United States: What's in a VC Term Sheet?

You've just received your first venture capital term sheet. Congratulations—you've earned it. Now what does it all mean? "Pre-money valuation," "liquidation preference," "pro-rata participation rights"? A seasoned venture capitalist (in this post, a VC or investor) has seen and invoked these concepts hundreds, if not thousands, of times. You? Maybe not so much. But this post can help: it aims to prepare you for a few of the most important terms you'll encounter in almost every term sheet. 

Purpose

The first step in understanding any term sheet is understanding its purpose. And, although term sheets can take many forms—from summarizing the principal terms of a proposed merger to setting out a joint venture's product development timeline—good term sheets are meant to accomplish a few simple objectives, namely to:

  • Focus Negotiations, Provide High Level Agreement/Understanding and Increase Deal Certainty. A term sheet focuses the parties by putting the framework for a transaction and its most essential terms on paper. This allows the parties to identify key issues on which there is (and isn't yet) agreement and determine if a deal is more likely than not to happen. If the parties think a deal will happen, they'll be more amenable to taking the next step and committing additional time and effort to the transaction.

When reviewing and negotiating a term sheet, it's important to keep these objectives in mind. For instance, a term sheet should not set out every detail regarding the company's relationship with its investors. There will be definitive agreements for that. At the term sheet stage, you and your investors should be able to understand the key terms and conditions of the investment. If you are all on the same page, then go forward together. If not, move on.

Down to Brass Terms

So what should be included in the term sheet and not deferred to the definitive documentation?

For one, the company's valuation, which sets a baseline for future financings and, together with the amount of the VCs' investment, determines how much of the company you and your co-founders will continue to own. When evaluating offers, it's important to remember that a higher valuation doesn't always equate with a better offer. Though a full explanation as to why is beyond the scope of this post, an inflated valuation can, for instance, lead to a later down round if results fail to meet expectations. Many unicorns, as Bill Gurley cautions, have faced, and others may soon face, this reality. Moreover, in some cases, valuations that appear higher on paper may contain terms—like a larger liquidation preference or pre-money option pool—with dilutive effects that may not be so readily apparent.

Valuation will probably be the point most important to you and to the investors, but what else will the investors care about?

Investors generally focus on three additional things in a financing (and therefore in the financing term sheet): 1) an ability (beyond their current stock ownership) to share in the company's upside potential, 2) protection against downside risks, and 3) information about and influence over the company's present and future. We highlight some examples of each below.

  • Upside Potential. If things are going well and your company contemplates raising more money to grow its business, a VC who has already invested time and money into the company will likely want the ability to share in this growth. This is where "pro-rata" participation rights in a term sheet come in. These rights allow the investor to purchase the same portion of a future financing round as the investor currently owns of the company and thus maintain his or her ownership percentage.
  • Downside Protection. What if things don't go well and the company contemplates selling itself at a valuation below that of its latest financing? In this case, a VC wants the right to say something to the effect of "at sale, give me the greater of my initial investment or my ownership of the company." The term sheet provision granting this right is an investor's "liquidation preference"—in this example, a 1x non-participating preference. We have covered various types of liquidation preference and why they matter in a previous post.
  • Information and Influence. Finally, an investor wants information—on the company's operations, results and outlook—as well as some ability to influence each of these. In other words, an investor will generally want the right to have a representative on the company's board of directors. The representative will have voting rights on, and in some cases veto rights over, major decisions such as whether to sell the company. Although you may initially recoil at this loss of control, experienced investors bring a number of skills that the company and the company's board of directors may lack. In a another previous blog post, WilmerHale Partner Josh Fox describes building a capable board of directors.

Binding Obligations

At this point, you may be asking yourself whether any of the terms in the term sheet create binding legal obligations on your company. After all, most term sheets are labeled "nonbinding" on the first page and sometimes on every page. The answer, despite these references to the term sheet being "nonbinding," is that certain specific terms will create legally binding obligations.

A VC will want a few legally binding commitments on your company so that the VC can devote the time and effort necessary to evaluate the potential transaction, whether or not money ever changes hands. To protect these resources, VCs will ask for a period of exclusivity during which you and the company agree not to shop for other potential offers. This period should generally coincide with the deal timeline—usually around 30 days. In addition, VCs will ask you to keep the term sheet and its specific terms confidential, in part to protect what VCs see as their competitive advantage—an ability to evaluate companies and propose winning terms.

Here it's also important to recall that a term sheet provides focus. Some terms, like the exclusivity and confidentiality obligations described above, will likely be must-haves for your investors and therefore legally binding. But, the other terms, while not legally binding, do set the framework for the transaction. In the negotiations over the definitive documents, you and the investors will point to these terms as if they carried binding authority. So, you should be careful about each and every term in the term sheet, both those that are legally binding and those that are not.

And, before leaving this topic, it's important to raise one word of caution regarding a term found in many terms sheets: an obligation to negotiate definitive documents in good faith. The Delaware courts have found this obligation to be legally binding even when the relevant parties did not sign a term sheet they had negotiated (but instead attached the term sheet to an agreement they did sign). This is one reason we advise deliberation and care in the term sheet process. We expect to cover the relevant decision and some of its implications in a later post.

Conclusion

What's in a VC term sheet? Your and the investors' clear and concise understanding of the terms of the investment. That's it. Contact us with questions. We're here to help.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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