In startup world, a “term sheet” is the name for a short document that summarizes the terms that founders and their investors agree upon when completing a round of financing. Whether using a SAFE, convertible note or priced round term sheet as the investment vehicle, the accompanying legal jargon can be an intimidating part of any founder’s raise.
To help demystify the process, I asked three startup attorneys, Layla Lumpkin at Thompson Hine, Brian Crump at Neal, Gerber & Eisenberg, and Paige Bolinger at Croke Fairchild, for their advice on what to look for, best practices, and mistakes to avoid as you go through the process:
What are the most important sections of a term sheet that founders should understand, and why?
Walking through a term sheet with your lawyer is the best way you’ll learn certain terms’ implications for you and your company. The three main questions I ask are:
- What does this mean in terms of company control?
- What does this mean for me and my employees’ ownership?
- How might these terms affect future fundraises?
Bolinger adds, “Other than verifying that the valuation reflects the agreed upon economic agreement between investors and the company, be sure to review the protective provisions section is really important. Oftentimes, investors will negotiate rights that confer certain classes of capital stock or a certain series of preferred stock voting rights over certain major decisions of the company. Make sure that you as a founder are giving up control that is commensurate with the stage of your company, the size of the check from the investor (a bigger check usually justifies greater control), and that you are giving these rights to investors that want to be true decision makers with you rather than just capital providers is really important, especially early on. This also extends to Board oversight and Board dynamics.”
What are the sections of a term sheet that are most often negotiated, and why?
My experience is that the most negotiated sections of term sheets fall into the economics and control buckets (unsurprisingly, people seem to care most about what they get paid and how much power they have) - Layla Lumpkin
Lumpkin finds it helpful to organize the concepts she covers in venture capital-style financing investment agreements into five buckets for founders: economics, control, monitoring, maintaining and increasing ownership, and liquidity.
“My experience is that the most negotiated sections of term sheets fall into the economics and control buckets (unsurprisingly, people seem to care most about what they get paid and how much power they have),” she says.
Having a standardized document framework and predetermined agreement contents leads to greater efficiency (and, therefore, lower legal spend). - Brian Crump
Crump adds, “The venture world has become very standardized when drafting financing documents across the pre-seed, seed, and Series A+ levels. Having a standardized document framework and predetermined agreement contents leads to greater efficiency (and, therefore, lower legal spend). Rather than spending time negotiating the framework itself, parties decide which framework to use upfront and focus on negotiating within it. With this background, ‘the framework’ is the most important phrase to understand when preparing a term sheet. For example, suppose the term sheet is for Series A financing. In that case, it may reference the National Venture Capital Association (NVCA) documents will be used for the transaction, which is the industry standard for Series A and beyond. If the term sheet is for SAFE financing, it may indicate that the form of SAFE will be based on the standard Y-Combinator form. While often a single sentence in a term sheet, this indicator sets the framework for the entire financing transaction and should not be overlooked.”
They agree that there are key sections to look out for around economics and control, specifically, in determining what to negotiate:
- Valuation/Valuation Cap/Discount – “In a preferred equity round, we are talking pre-money and/or post-money valuation. Companies and investors may start in different places and meet somewhere in between (not necessarily the middle). In pre-seed/seed convertible rounds (e.g., SAFEs or convertible notes) we are talking about the discount and valuation cap. Discounts are most commonly 20%, and valuation caps vary based on the percentage of the company the investor expects to own relative to the founders and employees before the new money comes in. All of these concepts are subject to negotiation and depend on bargaining power,” says Lumpkin.
Crump recommends founders pay extra attention to conversion terms on a SAFE– valuation cap, discount, and if the financing will be on a pre- vs. post-money SAFE basis. “Note that most aspects of pre-and post-money SAFEs are similar, but the conversion calculations vary significantly. When compared, the resulting conversions can materially impact a company's cap table, so it is vital to understand the difference. With equity financing (Seed, Series A, etc.), the economic negotiations focus primarily on the pre-money valuation. The pre-money valuation determines the price per share paid by investors. It is often tied to the price at which any outstanding SAFEs and other convertible securities will also convert. Hence, the value at which a company raises financing will significantly impact the cap table and should be well understood before agreeing to any valuation,” he says. - Vesting/Revesting – “Investors will often want to ensure that the founders are going to stick around post-investment,” Lumpkin shares. “One mechanism used is the concept that you earn your equity over time (i.e., vesting). So, if the founders are not already on a vesting schedule, investors will ask the founders to adopt vesting (or to vest for longer than their remaining vesting = revesting). Sometimes founders don’t feel like the vesting proposal from the investor accounts for time already invested and will negotiate for more equity to be vested (e.g. 50% equity be vested based on having a few years in the business versus starting from zero vested at the time of the new investment).”
- Option Pool Size – “Thoughtful founders may ask that the option pool (equity reserved for employees) be adjusted if they do not expect to grant equity in the amount reserved anytime soon or if they need more room if they have already promised equity,” Lumpkin says.
- Board Composition – “Investors will often ask for a board seat in preferred equity rounds (typically just one seat designated by the lead investor per equity financing round). There may be negotiation about the number of board members, who gets to appoint those members and whether other parties must consent to those members. In early rounds, the common stock (i.e., founders) can typically expect to have control of the board. That dynamic may shift in later rounds as there are more investors and as the company grows and becomes more complex,” Lumpkin explains.
- Protective Provisions – She continues, “This (sometimes) long list of actions requires the company to obtain stockholder consent before taking them. Usually, there are major decisions like selling the company or hiring/firing executive-level employees. Companies will sometimes push back on some of these actions that are less major or may be thoughtful about the percentage of stockholders that are needed for consent.”
“Typical control mechanics include an investor-elected board seat, preferred stockholder protective provisions, and preferred director approval rights,” Crump adds. “Each of these has a different application, and each is built into the NVCA form documents, so usually, negotiation comes down to (i) whether an investor will get a board seat, and (ii) which company actions will require the approval of investors (or the investor director, if applicable). These lists can include any number of actions - some of which are very typical and included in almost all deals and some that give investors a level of control that is out of market and can place a heavy burden on the operation of the company. - Lastly, when negotiating these points, it is essential to understand who controls these rights. Suppose certain actions require a majority of outstanding preferred stock to approve, but a majority of preferred stock is concentrated and held by one investor or a small subset of investors. In that case, a company could be putting a large degree of control in the hands of a relatively small group of investors so it is important to be cognizant of the dynamic among your investor group.”
What are some best practices or common pitfalls that founders make?
Engaging a competent lawyer that will partner with you from the beginning is key. - Paige Bolinger
“One of the biggest mistakes that founders make is handling legal work on their own rather than investing in legal counsel from the beginning of the company’s formation. Oftentimes when I am engaged to represent a company, founders have been handling legal documents and corporate governance incorrectly and/or insufficiently and my function involves “cleaning up” the documentation to adhere to corporate formalities and Delaware law (or the law of the jurisdiction the company is formed in). Frequently, document clean-ups occur in connection with a material event like a priced round. The resulting legal work can be costly and time-consuming because the company is under pressure to complete the transaction at a certain date. Engaging a competent lawyer who will partner with you from the beginning is key.
Similarly, another common pitfall is a poorly maintained capitalization table, especially if a company has raised capital on various types of convertible securities (convertible notes, SAFEs, warrants) that convert at different conversion prices and under different conditions and those dynamics are not properly tracked. You don’t want to be the founder who finds out that they have less equity than they thought that they did, or who delivers an incorrect capitalization table to investors. Tracking the capitalization of your company early and often is essential. Finally, another pitfall that founders make that can have big consequences down the line is promising and/or granting options and stock to employees or consultants in an incomplete manner and/or not completing a 409a valuation at the right time, or at all. Being thorough at the outset when granting options can save you a lot of money on legal costs and shows your investors that you are organized and diligent,” Bolinger shares.
“Another common pitfall that I see is regarding the organization of a formal board of directors. The state of Delaware (where most venture-backed companies are incorporated) requires that a corporation appoint at least one director, but typically it is best practice to appoint a minimum of three directors, one of whom would serve as an independent and/or disinterested director. It is important to appoint individuals that can help make decisions relating to conflicts between founders, related party transactions, and serve as a non-founder influence on the major decisions of the company. To that end, however, it is also critical that founders understand that directors and officers of a corporation owe fiduciary duties to the corporation and are required by law to act in the best interest of the corporation and its shareholders. A competent lawyer can help you understand the universe of consequences, benefits, and disadvantages regarding certain board decisions and dynamics.” she adds.
Final Advice for Founders as They Fundraise
“Simply put, you should have an attorney on your side that understands the venture world,” advises Crump. “Term sheets, cap tables, and financing documents contain countless potential pitfalls, and any mistakes made along the way can compound later. It takes time and practice to develop the experience necessary to navigate financing and understand the implications of different terms and provisions. Having a trusted advisor on your side will save you countless hours attempting to understand it independently and avoid the trap of "not knowing what you don't know." An attorney's role is not to impede a transaction or dictate what you cannot do, but to ensure you understand what you agree to before signing.”
In addition, “Focus on finding the right investor partner that can bring more to the table than just capital,” says Bolinger. “For example, some of the questions to ask yourself: Does this investor have a network that you can tap into to help drive strategic commercial relationships that are important for your business to scale? Have any of their principals served on the Board of Directors of a company before and are they willing to participate at the Board level (in a voting or non-voting capacity)? Can they bring a syndicate of trusted investors to the table to invest in your company as well? In these current economic conditions where capital is scarce your impulse might be to take what you can get but be as discerning as possible under the current circumstances.”
Thank you to Brian, Layla, and Paige for their perspectives, and founders, if you want to learn more, you can reach out at:
- Brian Crump: bcrump@nge.com
- Layla Lumpkin: Layla.Lumpkin@thompsonhine.com
- Paige Bolinger: pbolinger@crokefairchild.com