Term Sheet Series — Post #1 — Introduction

By Luciana Jhon Urrunaga, Esq. and Anibal Manzano, Esq.

I. Introduction

This series will focus on walking you through the elements of a term sheet. We will be using the National Venture Capital Association’s (NVCA) term sheet as our template, which you can find here.

II. The Basics

A term sheet is a preliminary, (typically) non-binding document that outlines the basic terms and conditions of a proposed investment. Term sheets may be used for Safe or convertible note rounds, or any type of agreement for that matter, but are more commonly used for priced (equity) rounds. In anticipation of an equity fundraising round, a lead investor will outline the key points of their offer to invest in a portfolio company in the term sheet. Because a term sheet is a summary of terms of the proposed transaction, it cannot possibly contain all of the terms of the potential investment (which will likely be formalized in 120+ pages of documents). Still, once executed, the term sheet becomes the guiding document of the negotiation process between you and your lead investor. Commonly, term sheets will include the following provisions (which we will explore in this series):

• Valuation, Number of Shares, Price per Share
• Closing Conditions and Expenses
• Dividends
• Liquidation Preferences
• “As Converted Basis” and Conversion Rights of Preferred Stock
• Voting Rights and Protective Provisions
• Anti-Dilution Provisions
• Carve-Outs to Anti-Dilution Provisions and “Pay-to-Play” Provisions
• Redemption Rights
• Company Representations and Warranties
• Registration Rights
• Management and Information Rights
• Preemptive Rights
• Matters Requiring Preferred Director Approval
• Non-Competition and Non-Solicitation Agreements
• Non-Disclosure and Developments Agreements
• Board Composition
• Right of First Refusal (ROFR) and Co-Sale (Tag-Along) Rights
• Drag Along Rights
• Founder Vesting
• No-Shop and Confidentiality Provisions

As you can see, while short, a term sheet can cover a lot of ground. It lays out some of the most important terms and conditions of the investment transaction. This is why it is important to ignore the common urge to focus solely on valuation and look beyond that to terms that can largely affect your future ownership and control over your company.

III. Binding vs. Non-Binding; No-Shop and Confidentiality Provisions

A term sheet is typically not binding and, therefore, not a legal commitment to invest. It should not be taken as assurance that the deal will actually close. However, it is a road map used by both parties to guide them through negotiations in preparation of the final (binding) investment documents and should be entered into in good faith. However, the no-shop and confidentiality provisions in a term sheet are typically binding. These will be discussed in more detail in a subsequent post, but it is important to note that the no-shop provision requires the company not to solicit any offer of investment by anyone other than the investor signing the term sheet for a certain period and the confidentiality provision provides that the company may not disclose the terms of the term sheet to anyone other than its officers, directors, accountants, and attorneys without the investor’s consent.

An extensive no-shop period can hurt a startup significantly and reduce its leverage considerably prior to closing — a startup’s runway is depleted, and a no-shop period eats away at it. Therefore, special attention should be paid to this provision.

IV. A Fair Deal

Founders may be overwhelmed when presented with a term sheet because it is often the first time that they have seen one and they are unfamiliar with many of its terms. On the other hand, Venture Capital firms (VCs) deal with these documents on a regular basis, leading to a significant power imbalance between the parties. To mitigate this disadvantage, founders can consider the following:

• Consider speaking to multiple investors — This will put you in the best negotiating position and will prevent you from being pigeonholed into unfavorable terms simply due to lack of funding options.
• Make sure your investor is committed — If you agree to exclusivity with an investor via a “no-shop” clause, be confident the investor has the commitment, resources, and money you need before the negotiations go too far.
• Hire an attorney with expertise in the area — An expert will provide the support and advice you need to negotiate the most favorable terms for your deal and will be able to point out any uncommon terms. Although a term sheet is typically non-binding it is ultimately a non-binding commitment that the company makes. If either party decides not to respect its obligations under this non-binding agreement, it will likely be seen as a red flag by the other side. Furthermore, this preliminary stage of an agreement is sometimes the first time parties are negotiating with each other, which is a valuable opportunity to determine if the investor and the company are a match.
• Nail down your priorities — Negotiations are riddled with disagreements. Before you begin negotiating, identify issues that are deal killers and issues where you can be flexible.