Financial Considerations on Term Sheets – Part I

Tuesday 20th September, 2022

The term sheet is, in many ways, the most important document in a fundraising: it sets out the key terms on which investors are willing to invest in a company and details the process from the start to getting cash into the bank.

There are two key areas of focus in a fundraising term sheet:

  1. The financial side (including what your valuation will be).
  2. The governance side, or how the company is going to be run and who has the right to influence decisions.

Understanding term sheets enables founders to negotiate and protect themselves, and set the company up in the best possible way to achieve success following its fundraising. It also helps to know what you are getting into; remember that issuing term sheets is an investor’s day job, and they will, therefore, almost invariably have a better understanding of the terms being offered. It’s important to level the playing field by getting independent advice on the terms and what they mean for the company.

First-time founders are often very reluctant to negotiate anything on the term sheet they’ve received (which can itself be concerning for investors as it points to a lack of rigour and/or understanding). In the current economic climate, founders, more than ever, need to make sure all the terms they need are in the term sheet. Unlike the last couple of years when competition led to very founder-friendly processes, investors are now less likely to be willing to deviate from the term sheet and so founders need to be comfortable with what they have signed up to.

Term sheets are saturated with legal jargon. Below, we look at some of the financial terms that are likely to arise on your term sheet.

1. Valuation

A term sheet or heads of terms for an investment will typically set out the financial basis upon which the investment is being made in the form of the pre-money valuation of the company (the value of the company before any new cash is invested based on the financial condition of the company and forecasts) and the post-money valuation (the pre-money valuation plus the new money received as investment).

Make sure you understand what the valuation means for your shareholding in the company, which shareholders will have influence, control and blocking rights, and what the economics look like on an exit if no further capital is injected. You should agree a pro forma cap table with the investor prior to signing the term sheet.

Also look at what is happening with any option pool being created or topped up. Investors will most commonly expect the new options to be included in the pre-money valuation, so not diluting their shareholding. This is a means of negotiating the valuation through the back-door. Only founders in very strong negotiating positions will be able to move away from this.

2. Liquidation preference

This determines the pay-out process when a company is acquired, merges or is wound-up. The preferred shareholder will receive the first bite of the apple when it comes to dividing the proceeds.

It is industry standard for VCs to ask for a liquidation preference, and the most common type is a 1x non-participating liquidation preference. This gives the investor downside protection only, so that if there is an exit where they would get less money than they invested if the proceeds were distributed proportionately among shareholders, they instead get their money back (and everyone else’s share is reduced accordingly). In all other circumstances, they share the proceeds according to their percentage holding.

Watch out for multiple liquidation preferences, where investors have to get, say, 2x their money back before other shareholders can share in the proceeds. Potentially worse for founders is a participating preference, which means that the investors always get their money back, and then share in any remaining proceeds proportionate to their shareholding.

3. Anti-dilution rights

Anti-dilution rights enable an investor to limit a potential decrease in the value of its investment in the event its investee company later raises funds at a lower valuation than the valuation the investor originally based its investment on (a “down round”).

These rights are typically included in the company’s articles of association and usually give the investor the right to be issued additional shares to compensate them for the reduction in the value of their shareholding.

These are industry standard for VCs, and any trend away from them is likely to be slowed by the current economic conditions. Make sure to avoid “full ratchet” provisions which are particularly dilutive to founders; broad based weighted rights are commonly accepted as the fairest standard.

4. Vesting

Employee share options and shares held by founders typically vest over a period of time, i.e., they can only be converted into shares or considered to be held after this period – the employee or founder in question effectively needs to “earn” their shares. The rationale here is that the individual has received the shares for free and, in the case of the founders, if they leave the business that potentially significantly impacts the value of the company which the investors have invested in and so they want to tie them in for a period.

The main purpose of vesting is to incentivise key employees to stay with the company. The most common vesting schedule is 48 months with a one-year cliff (i.e. nothing vests in the first year but after that the employee gets ¼ of their shares and the remaining shares continue to vest on a monthly basis for the next 3 years).
Founders should carefully review these provisions to ensure they understand the impact on their shareholding, and whether there are any “bad leaver” scenarios where they could lose all of their shares.

5. Warranties

A key issue that arises during the term sheet stage is whether the founders will also be giving warranties (statements about the current condition of the company, on which the investors rely when investing) personally. The company always gives warranties, and whether the founder also gives them is case-specific. This is more likely to arise if a founder is to receive liquidity or if there are intellectual property concerns. They are also more common in early funding rounds, where the founder bears greater risk than in later rounds.

In the US, personal founder warranties are much less common, and we have seen a gradual trend away from founder warranties in the UK as more US money here influences terms. It remains to be seen if current economic conditions lead to a shift back.

Summary

Remember: if an investor has decided to issue a term sheet, they are very unlikely to walk away because a founder tries to negotiate the terms, so it is always worth a try and, with the right advisors, can be dealt with quickly. Besides, you want to have an investor that you can openly discuss things with; the fundraising process sets the tone for the start of a long relationship.

For a further discussion about how we can help with your term sheets, please contact David Strong or Fran Spooner.

Articles by David Strong