There ain’t no such thing as a free lunch
While the whole idea of getting funded and getting a term sheet sounds fun. The money comes with serious riders and conditions. After having researched a bit, this looks some of the most densely populated contract/agreement.
The goal here is to neither offer counsel or nor make any recommendation but to rather compile information and create a compendium for future reference while taking notes for oneself. The idea being, there’s nothing wrong in getting a good understanding of the different terms and what their implication is.
Each term allows certain protections and rights for the investor since he happens to be the minority shareholder and thereby needs to protect his money due to his limited control.
The term sheet is basically non-binding, which essentially means, the terms are agreed upon in good faith and cannot be contested in courts in case of a breach. Though, exclusivity is binding. It is followed a set of days for which, the founder cannot entertain any other offers. This is to kind of evade shopping around. Though, in my understanding, it’s not very strongly enforced.
Now that, we have set up the foundation. Time to go through the key terms and the meaning. For details, deep dive into the link.
- Convertible Preferred Stock: Preferred stock is different from common stock in the sense that, they have a higher liquidity preference like debt has it over equity. Lower risk. The convertible component is to give the option to convert to common stock in an event when the overall valuation is of VC’s share is larger than their preferred stock. This allows them to participate in the overall gains.
- Liquidation Preference: This is a more detailed take on the below two points on liquidation preference:
- There is more to it when multiple investors jump in at different levels. Should their preferences be stacked themselves or can all investors irrespective of their order of investment (seed, series A, B etc) be treated the same?
- The other caveat is the preference multiplier. In case of a standard multiplier of ×1, it essentially means in that in an event of sub-par performance. The investment amount equivalent to investment get’s paid out and then the founders and other common stockholders (typically employees).
- An example case: If the investment was $1 million at a post-money valuation of $5 million. The founder’s worth is $4 million. If for some reason, it gets sold out for $2 million. The founders will stick to preferred and get back $1 million. The founders end up with $1 million. But on the other hand, the startup did better than the valuation, say $10 million. The investors will convert preferred to common stock and cash out $2 million.
- Vesting Clause: Typically a 4-year journey with a 1-year cliff. The idea being, investors want you to be committed to their money for at least 4 years. I have been told, this gets reset for the remaining shares, as soon as a new investor pops in.
- Anti-Dilution: This will kick in if there is a down round aka the financing happens at a lower valuation. The article goes into details but there are broadly two terms, full ratchet and weighted average. The weighted average is the norm in the market.
- Some Standard Rights:
- Right of first refusal: Essentially this allows the investor the first right to purchase founder stake in case of a sale.
- Tag-Along right: If any of the stakes are put up for sale. The minority tags along with the majority shareholder. Essentially investor and the founder.
- Drag-Along right: This is the other way around, where the investor, still being a minority can drag along the majority shareholder to liquidation. This comes into effect a few years post the investment and gives the investor right to act in case they feel, the activity is slow. This is available as protection but very rarely used.
- Pre-emptive rights: These are essentially used to allow them to maintain shareholding levels buying more shares in future in case of dilution.
- Limited Angel right: This limits any other angel’s rights. The conditions are mentioned henceforth.
- Veto Rights: To further protect their investments and any kind of leakage, the typical term sheet asks for certain veto rights. These are contentious though as future investors might ask for the same rights or be deterred by existing rights already given. This needs to be understood before giving in.
- New Shares, Dividends, Buy Back
- Related Party Transactions
- Borrowing or Early-Payment
- Merger, consolidation, sale or IPO
- Change in management control
- Change in Board of Directors
- Changes in MoA
- Key employee appointment or removal
- Change in scope of business
- Lockin-Period: This is the period for which, the shares are locked in. This could be defined using a timeline or an event.
- ESOP Pool: This is the pool of the shares allocated exclusively for employees and typically go between 10-15% depending upon the size of the founding team. It’s on the lower end for a full-fledged founding team including business, tech. Single founder teams might have a higher pool allocated for either CTO or any critical roles like CMO or CSO etc for specific firms later in their journey.
There are a bunch of other smaller terms but less important. Representations, Sunset clause, reporting metrics, due diligence/legal expenses etc. In an attempt to prioritise, these are more typical operational aspects and will not really make change the fate of the firm in the larger scheme of things. The above points though pretty much add some kind of constraints into your future manoeuvrability.
Going through and trying to understand these terms really brings perspective to the term sheet and fundraising. What is basically a celebrated event in the media, the number and complexity of riders make a really hard sell. You absolutely need should try and bootstrap in my opinion or add in equity investing when looking for short and specific goals or milestones.