Startup Term Sheets
Warrant
Another name for an option to buy company stock. These are often given to investors
Net share settlement
A form of settling an option in which the holder receives shares with a value equal to the in-the-money amount of the option Or An alternative form of settling an option contract in which the holder of the option is not required to buy the shares
Pay to play
A lead investor may want to require that all investors must continue to participate in future rounds or lose certain rights, such as they liquidation preference
Assignment
A term for the transfer of property that starts with an 'A'
Cap table
A tool for keeping track of investments through multiple rounds
No shop provision
Although the terms themselves are not legally binding, it is often the case that the parties will agree to use their best efforts to try to close the deal. The company raising money will agree to not continue to seek funding for a fixed period of time. This obligation is legally binding
The standard venture equity investment
Created as participating preferred stock. This means that the investor will have a preference on liquidation like preferred stock, but also participate in the upside like common stock
Drag-along rights
If one group of shareholders agrees to a sale, all of the other investors must agree as well
Liquidation preference
If the company liquidates, the investor will have a claim of $X on the proceeds ahead of the common stockholders. Typically, this amount is equal to the investment plus any accrued and unpaid dividends
Howey test
Investment of money Common enterprise Expectation of profit From the efforts of others
Right of first refusal
Investors may ask for the right to invest in the future at terms agreed to by the company with another investor (beyond their pre-emptive right to participate pro-rata). This can make it more difficult to raise money as it introduces a third party into the negotiations
Pre-emptive rights
Investors typically have the right to invest in future rounds to preserve their percentage ownership. For example, if an investor owns 10% and the company is issuing 1,000 shares, the investor has the right to buy 10% or 100 of the shares
Anti-Dilution protection
Investors typically will want to be protected from dilution from shares being issued in the future for less than the amount that they pay, often called a "down round". This is general accomplished by issuing the existing investors additional shares in such an event
Information rights
Investors will likely require the periodic delivery of financial statements and timely tax information, such as a Schedule K-1 in the event of a partnership
Who initiates
It is common for the lead investor to initiate the term sheet
Protective provisions
It is common that certain major corporate events, such as a sale, must be agreed to by a majority or super-majority of each class of shares. This allows a minority investor to be protected from the unilateral will of the majority. Note that there is always some degree of protection in the form of fiduciary duties owed by directors and officers to all shareholders
Reserve
Money that a VC will set aside to make future investments in startup companies that it invests in
Tag-along / co-sale rights
One group of investors cannot sell shares unless all other investors have the opportunity to participate in the sale on a pro-rata basis
Condition precedent
Something that must happen before the funding closes
Dividends
Startup shares often have dividends, but they are rarely ever paid in cash. The dividends accrue until a sale or liquidation
Timing
Term sheets are normally delivered after several meetings between the lead investor and the startup. Startups hope to obtain term sheets from multiple investors in order to increase their bargaining power. The term sheet will often state how long the terms are available to be accepted by the startup. The parties will then negotiate the terms. Once the term sheet is signed, the parties will work to close the transaction. The term sheet will often stage a target closing date, which is typically within weeks or a few months, depending on the complexity of the due diligence process and documentation
Legal / reputation importance
Term sheets are normally not legally binding. The contracts are not final until the full documentarion is signed. However, it is considered very bad form for a party to a term sheet to back out of a deal unless significant new information found during due diligence
Purpose
Term sheets are used by business people to document the basic economic terms of a deal before starting the documentation and due diligence process. The idea is to make sure the important terms of a deal are agreed before spending time and money on the details
Standard form
Term sheets are usually 1 to 5 page documents. They are normally in a standard form, but they can also be in the form of an email or other casual presentation. They can be full, with many terms outlined, or limited to the biggest terms such as amount and price
No shop provision or exclusivity
The company will often be asked to refrain from trying to raise money from other potential investors for a fixed period of time
Carried interest
The compensation to the VC manager in the form of a percentage of profits
Contingency
The investor may want to condition the investment on certain milestones being hit. This can introduce counterproductive incentives on management, but may be necessary in certain situations
Protective provisions
These terms provide special voting rights to certain classes of shares in extraordinary events such as a sale of the company
Participation
This is usually structured as a conversion of the instrument to common at the option of the holder. The holder can convert its preferred shares to a common at a price equal to the pre-money valuation divided by the pre-money shares
Assignment
Transfer of shares is usually highly restricted except to certain affiliated parties. Assignment in this context means transfer
Capital call
VC's will make this to request pre-committed funding from an LP in a VC fund
