Termsheets: An Introduction to Venture Capital Deal Terms

Many young entrepreneurs trying to raise funding never dealt with venture capital deal terms before. Some of them might have received a business angel investment with some basic contractual work and negotiated valuation. But for many negotiating a term sheet with venture capital deal terms is a first-time experience. This article is meant to be a starting point to learn about venture capital deal terms and to explain the basic concepts of the most relevant terms you find in a termsheet.

Disclaimer: This is not a legal advice.

Getting Started

Generally, a term sheet is considered a non-binding document (except for some clauses, I will address that later) laying out the terms which should be agreed upon in the formal documentation later in the process. In other words, it is kind of a letter of intent that is not legally enforceable by either of the parties.

When you are starting to negotiate a term sheet, you soon realize that VC (venture capital) funds have different policies around their term sheets. Some of them issue a term sheet early in the process to test whether there is a common understanding or to have a foot in the door. Other do it extremely late in the process after having gone through all the internal processes including their investment committee. In any case, receiving a term sheet is a serious sign of interest. However, founders are well advised to not overstate commitment expressed through a term sheet.

Term sheets can vary significantly in length and depth. From two pages with high level terms to 15 pages pre-contractual style; I have seen everything in the last years. The more detailed the term sheet, the shorter the negotiation of the final contract and vice versa. IMHO, there should be sufficient details in the term sheet to prevent unpleasant surprises in the later stages.

Venture Capital Deal Terms you find in a Termsheet

A lot has already been written about the topic of venture capital deal terms, and this article is merely a first introduction for those of you not experienced in the matter. It shall provide a starting point and give an overview about what to expect from your discussions.

These are the key terms that most often are addressed in term sheets or latest in the final contractual documentation:

  1. Valuation and Share Price
  2. Milestones/Performance Clauses
  3. Roundsize
  4. Liquidation Preferences
  5. Anti-Dilution Protection/Down Round Protection
  6. Right of First Refusal
  7. Tag Along
  8. Drag Along
  9. Vesting
  10. Founder Lock-up
  11. ESOP/VSOP
  12. Guarantees
  13. Significant Transactions
  14. Board
  15. Duration
  16. Exclusivity
  17. Break Up Fees
  18. Due Diligence Cost
  19. Confidentiality

Below you will find a brief description, and the most relevant arguments and rationales around those key terms.

#1 Valuation and Share Price

For most of the founders it is THE most important term. It tells what your company is worth in the eyes of venture capital investors. Its normally expressed as a pre-money valuation ( = before the new money comes in). Based on the valuation and the number of outstanding shares you calculate the share price, the investor would be willing to pay to acquire shares in your company.

When talking about valuations it’s important not only to consider the existing share capital but also ESOP (employee stock ownership plan) programs and outstanding convertible loans that might be converted into shares in the current round. Investors usually communicated valuations on a fully diluted basis. That means they are (economically) not bearing the burden of dilution coming from these components. Here is a small example to make it clearer:

Valuation: 5 Mio. EUR (on a fully diluted basis)

Share capital: 25.000
ESOP-shares: 2.777
Total shares: 27.777

Share price (on a fully diluted basis) = 5.000.000 / 27.777 = 200 EUR
Share price (undiluted) = 5.000.000 / 25.000 = 180 EUR

Shares created from convertible loans would also play into this and would change the equation.

Pro-Tip: Always look at the share price, since it reflects whether or not the investor took ESOP or existing convertible loans into account (or should have done maybe).

#2 Milestones/Performance Clauses

Often you will find milestone payments in term sheets. Milestones are created as a measure of risk management. The investment amount is then paid out in tranches bound to certain achievements. Milestone can e.g. be defined with reference to financial KPIs (key performance indicators) or product development.

From my experience milestones often come into play when the parties are negotiating (too) high valuations or the maturity of the business is very early or technically risky. The most important question here is whether they are structured as an earn out or not?

Assume you get the funds paid out in two tranches, e.g. 50% after closing and 50% after reaching the defined milestone. The venture capital investor takes over the shares from the round at closing. If you don’t reach the milestone and the investor keeps all of the shares, he basically paid half the price (so half the valuation). Looking from an investor’s perspective this might be fair, since you couldn’t deliver what you promised. With a founder view, it might feel unfair. An alternative structure would require the investor to return 50% of his shares if he does not pay out the second tranche.

Pro-Tip: Don’t over pace with valuation and try to prevent milestones or at least create some room to manoeuvre within the milestone definition.

#3 Roundsize

As the name suggests this is a simple definition of how many funds you are going to raise in that round. Some venture capital investors might be willing to invest only if a certain total round size can be realized or if you could find someone else to put in the same amount of money. Many co-investors might ask for a bigger investor leading the round. Founder should bear in mind that roundsizes are not a random number, but are derived from an underlying business plan.

Pro-Tip: Its always easier to start with a smaller roundsize and make it bigger if there is interest from the market. Prevent starting with a (too) big round and go back to investors telling them, that you can also do the same with less money.

#4 Liquidation Preferences for Venture Capital Investors

Liquidation preferences limit the risk for venture capital investors to lose their money. In case the company is sold or winded up, they stand first in line to receive their invested money back before anyone else. On the other hand, it can be applied to secure a certain minimum return for investors even if the company is sold for a less than expected value. Liquidation preferencens are one of the most relevant venture capital deal terms. There are several forms of liquidation preferences. The most relevant forms arE:

1x, Non-participating
Investors get back at least one time their invested capital. If their percentage share of the exit proceeds is higher than their invested money than they will get the higher amount.

Example A:

Investors’ share in the company: 15%
Invested amount: 1.000.000 EUR
Exit Proceeds: 10.000.000 EUR
Investors’ return: 1.500.000 EUR

Example B:

Investors’ share in the company: 15%
Invested amount: 1.000.000 EUR
Exit Proceeds: 2.000.000 EUR
Investors’ return: 1.000.000 EUR

1x, Participating (double dip)
Investor gets back one-time his invested amount. The remaining proceeds will be distributed among all shareholders with the venture capital investor participating (hence the name) again, receiving his percentage share of the remaining proceeds.

Example:

Investors’ share in the company: 15%
Invested amount: 1.000.000 EUR
Exit Proceeds: 10.000.000 EUR
Investors’ return: 1.000.000 EUR plus 1.350.000 EUR (15% of 9.000.000 EUR) = 2.350.000 EUR

1x, Participating with Interest (triple dip)
Investor gets back one-time his invested amount plus a guaranteed interest in addition to that amount plus his percentage share of the remaining proceeds.

Example:

Investors’ share in the company: 15%
Invested amount: 1.000.000 EUR
Interest rate: 6%
Time between investment and exit: 5 years
Interest on investment: 300.000 EUR
Exit Proceeds: 10.000.000 EUR
Investors’ return: 1.000.000 EUR plus 300.000 EUR in interest plus 1.305.000 EUR (15% of 8.700.000 EUR) = 2.605.000 EUR

Depending on the risk of the case and the negotiation power there are several other forms of liquidation preferences. They range from multiples on the invested money (e.g. 3x) to sliding scales depending on the exit valuation (e.g. 3x until 150 Mio. EUR, 2x until 300 Mio. EUR etc.).

Pro-Tip: Try to keep the liquidation preference at 1x, non-participating as long as you can. Otherwise liquidation preferences pile up and founders stand last in line. Consider carefully whether you trade valuation for liquidation preference.

#5 Anti-Dilution Protection/Down Round Protection

The concept of anti-dilution protection is sometimes confusing for first time founders since it basically protects venture capital investors from a decrease in share price. The basic idea of anti-dilution protection is to issue additional shares to the investor in order to compensate for a decrease in share price. Let’s do a simple example to clarify the concept:

Share price in the 1st financing round: 100 EUR
Share price in the 2nd next financing round: 50 EUR
Investment of Investor A: 1.000.000 EUR
Shares of Investor A after the 1st round: 10.000 shares

Investor A invested in the current round and pays 100 EUR per share. The company does a next financing round and is now issuing shares for 50 EUR. Anti-Dilution Protection rules are made for compensating Investor A and to bring down the share price he paid towards (or down to) the current valuation.

The most common forms of Anti-Dilution Protection are the following:

  • Weighted average

Investor A would get additional shares (for free) to bring his share price down to the weighted average price of the financing rounds. The weight of each round is equivalent to its size in EUR. Assuming the above example with two identical roundsizes, this would lead to weighted average share price of 75 EUR. Consequently, Investor A would get so many additional shares that his average purchase price per share would become 75 EUR.

In the above example Investor A would get 3.333 additional shares.

  • Full Ratchet

The investor will get as many shares as he would have received at the lower share price. In other words, he will entirely be protected from the down round.

In the above example Investor A would get 10.000 additional shares and will hold 20.000 shares in total after the second round, since he is put as if he had invested at the lower share price.

There are some variations from these forms (especially of the weighted average form considering different weights of the rounds or including ESOP shares into the calculation), but I will leave that for a more detailed article in the future. The consequences of anti-dilution clauses for founder are easily underestimated since they can have a devastating effect diluting the non-protected shareholders and founders. Hence hitting founder motivation hard.

An absolute standard clause. In case one of the shareholders plans to sell his shares to a third party, the existing shareholders are granted the right to buy those shares before they go to a third party. The existing shareholders need to pay the same price as the third party would have paid.

#7 Tag Along

Also, a venture capital standard clause that grants shareholders the right to sell their shares at the same conditions as other shareholders do. In other words, if one or more shareholders want to sell their shares the other shareholders have the right to co-sell their shares at the same conditions. In some cases you find versions that are limiting the tag along right to certain groups of investors or other conditions that must be met in order to execute your tag along right (e.g. a threshold in the percentage of the company that is sold). Additionaly, sometimes investors demand the right to sell their shares first in case the purchasing third parties don’t want to buy all the shares investors are willing to sell.

#8 Drag Along

Almost all venture capital investors need to sell their shares at some point in time due to the duration of their funds and the need to generate exit proceeds. In addition, the shareholder structure of every venture is growing over time and consent between all parties is not easy to maintain over the years. A drag along clause is made to create a possibility to make an exit happen, even if not each and every shareholder is willing to sell. A typical drag along clause would foresee that all shareholders are obliged to sell their shares if e.g. a majority of 90% of the shareholders wants to do the deal. Drag along clauses are always two-sided and depending on your perspective it is a “being dragged” – thread or a “can drag” – opportunity.

When drafting drag along clauses one must consider the different interests of the parties having invested at different points in time and on different valuations. What might be very good exit for the founders is not necessarily a good exit for the latest investor coming in at a very high valuation. While the founders might make a fortune with the sale, the investor might only generate a negligible return. Most drag along clauses therefore require a combination of different majorities, e.g. majority of founders shares plus an investors majority.

#9 Vesting

Especially in early stages of venture capital financed business, the founders are the key resource of the company. They bring in their knowledge, their network, and are responsible for building a thriving business. Although investors try to be very close to their investments, they are not the ones managing the company on daily basis. Vesting clauses are made to bound the founders to the company and to take precautions in case a founder leaves the company or needs to be fired due to committing a crime. As a result, if a founder leaves the company, a certain portion of his shares goes back to the company and can be used to find someone new who can be incentivized by allocating these shares to this person.

Normal vesting clauses consist of a duration, a cliff, and a regime defining when someone is a good leaver or a bad leaver. They also define how many of the vested shares stay with the leaving founder, how many are going back to the company, and which price the unvested shares are returned to the company.

A pretty common constellation for an early stage company would be:

  • 100% of the founder shares are underlying the vesting scheme.
  • After a cliff of one year, 25% of the shares are vested, the rest vests linearly over 36 months.
  • In case of a bad leaver event all shares are returned to the company at their nominal value.
  • In case of a good leaver event the unvested shares are returned to the company at 50% of their market value.

Vesting clauses can be very complex and I will leave the details to a separate article.

#10 Founder Lock-up

This clause explicitly prevents the founders from selling his shares for a certain time (e.g. 2 years) with a permission by the shareholders. The motivation behind that is to make sure the founders are bound to the company.

#11 ESOP / VSOP

Termsheets normally define how existing Employee Stock Option Program (ESOP) is handeled or how they should be treated in the future. The main questions are always how big the program ist and who bears the economic burden of the program. Sizes of ESOP programs differ significantly depending on the maturity of the company. A size of 5% to 10% of the share capital are not unusual. Existing ESOP programs are normally born by the existing shareholders, however the new shareholders share in the cost of any extension of the program.

#12 Guarantees

Although venture capital investors try their best to check and diligence the target company, they still remain on the side-lines somehow. In addition, especially in early stage, companies’ investors (and founders) can’t afford extensive due diligence with external lawyers, which would cause high costs in relation to the investment sums. That is why investors ask founders to guarantee for a catalogue of issues regarding the company and the state of the business. First of all, this should ensure that founders disclose all critical issues. Secondly, it should protect the investor in case the founders break the guarantee.

Title guarantees are confirming that the guarantor is really the owner of the shares and can decide on those shares and can enter into relevant agreements. Business guarantees (the bigger part of the catalogue) covers all relevant aspects of the company’s business. Common guarantees include, e.g. the financial statements of the company, that the company holds all needed legal permissions to conduct its business, or that the company is owner of all the IP (intellectual property).

To which extent founders can be held liable is always a critical question. In case of a breach of warranty the founders can reimburse the investor in cash, or in shares, or a combination of the two.

#13 Significant Transactions

Taking in an investor, may it be a business angel or a venture capital funds, comes at a price. As founder you are not the only shareholder anymore. VCs normally make sure that significant transaction cannot be executed without their consent. Therefore, normally a catalogue of significant transaction is defined that requires the approval of the investors or at least a defined majority of the investors. Issues that need the consent of investors include both company level decisions (e.g. issuing new shares), as well as operational matters (e.g. hiring employees above a certain compensation level). It’s a judgement call how strict the catalogue has to be. It’s also very important to find a pragmatic way of how to make decisions and collect the investors’ votes. You don’t want to chase after each and every small investor for weeks.

#14 Advisory Board

Depending on the maturity of the company, the number of shareholders and the numbers of venture capital investors engaged in the round investors might demand the installation of an advisory board. It’s very important to distinguish between a consulting board and a board that has real decision-making power. Normally a board is set up to consult the company and help the founders to successfully develop the business. However, it’s also possible to give real decision-making power to the advisory board. In that case, some (or all) of the significant transactions would be moved to the advisory board. Whether or not the board that has real decision-making power is very relevant for defining the concrete numbers of board members, and who has the right to nominate board members.

In case of a merely consulting board structure its okay to have more investors or external persons building the advisory board. Board members should ideally be selected based on their experience in your industry, their networks, or other aspects in which they can help the founders grow their business.

In case the board has real decision-making power for a catalogue of significant transactions, the investors will be very strict and demand that they can nominate board members, since this will be the place where they have to represent their interest.

Pro-Tip: Try to start with a consulting board that can be formed with lots of industry experts who can help you make the right decision regarding product and business development. Forming a deciding board might be useful if you have a complex shareholder structure. In that case you could effectively limit the numbers of investors you have to ask permission regarding significant transactions.

#15 Duration

The time until the term sheet is valid. This is normally defined to be the time until the deal should be closed. If the term sheet expires, the parties are no more bound to the clause agreed upon in the term sheet.

#16 Exclusivity

Once an venture capital investor is willing to sign a term sheet as a soft commitment to complete the investment, he might ask for a period of exclusivity. This will ensure that the company is not doing the deal with someone else. Also, after signing a term sheet the investor normally starts his due diligence which is also causing additional costs for lawyers and technical experts. Therefore, the investor wants to be sure that he can close the deal.

#17 Break-up Fees

A penalty payment that has to be paid by the company in case it breaks the exclusivity clause. Usually, this secures that the investor gets compensated for the external costs he incurred.

#18 Due Diligence and Legal Cost

Many venture capital investors demand a reimbursement for the due diligence and legal cost they incurred during the process of making the deal. This normally refers to the external costs the investment company has to bear, which is then up to a certain amount deducted from the investment amount.

Example: The investor is allowed to deduct up to 20.000 EUR from the investment amount to cover his cost. Given a planned investment of 1.000.000 EUR, the company would only receive 980.000 EUR.

#19 Confidentiality

A standard clause that forces the parties to keep the content of the term sheet confidential.

Term sheet template

I have created a simple term sheet template. You can download it here.

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