In This Article
- Funding Rounds
- Pros / Cons of Fundraising
- Setting the Stage Between Investor and Entrepreneur
- Investor Key Objectives
- Entrepreneur Key Objectives
- Potential Sources of Conflict
- VC Term Sheet Example
- Breaking Down Key Sections of the VC Term Sheet
- 1) Offering Terms
- 2) Charter
- 3) Stock Purchase Agreement (“SPA”)
- 4) Investor Rights
- 5) Right of First Refusal / Co-Sale Agreement
- 6) Voting Agreement
- 7) Other
The VC Term Sheet establishes the specific conditions and agreements of venture investments between an early-stage company and venture firm. The term sheet is short, usually less than 10 pages, and is prepared by the investor.
The VC term sheet is a non-binding legal document that forms the basis of more enduring and legally binding documents, such as the Stock Purchase Agreement and Voting Agreement.
Although short-lived, the VC term sheet’s main purpose is to lay out the initial specifics of a VC investment such as the valuation, dollar amount raised, class of shares, investor rights and investor protection clauses.
The VC term sheet will then flow into the VC capitalization table, which is essentially a numerical representation of the preferred investor ownership specified in the term sheet.
A VC term sheet is created at each investment round, which is usually designated by a letter:
|Seed-Stage||Angel Round or “Family & Friends” Round|
|Early-Stage||Series A, B|
|Expansion Stage||Series B, C|
|Late-Stage||Series C, D, etc.|
Historically, deal counts tend to favor earlier stage investments as shown below. In the last few years, however, there has been a noticeable move towards deals of larger magnitude.
Deal Count by Size (Source: PitchBook)
As you would expect, the average deal sizes are significantly larger for later-stage investments, but early-VC investments have been trending up across the board.
Median Valuations by Stage (Source: PitchBook)
Pros / Cons of Fundraising
From the perspective of an entrepreneur and existing investors, there are several advantages and disadvantages of raising outside capital.
We have listed some of the most important considerations in the table below.
Increased valuation if the company performs well, more capital to implement new expansion plans, access to experienced value-add partners
|Time-consuming process to raise funds (i.e. takes time away from managing the business)|
Control mechanisms (go or no-go decision) with options to double down or hedge risk, validation of the firm’s investment thesis
Potential for ownership dilution, less voting power
Venture Capital Timeline
While time to investment can vary from a few weeks to a few years, the venture capital timeline for an early-stage company has six discrete steps:
1) Start-up Formation: formulation of the idea, core team hiring, intellectual property filings, MVP
2) Investor Pitch: “roadshow” marketing of start-up, feedback on the idea, the start of diligence
3) Investor Decision: the continuation of due-diligence, final investor pitch, venture partner decision
4) Term Sheet Negotiation: deal terms, valuation, cap table modeling
5) Documentation: complete due-diligence, legal documentation, government filings
6) Sign, Close and Fund: fund, budget and build
Setting the Stage Between Investor and Entrepreneur
The investor and entrepreneur have different objectives that will play out in any term sheet negotiation.
Investor Key Objectives
- Maximize the financial return of each investment while mitigating risk
- Govern the portfolio company’s financial and strategic decisions (i.e. have a seat at the table)
- Provide additional capital if the investment is progressing well
- Obtain liquidity through eventual sale or IPO
- Return a high rate of return on their fund and leverage success to raise an additional fund
Entrepreneur Key Objectives
- Prove the validity of the business idea
- Raise funds to operate the business with more flexibility
- Maintain majority control of the company while sharing some risk with financial backers
- Establish operational success for the company
- Lead to the next stage or repeat the start-up process with a new venture
Potential Sources of Conflict
As a result, the potential sources of conflict, which will be negotiated in a term sheet, include:
- Valuation: What is the worth of the business today?
- Definition of Success: What does success look like in the future?
- Control Rights: Who has control of the company’s future?
- Time to Achieve an Outcome: How long will it take to monetize their VC investment (i.e. IPO, M&A)?
- Share of Returns: How will proceeds be split between the investor(s) and the management?
VC Term Sheet Example
So what does a VC Term Sheet actually look like?
In this section, we are going to break down the 7 common sections of a VC Term Sheet. Before we do though, it’s helpful to actually see what a few actually look like:
Sample term sheet template
While a term sheet should always be created and negotiated by legal counsel, a free representative term sheet is available through the National Venture Capital Association (NVCA) and can be found here: https://nvca.org/model-legal-documents/
To see another example of a standard term sheet, Y Combinator (YC) has a Series A Term Sheet Template posted on their website for free. This term sheet is widely circulated within the VC industry for first-time founders and those interested in learning about VC investing.
Disclaimer: Wall Street Prep has no affiliation with Y Combinator or the NVCA.
Breaking Down Key Sections of the VC Term Sheet
We’re now ready to analyze the key sections of the typical VC Term Sheet.
1) Offering Terms
The offering terms section includes the closing date, investor names, amount raised, the price per share and pre-money valuation.
Pre-Money vs. Post-Money Valuation
Pre-money valuation simply refers the value of the company before the financing round.
On the other hand, the post-money valuation will account for the new investment(s) after the financing round. The post-money valuation will be calculated as the pre-money valuation plus the newly raised financing amount.
Following an investment, the VC ownership stake is expressed as a percentage of the post-money valuation. But the investment can also be expressed as a percentage of the pre-money valuation. For example, if a company is valued at $19 million pre-money and an $8 million investment is being contemplated, the post money valuation would be $27 million and this would be referred to as an “8 on 19.”
Valuation is perhaps the most important element negotiated in a term sheet. While key valuation methodologies like Discounted Cash Flow (DCF) and Comparable Company Analysis are often used, they also have limitations for start-ups, namely because of the lack of positive cash flows or good comparable companies.
As a result, most VCs employ the VC Method of valuation. If you are not familiar with the VC Method for valuation , read our article ‘6 Steps to VC Valuation’ to understand how valuation is determined in the VC context.
The offering terms section establishes a new class of Preferred Investor (generally named after the round like Series A Preferred, with certain rights (e.g. dividends, investment protection & liquidation rights) that supersede those of common shareholders.
The charter shows the dividend policy, liquidation preference, protective provisions, and pay to play provisions
- Dividend Policy: clarifies the amount, timing and cumulative nature of dividends
- Liquidation Preference: represents the amount the company must pay at exit (after secured debt, trade creditors, and other company obligations). The liquidation preference is perhaps one of the most important clauses found in a term sheet. While most entrepreneurs focus on the valuation, the VC focuses on the structure of the liquidation preference. Read about how Liquidation Preferences work here.
- Anti-Dilution Protection: protection for VCs in case of a down round, so that their conversion ratio to common stays equal to new investors
- Pay to Play Provision: preferred shareholders lose anti-dilution protection unless they invest in the next round at a lower price (“down round”); normally preferred will automatically convert to common in such a case
3) Stock Purchase Agreement (“SPA”)
The SPA includes initial clauses on reps & warranties, foreign investment regulatory stipulations and legal counsel designation for the eventual Stock Purchase Agreement.
4) Investor Rights
The investor rights section highlights registration rights, lock-up provision, information rights, right to participate in future rounds, and employee stock option specifics
- Registration Rights: right to register shares with SEC so that investor can sell on the public market
- Lock-up Provision: establishes the timing limitations for sale in case of an IPO
- Information Rights: right for preferred shareholders to get a copy of quarterly and annual financials
- Right to Participate: existing investors have the right to buy shares offered in subsequent financing rounds
- Employee Option Pool: the percentage of stock reserved for key employees (existing and new hires) and timing of vesting of the options
5) Right of First Refusal / Co-Sale Agreement
The right of first refusal (ROFR) provision gives the company and/or the investor the option to purchase shares being sold by any shareholder before any other 3rd party.
A co-sale agreement provides a group of shareholders the right to sell their shares when another group does so (and under the same conditions).
6) Voting Agreement
Establishes the future Voting Agreement, with callouts of Board composition and drag-along rights
- Composition of Board of Directors: usually a mix of founders, VCs, and outside advisors (~4-6 people on average)
- Drag Along Rights: all shareholders must sell if the board and/or majority shareholders approve
Other terms could include a no shop/confidentiality clause, the term sheet’s expiration date, and a copy of the pro-forma cap table.
This brings our article on the VC term sheet to an end. We hope that you found our introductory guide to how VC professionals determine the investment size and ownership stake of their investments helpful.
For a deeper diver into term sheets, enroll in our course on Demystifying Term Sheets and Cap Tables, where we explore the respective negotiating positions of VCs and entrepreneurs as well as dive into the more sophisticated math associated with the world of venture-backed start-ups.