in board decisions. They are usually appointed by investors who want to avoid the more onerous obligations that come with being a director or by a minority investor.
Consent matters
Even if a VC wants the right to appoint a person of their choice to the company’s board of directors, because decisions of the board are made by majority, the VC will not have control at board level. Therefore, a VC will often also want the benefit of consent matters, being a list of matters which the company cannot carry out without the investor agreeing.
As a founder you will want to ensure that this list of consent matters is appropriate and only relates to key decisions which could impact overall value of the company (and therefore the VC’s investment) and does not restrict the day to day running of the company.
Liquidation preference
Liquidation preference is another common right which VCs seek in return for their investment. It sets out the order and the amount that investors will be paid out if the company goes into liquidation or is sold. It is usually expressed as a multiple of the VC’s original investment. For example, if an investor has a 2x liquidation preference, they will receive double the amount that they initially invested in the company before returns are distributed to the other shareholders.
Liquidation preference is a protection for the VC investor, should the company fail or be sold for less than the VC invested. An investor taking a larger risk will typically seek a higher multiple in order to mitigate that risk.
Liquidation preference is an important clause to negotiate with your investor because it will affect how much return the other shareholders (including founders, employees etc.) will get at a later date. You should also bear in mind that liquidation preferences can become important in future funding rounds as future investors may be unwilling to accept a lower multiple than an earlier investor.
Anti-dilution rights
Anti-dilution rights are another common request from VC investors who seek to protect their ownership from being diluted when new shares are issued on a ‘down-round’ (i.e. at a lower valuation than when the VC originally invested) by being issued with further shares on the down-round.
There are two types of anti-dilution rights:
- Full Ratchet: the number of shares issued to the VC is calculated as if they had invested at the down round valuation.
- Weighted Average: the new shares issued to the VC are calculated by taking into account equity previously issued and the equity that will be issued in the down-round to give a weighted average price per share.
The full ratchet method is the rarer and more punishing method of anti-dilution protection for existing shareholders, as it will dilute their shareholding more. It may also put off future investors if they are not able to negotiate the same rights.
Leaver provisions
Leaver provisions determine what will happen to an employee’s shares in the company when they cease to be an employee. In VC agreements, departing employee shareholders can be categorised as either ‘good leavers’ or ‘bad leavers’ based on the circumstances of their departure.
Good leavers: Typically, a ‘good leaver’ leaves the company under favourable circumstances, such as departure due to death, disability, or termination without cause. Good leavers can retain some or all of their shares in the company and/or receive a fair value for their shares upon leaving.
Bad leavers: On the other hand, a bad leaver leaves the company under unfavourable circumstances, such as resignation or termination for cause. Bad leavers often forfeit some or all of their shares in the company or receive a reduced value for their shares.
A VC may seek to increase what can be categorised as a ‘bad leaver’, for example, by defining all leavers who are not ‘good leavers’ as ‘bad leavers’. This can be negotiated, along with other considerations such as who these leaver provisions apply to (e.g. if they apply to the founders or not) and how many shares the leaver provisions should apply to (e.g. a reverse vesting structure could be negotiated).
VC Fees
You should also be aware that VCs may expect you to pay some, if not all, of the fees associated with their investment in your company. This will usually include legal, due diligence and administrative costs. You can manage this by negotiating a cap on the amount of fees your company will pay. VC investors may also ask for a ‘board fee’ or a ‘monitoring fee’ to account for their presence on the company’s board and the responsibility of monitoring their investment. These should be avoided where possible.
I hope that this has given you an idea of what to expect when you reviewing your term sheet and where you may have space to negotiate with the VC. I wish you good luck on this very exciting next step!
Yours sincerely,
KN
An article by:
Kingsley Napley
