Startups: The Ultimate Guide to Term Sheets - Part 3

The importance of a term sheet cannot be underestimated. Any founder who is being offered funding from a professional investor or venture capital firm will find a term sheet attached.

While the thought of receiving those much-needed funds will naturally excite you, it is imperative that before final acceptance you understand exactly what the terms involved are and what you are agreeing to.

Because of this, WOWS Global is putting down a 4-part series on exactly what term sheets are and why they are so important.

In part 3 we will continue with descriptions of common terms and clauses that founders will very likely come across in any term sheet offered.

Key Terms and Clauses of a Term Sheet - Continued

Following on from the terms explained in Part 2, here is a continuation of common key terms and clauses.

Starting with…

Investor Rights and Protections

As the term suggests, investor rights and protections relate to clauses that are designed to protect an investor’s investments. Common ones include:

Anti-Dilution Rights

These rights protect preferred investors' rights in the event of a “down round” aka when a lower valuation is given than what they have invested in. This means that if a company’s valuation decreases from different financing rounds, holders of preferred shares are protected by being given additional shares.

Founders must understand the potentially devastating damage this can cause them.

To explain further, there are 2 types of adjustments that founders need to be on the lookout for:

Full ratchet

It should be said that this is a rare adjustment type but one that founders need to be very wary of. A full ratchet adjustment brings down the conversion price to the lowest issued stock price after the issuance of the investor’s preferred stock and is regardless of the number of shares.

A full ratchet adjustment clause should be seen as being very disadvantageous to founders as well as other common stockholders. This is because if it is enforced then their share of stock is further diluted.

Another issue comes with the fact that if a full ratchet provision is in place it will make it difficult for the company to attract new rounds of investment in case the global investment climate is not conducive.

Weighted average

When this clause is fairly established it is more favorable to founders than a full ratchet clause. A weighted average clause takes into account two factors. The lower price and the actual number of shares issued in the down round. This is done using one of two weighted average formulas:

• Broad-based: This takes into account fully diluted capital stock and includes all issued stock as well as all unissued stock (an example of the latter is stock options).
• Narrow-based: This takes into account only outstanding capital stock.

When considering these two types of weighted average options a broad-based approach is typically the one founders should go for. This is because it is based on a smaller percentage of a larger amount.

Pro-Rata Rights

This clause gives investors the option to participate in any future funding rounds. It can be used to ensure that they keep their current percentage ownership in the company which would otherwise be diluted if they did not participate.

Founders should view pro-rata rights as a) essential in early-stage funding rounds and b) as mostly positive factors when included in a term sheet.

It is also the case that pro-rata rights are generally given to larger investors in funding rounds. These rights are not always enforced because it depends on the type of investor and their strategy. It may well be the case that they choose to take up their pro-rata rights during later funding rounds.

ROFR - Right of First Refusal - and Approval of Sale

If a right of first refusal clause is included in a term sheet there is a requirement for all current shareholders to be notified. They then have the right to purchase stock from the investor who is selling.

Combine this with an approval of sale clause and any secretive transfers of stock are prevented. An example here is by stopping a current investor from selling your stock to a competitor.

No-Shop Clause

If you agree to a no-shop agreement this is generally part of the final term sheet and comes into play once a lead investor has been chosen. Founders need to be aware that part of the process during negotiations of the final term sheet with the lead investor is to reach an agreement that commits to getting the deal done.

With regard to timescales, founders should consider binding the no-shop clause to a set period. This could be 30-60 days. By doing so, you are making the commitment mutual.

This mutual agreement is made with the understanding that the founder agrees not to shop the deal around to other investors while the VC investor agrees to complete things within a reasonable period of time (as per the above-mentioned timescale).

Governance Management and Control

Another very important feature of a term sheet. Governance management and control set rules relating to who is in control of the company. It also defines such actions as voting-, board-, and information rights as well as founder vesting.

Let’s look at these factors in greater detail:

Voting Rights

This relates to a shareholder’s right to vote on company policy. Founders will find this clause makes a clear division on voting rights across various instruments. For example; A, B, and Preferred. It also sets out which corporate actions need a majority vote.

Depending on how the majority vote, it gives the instrument holder the ability to block certain actions. Examples being:

• Liquidation of the company.
• Dividend payouts.
• Any revisions to the number of board members.
• Annual spending budgets.
• Any amendments to the charter or bylaws.

Protective Rights

Protective rights are provisions designed to protect investors. They give them the right to veto or block certain actions. This includes those actions that have been Board of Directors authorized.

What this means is that a percentage consent of preferred stockholders is needed before moving forward. The aim of protective rights provisions is to help protect minority shareholder interests should they disagree with the majority stockholders regarding courses of action they want to take for the company.

Standard Protective Provisions

As the term suggests, these provisions are seen as standard. They can cover a wide variety of actions including:

• A sale of the company.
• A similar liquidation event.
• Amendments to the company’s COI (Certificate Of Incorporation) or bylaws in order to change preferred stock rights.
• Increases / Decreases in shares of preferred or common stock.
• Issuance of any equity security that has preference over preferred stock.
• Redeeming and/or purchasing preferred or common stock.
• Dividend payment from shares of any stock.
• Any revision in the number of company directors.

Non-standard Protective Provisions

In some cases, investors will request for additional items to be included in a term sheet. These will be over and above the standard provisions. While not limited to, here are 5 examples of these non-standard protective provisions:

• Acquiring more than $100,000 of debt.
• The hiring and firing or the authority to change the compensation of executive officers.
• Entering into a transaction with a company director, executive, or employee.
• Authority to change the principal business model.
• Make purchases of other entities' assets.

As a founder, if you have sufficient leverage it is recommended that any included non-standard protective provisions be carefully negotiated. The reason for stating this is that it will reduce or take out all (or the majority) of any non-standard provisions.

Board Rights and Information Rights

Both of these ‘rights’ are very important for founders to understand. With that in mind, let’s look at each in turn:

Board Rights

As should be understood, the Board of Directors is made up of a group of selected people. Their collective role is to represent the interests of shareholders in the company. It is also generally accepted that the board will establish a framework of corporate management policies and enact major decisions.

It is also crucial for all founders to understand that the agreed company bylaws set the board structure and the number/regularity of board meetings. It is the case that some investors may try adjusting this to allow them more control over the board. If that is the case, founders need to be aware of this risk.

Information Rights

Information rights included in a term sheet clearly state that founders agree to share the company’s financial status on a regular basis with investors.

It is most usually the case that quarterly management reports and a detailed annual financials report are required post-fiscal year-end.

Founders Vesting

With founder share vesting, founders will find it difficult to abandon a company because doing so will be placing shares at risk. If those shares are returned that allows the company to secure a suitable replacement.

What this means is that founders need to negotiate a vesting program that will work in their interest. One such way to achieve this is by excluding a portion of their holding from the agreement.

Exits and Liquidity

When considering the terms that govern exits and liquidity these set out what will happen should there be a company sale and what the shareholder rights are during this process.

Two important terms for founders to look out for are:

Drag-along and Tag-along rights

Here’s what these two terms mean:

Drag-along rights

When a company sale takes place, drag-along rights are used to stop minority shareholders from blocking the sale if it has been approved by either the majority shareholders or by a collective majority,

Drag-along rights can also benefit minority shareholders because it ensures that all parties involved are offered the same deal.

Tag-along rights

These rights give further protection to minority shareholders because they offer them the right to join in any majority shareholder action. Because of their standing, majority shareholders will often find more favorable deals, ones that minority shareholders would not be offered if this provision was not in place.

Redemption rights

Founders need to look closely at the redemption clause in a term sheet. This is because of the potentially negative impact it can give through its capability of creating a liquidity crisis for the startup. If this clause is put into force by investors, they can demand redemption of stock in a stated amount of time.

What that means is company management might be forced into making a quick sale of the company to redeem the required funds or appeal to shareholders for them to provide the necessary funding in a hastily arranged financing round.

The way such action is resolved comes by the company paying the redeeming party the greater amount of FMV (Fair Market Value) as well as the original purchase price plus stated interest.

Reach out for Essential Assistance

The above Part-3 of our 4-part article series on the Ultimate Guide to Term Sheets from the highly experienced team at WOWS Global contains a lot of important points. They relate to essential terms and clauses that will be included in your term sheet(s). Ones that founders cannot ignore.

Part 4 will complete this comprehensive guide to term sheets for founders. It will include details of how to be a smart term sheets negotiator, what terms are the most important to negotiate on, what should be seen as term sheet red flags to avoid, and some final considerations:

While being offered term sheets is a major step in the right direction, founders then need to make the right decision before committing.

This is where WOWS Global can be of huge assistance. Our professional management team is well-versed in all aspects of the startup world. When it comes to seeking and securing funding as well as reviewing term sheets offered we are a step ahead.

Access to our secure online digital ecosystem will ensure that you have everything at your fingertips. Just as importantly, the personal advice and guidance we can offer founders will give you that extra advantage.

Our goal is to see your startup prosper in a way that is right for you as a founder and one that is right for your venture.

Any founder who would like to understand what WOWS can offer should reach out to us for an initial no-obligation discussion at:

support@wowsglobal.com