For early-stage companies, receiving a term sheet from a VC firm can be a satisfying moment worth celebrating. Some founders may feel confused about the terminology on the term sheet, and have no idea which terms are standard and which terms need to be negotiated with VCs. To help founders understand term sheets better, this article provides a brief introduction of each term under the following sections: offering terms, charter, stock purchase agreement, investors’ rights agreement, right of first refusal/co-sale agreement, voting agreement, and other matters.

Offering Terms

  • Security: the type of the security, such as Series A Preferred Stock, or Series B Preferred Stock.
  • Closing Date: this could be a specific date, or when all the conditions have been met.
  • Investors: the identity of the investor(s).
  • Amount Raised: This might be the most important term of the term sheet.
  • Number of Securities: The number of the shares being sold/issued to the investors.
  • Consideration: Cash, SAFE, convertible notes, or a mix of cash and convertible debts.
  • Pre-Money Valuation: This is the valuation of the company prior to the investment. It is a fully-diluted valuation that includes the employee incentive plan.
  • Price Per Share: The price per share is calculated based on the pre-money valuation.
  • Post-Money Valuation: This is the valuation of the company after the investment.

Charter

  • Dividends: founders would want to negotiate to the terms that do not include “noncumulative dividends when declared by the board”, because automatic dividends may cause financial struggles for the company, especially when a large investment amount is involved.
  • Liquidation Preference: This is another important term. It includes the preference and participation of the investor. Preference means that in the event of any liquidation of the company, the investors will receive some multiple of the original purchase price plus unpaid dividends. Participation has three types: non-participating, fully-participating and capped participation. 1X non-participation is commonly seen in early-stage financing.
  • Voting Rights: this term defines how preferred stock holders vote, such as whether they vote as a separate class or together with common stock holders.
  • Protective Provisions: This term illustrates certain protections that the preferred stock has, such as the veto rights of preferred stock holders regarding certain transactions. Investors want to protect their interest by having a final say on major events that affect the company, especially those directly related to the change of control of the company.
  • Optional Conversion: The preferred stock holders have the option to convert their preferred stocks to common stocks at a certain ratio, usually it is 1:1.
  • Anti-Dilution Provisions: If the company issues equity at a lower price in a later round, investors could adjust their conversion price to reduce the dilution. Weighted-average anti-dilution is more common than ratchet-based anti-dilution.
  • Mandatory Conversion: In the event of IPO, the preferred stocks will be converted into common stocks.
  • Pay-to-Play: Under this provision, investors must participate in the next round pro-ratably to prevent their preferred stock from being converted into common stock.
  • Redemption Rights: This term allows investors to redeem their shares after a certain numbers of years, an uncommon term for Pre-A or Series A rounds. Founders should be vigilant here, because if a company becomes insolvent, they may not be able to buy back all the shares when redemption rights are triggered.

Stock Purchase Agreement

  • Representations and Warranties: All stock purchase agreements have this standard term.
  • Regulatory Covenants (CFIUS): This applies to a deal where a CFIUS filing is or may be required.
  • Counsel and Expenses: legal fees, typically paid for by the company.

Investors’ Rights Agreement

  • Registration Rights: This term is related to IPO. The company is required to register investors’ shares and handle additional filings after IPO. It is a very long term that includes demand rights, piggyback rights and S-3 rights, but it’s usually very standard.
  • Expenses: this term is about who bears the costs regarding the registrations.
  • Lock-Up: this term refers to a restriction on investors or employees where they cannot sell their stocks within 6 months following the company’s IPO.
  • Termination: This term refers to the event/condition regarding the termination of the registration rights.
  • Management and Information Rights: The Company shall provide investors a Management Rights Letter prior to the closing of the deal. Information rights are the investors’ right to review and inspect the company’s reports, financial information, books and any other documents.
  • Right to Participate Pro Rata in Future Rounds: Any major investors will have a right to purchase a pro rata share of any offering of new securities by the company, subject to certain exceptions.
  • Matters Requiring Preferred Director Approval: This term lists corporate actions that require special approval from the preferred director.
  • Non-Competition Agreements: Non-competes are not enforceable in California, and other states may have certain restrictions as well.
  • Non-Disclosure, Non-Solicitation and Development Agreement: Founders should expect investors to require these agreements. However, just like the non-compete clause, some of these clauses may be prohibited or have restrictions in certain states, so they should be closely and carefully reviewed.
  • Board Matters: This term covers details of board matters, such as reimbursement of the expenses in connection with attending board meetings, D&O insurance, and indemnification agreement of the preferred director.
  • Employee Stock Options: This is an important term that defines the percentage of the employee option pool associated with the financing. It is common for the company to reserve 10% of the outstanding shares for the option pool.

Right of First Refusal/Co-Sale Agreement

  • Right of First Refusal: When there is a proposed transfer of shares (usually by a current or future employee holding 1% or more of the common stock), the company first and investors second will have the right of first refusal to purchase any part of these shares. If the investors exercise the right of first refusal, each investor may participate on a pro-rata basis. Right of first refusal terminates upon acquisition or IPO.
  • Co-Sale Agreement: If a founder sells shares, and the shares are not purchased by the company or investors, the founder can sell the shares to a third party. Under this circumstance, the investors have the opportunity to sell their shares proportionally as well. Co-sale rights terminates upon acquisition or IPO.

Voting Agreement

  • Board of Directors: this term states the structure of the board. For early-stage companies, the board usually has 3-5 members.
  • Drag Along: When there is a proposed sale of the company, the preferred stock holders may force other stockholders to agree on the sale.

Other Matters

  • Conditions Precedent to Financing: Founders should not overlook this term. Usually conditions include satisfaction of financial and legal due diligence, completion of securities laws and filings, and sometimes clearance from CFIUS. Investors may require the company to pay for legal fees whether or not the deal happens, so watch out for conditions that are not standard.
  • Founders’ Stock: This term provides the vesting schedule of the founders’ stocks.
  • No-Shop: This term is included when the company is working on closing with the investor and stops shopping around for better deals from other investors.
  • Confidentiality: This term requires the company to keep the terms confidential.