The Term Sheet for funding : What to look out for

The Term Sheet captures the main points agreed by the investor and the startup when arranging funding. It sets out the structure of the investment and how the mechanics of funding work between the parties. 

 Startups raise funds either on a priced or non-priced round of funding. A priced round of funding indicates that the parties have agreed on a fixed valuation for the business. In a non-priced round of funding, valuation has not been crystalised and will depend on the price set in a future round of funding. It is common for startups in pre-seed or seed stages to go for non-priced rounds. In Series A or later stages, we tend to see mostly priced rounds. 

Whether it is priced or non-priced rounds, the following are the important points to look out for when negotiating a Term Sheet.

The non-priced round 

Early stage startups in the pre-seed or seed stages usually have a very limited track record and this makes it difficult to establish a reliable valuation. Their business models may not be cast in stone and may still be undergoing some tweaking. By doing a non-priced round, the parties can postpone the question of valuation and close the round quicker.

In a non-priced round, the investment takes the form of a convertible instrument which is converted into ordinary shares upon the company raising a priced round in the future. In many cases, the conversion price is set at a discount to the valuation of the business in the next priced round. Discount rates can range from 10% to as high as 50%. Alternatively, a maximum conversion price, known as a ‘cap’ is set. If the next round of financing occurs at a higher valuation than that indicated by the cap, the conversion will take place at the cap price. If they prefer, the parties can also agree to both a discount plus a cap. The aim is for the investor to have a low enough conversion price as compared to the valuation of the next round to justify the risk taken.

Examples of instruments for non-priced rounds are the Simple Agreement for Future Equity (‘SAFE’) created by the Y-Combinator accelerator in the USA and Convertible Agreement Regarding Equity (‘CARE’) which is part of the Venture Capital Investment Model Agreement kit of Singapore. These instruments are similar to a convertible note, except that they do not bear interest and the funds do not need to be repaid. They are intended to be converted into equity at an subsequent point in time under various circumstances. The use of these instruments speeds up negotiation as they are widely used agreements thus saving time and costly legal fees. 

When the company next closes a priced round, for example in the form of an issue of preferred shares in a Series A financing, the SAFE or CARE will automatically convert into preferred shares according to its terms. 

Where the next round of financing takes place at a very high valuation, especially if some time had passed, the investor will be exposed to the impact of the high valuation when he converts, depending on the size of the discount. 

The use of a cap will alleviate this ‘overpaying’ to an extent. However, it can serve as a double-edged sword as the cap may be perceived as a benchmark valuation in future rounds of financing. Investors in the next round may be reluctant to offer a much higher price than that suggested by the cap. That is one disadvantage to the startup of having a cap built in.

An important clause in the Term Sheet is the one on liquidation preference. In the event where the company is sold to a buyer, the investor will be entitled to a share of the proceeds of the sale in priority to ordinary shareholders. Very often, this clause allows the investor to receive the greater of their investment amount (or a multiple of it) or the price for their shares if sold to the buyer. Only after the investors are paid this ‘preference’ amount can the rest of the sale proceeds be shared among the ordinary shareholders.

The priced round

Priced rounds, where there is a fixed valuation, usually involve the issue of convertible preferred shares to the investor. This usually takes place in the Series A or later rounds of financing. Preferred shares are a different class of shares with their unique rights as compared to that of ordinary shares. They can be converted into ordinary shares at any time at the option of the investor.

Below are the more important terms to look out for in a priced round:

Valuation and cap table

In a priced round, the pre-money (before financing) and post-money (after financing) valuations are usually set out in the Term Sheet with the relevant capitalisation table (‘cap table’) setting out the breakdown of the shareholding. Founders and investors will also agree on the proportion of shares allocated for stock options to employees. This employee pool is made up of issued and unissued options. This is set out clearly in the cap table in both pre-money and post-money scenarios.

Vesting for founders’ and employees’ shares

Stock options granted to founders and employees have a vesting period that corresponds to their length of service with the company. If they were to leave the company before the options fully vest, they will only receive a percentage of the options they are entitled to. It is common to have employees stock options vest over 4 years from the date of the grant. 

Reserved matters or Protective provisions

Venture capital investors usually prefer to end up with a minority stake in a company assuming that their preferred shares are converted into ordinary shares. Therefore, they will likely be outvoted by the majority shareholders in many instances. For the protection of investors, Term Sheets usually set aside reserved matters – important items in the company’s affairs that require approval of the investors in order to proceed. These include items like incurring substantial debt or borrowings, sale of disposal of major assets, amendments to memorandum and articles of association, issue of new securities, etc. . Founders should realise that a significant part of their control over their business is shared with the investors as a result of these protective provisions.

Liquidation preference

A similar clause on liquidation preference as with non-priced rounds described earlier will also be found in a priced round Term Sheet.

Anti-dilution

This clause, commonly found in Term Sheets, protects the investor from dilution of their shareholding. Where the company issues new shares at a price lower than the conversion price of the preferred shares, then the conversion price will be adjusted downwards according to an agreed formula. A lower conversion price would mean the investor gets more shares when they convert.

The adjustment can be on what is known as rachet or weighted-average basis. In a full-rachet adjustment, the conversion price of the preferred shares is adjusted fully to the lower price of the new issue of shares. In a weighted average adjustment, the conversion price is adjusted downwards taking into account the original conversion price and the lower price of the new issue on a weighted average basis.

Board representation

It is customary for investors to be given seats on the Board of Directors of the company which corresponds to the size of their investment. Founders should aim for a composition of the Board that reflects the interests of the founding team, the investors and the need for an independent voice.

Drag-along rights

There will come a time when there will be offers by third parties for the company and where the shareholders will contemplate selling their shares. If a majority of shareholders decide to accept an offer by a third party for their shares in the company, a drag-along right enables them to compel the rest of the shareholders to do so as well. The Term Sheet should provide that preferred shareholders can be part of such a majority as if they have converted their preferred shares.

Conversion of preferred

Holders of preferred shares can convert their shares into ordinary shares at any time. However, Term Sheets usually allow for automatic conversion of preferred shares when the company undergoes an IPO.

Dividend

In startup financing, preferred shares’ dividends are usually non-cumulative, which means they will only be paid if declared by the Board. Most investors do not expect dividends to be paid regularly as startups usually operate in tight cash flow environments when scaling their business. 

The terms covered above go towards structuring a piece of financing. It is important for founders to be aware of how such terms work for or against them when negotiating the Term Sheet with investors. Talk to us and let’s discuss how best to structure a financing deal and adopt a good negotiation strategy.