The Termsheet: A Primer

A big moment in the life of an entrepreneur is when he/she and the team receive a term sheet from an investor. Although term sheets are distinct from LOIs and memorandums of understanding (MOUs), the three documents are often referred to interchangeably because they accomplish similar goals and contain similar information. However, in investment parlance, the former is most often associated with startups raising money from venture capitalists.

A term sheet contains all the ‘terms’ under which the venture capitalist will invest, and take a stake in the investee company i.e. the startup. While VCs come across multiple term sheets in their business voyage — even a well-funded startup will only get so many chances to familiarise themselves with this document. Thus, even though there are multiple junctions at which the VC and the founder can have an informational gap — commercial model, business plan, org structure etc; the term sheet heavily piles onto that information asymmetry. And while both sides will have lawyers doing the dirty work of drafting and implementation — the negotiation on the commercial aspects lies heavily on the VC and the founders themselves. Hence, for my own understanding as a VC analyst, and for the benefit of all entrepreneurs reading this, I will touch upon various clauses of the term sheet — and supplement them with their practical application wherever possible.

The term sheet is a non-binding document that forms the basis of the formation of the Shareholder Agreement and the Share Subscription Agreement — which are in fact binding in nature, and will detail out the terms agreed upon in the term sheet. These two documents can be collectively referred to as the “Definitive Documents”. In that sense, the term sheet is a precursor to the binding documents and provides conceptual clarity on the terms agreed upon. It is a statement of significant interest by the VC to invest in the startup. All the clauses on the term sheet are negotiated simultaneously — since it needs to account for events that may (or may not) arise even in the distant future. However, some events will invariably occur before others. I will try and cover the various components of the term sheet in the order that they are likely to occur in real-time.

Upon making the decision to invest, the initial decisions to be made are — which security the investor will get and how much stake of the company he will get for his investment i.e. what will be the valuation at which the investor will invest. There are broadly the following securities an investor can choose from:

• Common Stock - This security is almost never preferred by the investor since it does not grant him the kind of protections and rights that he desires.
• Compulsarily Convertible Debentures (CCD) - Fixed income security that will need to convert in 10 years' time (or sooner if agreed).
• Convertible Notes - Fixed income security that can only convert to common stock, owing to which it sees less adoption in the ecosystem.

An additional plus point of any convertible security is that it allows to defer the conversation around valuation/pricing of the startup to a later stage. This is especially useful for an early stage company that has little revenue/cashflows needed to make meaningful projections; and where the core IP is relatively harder to price. That being said — founders should be mindful to not raise too much money through convertibles as it could lead to severe dilution when these notes eventually get converted. Additionally, many times the investor will put a cap on the valuation at which the note will get converted — which leads to further dilution for the existing shareholders (no matter how well the company performs).

• Compulsorily Convertible Preference Shares (CCPS): This is the number one go-to that investors prefer in the VC world. It gives them preference shares — which makes the round a priced one, and gives them liquidation preference over others on the cap table, like common stockholders. Will have a conversion ratio — and will need to be converted to common stock within a maximum of 20 years.
• iSAFE - Stands for India Simple Agreement for Future Equity. To comply with Indian law, they take the legal form of a CCPS. An iSAFE is a convertible security that is neither debt nor equity, there is no interest accruing, and for legal compliance purposes, they carry a non-cumulative dividend at 0.0001%. Not only does it delay the crucial valuation conversation, but does away with long and one-sided Shareholder agreements presented by VCs during the early stage of a company. It is a template-driven, 6 page agreement that has a minimal legal cost and more favorable terms for entrepreneurs.

The next step is to decide on the company’s pre-money valuation; since it would determine the VC’s stake in the company. As a rule of thumb — pre money valuation + investment amount = post money valuation. Finance 101 dictates that the value of a company is the present value of all its future cash flows; and who are we to argue with the same. The discounted cash flow analysis is the most common way of arriving at the valuation of the startup. However, it is argued that the cash flows of an early stage startup, especially one that is a unique player in its space — can be difficult to project. Particularly the cash flows of the later years, which contribute more heavily to the overall valuation. One alternative is to see how similar companies in the market have been priced. For example, assume a scenario where Swiggy and Zomato have equal market share. In such a case, if Swiggy is valued 10 times its revenue, then it would be fair to also value Zomato at 10 times its revenue (even if there are slight differences in their business model). If neither of these methods is serving as a good fit — then both parties will draw upon their negotiational prowess and set the precedent for how other similar companies should be priced in the market.

Post investment, the next step for the VC would be to take a stance on how involved he wants to be in the operational and executive decision making of the business. The VC also has a fiduciary duty towards its own investors (Limited Partners) to ensure that the money infused is being optimally deployed, and/or is being used for items as discussed during the time of the investment. There are broadly 3 ways in which the investor can set his desired level of involvement:

• Board Seats: The investor can negotiate the composition of the board and can ask for seats basis the investment amount and subsequent risk that they are undertaking (as a rule of thumb, an early stage investor will be supposing more risk than a late stage one). The board seat will allow the investor to significantly weigh in on important decisions such as appointment of new CEO, acquisition of another business, etc. They can either get a director seat — which will grant voting rights, or an observer seat, which will allow them to participate in discourse (but not be able to vote on matters itself)
• Reserved Matters/Protective Provisions/Veto Rights: As if the potential board seat(s) was not enough —if negotiated well, the VC is granted veto rights on certain executive matters. As a good practice, the VC should ensure that the exercising of these rights does not infringe on the operational flexibility of the founder/management team. Following are a few items that are covered under the reserved matters: authorization of new classes of stock (especially those which have superior rights than the existing investor), increase in option plan, compensation structure of senior management, a significant change in operations (pivoting to new business/commercial model), regulatory/compliance matters, any M&A activity, authorizing indebtedness, etc. The extent of these matters is once again, a factor of the negotiation power of both parties (and their lawyers).
• Information Rights: These are rights required by investors to stay updated on the progress of the company — and how capital is being spent. Key information rights include: Monthly reports in a pre-decided format noting movements in key operational and financial metrics, quarterly P&L, balance sheet and cash flow statements, minutes of meetings with board members, any other information agreed to between the parties.

Now that the investment is made and the business is running smoothly under the watchful eyes of the investor — all associated parties can gear themselves up for the next round of investment. Assuming that a new investor is ready to enter the cap table, the existing investors (including the existing VC: let's call him VC 1 and the new investor VC 2) will suffer a dilution. Mostly, VC 1 would have negotiated for themselves prorata rights that would allow them to maintain their stake prior to the fresh investment — by infusing additional funds. Now generally, this should not be a problem to any parties involved. However, sometimes oversubscription can create tensions. There is a finite amount of money the company (and its founders) likely wants to raise in a particular financing round and, correspondingly, a maximum amount of ownership dilution they are willing to accept. Exercising of such pro rata rights by VC 1 means additional dilution for the other shareholders — primarily the founders.

Most fresh rounds of investment are associated with a surge in the valuation of the company. As long as this keeps happening — VC 1 does not need to worry about antidilution provisions (even though there will still be some dilution in case the prorata right is not exercised). This provision protects the stake of the existing VC (or any investor that has negotiated said provision) in the scenario of a “down round”. It provides a price adjustment to minimize the excessive dilutive effect of such a round. There are two ways in which this price adjustment can be made:

• Full Ratchet: It is the resetting of the price of the previously issued securities to the price at which the latest securities were issued if the price previously issued securities were issued at a higher price than the latest round. As an example, if a shareholder held 10,000 shares worth rupees 5 each by the end of the previous round; and the latest down round readjusted the share price to rupees 2 — then the shareholder would have to be issued an additional 15,000 shares in order for the value of his stake to be maintained (10,000*5 = 25,000*2). His overall stake in the company will also go up.
• Broad-Based Weighted Average: Think of the broad-based weighted average as an intermediate form of antidilution protection. VC 1 does not get to reset its original purchase price fully to the new, lower purchase price, but it does get a blended price in between these two that is weighted by the amount of capital raised in the different financing rounds. The formula is also a handful — and the explanation of which is not something I will be getting into in this piece. What is important to remember is that this is the more accepted form of anti-dilution between the two methods, and what is used in almost all term sheets (and subsequently the shareholder agreement)

Now that the down round has been dealt with (or averted, hopefully), the investor can set his sights on getting an exit from the company. The term sheet will generally put the onus on the company to get its investors an exit on a “best effort basis”. Even though some aspects of this clause are harder to enforce — such as achieving the desired IRR of XYZ%, or ensuring an exit through an IPO; there are other measures built in to aid the exit chances of a VC. Following are the ways/means through which a VC can expect/hope for an exit:

• Qualified IPO: Listing of the shares of the investor (or a number of shares agreed to) on a recognised stock exchange — in order to create marketability of the shares held by the investor
• Promoter Purchase: The promoter(s) purchase the shares of the investor at an agreed price
• Buy-Back: The company itself can buy-back the shares held by the investor at the fair market value of the shares
• Third Party/Strategic Sale: The investor can sell his shares to any third party financial investor — at a price agreeable to both parties.

As mentioned, the above stated methods are exit avenues for the investor that are inculcated in the term sheet and shareholder agreement — but are only enforceable to the extent of the best effort of the company and its founders. A company would very much like to move towards a qualified IPO for the sake of its own growth, if not to get its investors an exit. However, there are some additional clauses built in that allow the investor to maneuver himself in an exit, in the scenario that an exit is not achieved within a reasonable timeframe. Most of these clauses are pretty standard in modern day agreements — however, the details can always be negotiated.

• Drag Along: This right is generally given to the lead/majority investor. It allows such an investor to “drag” the other shareholders in the scenario that a large chunk of the company is being bought out — so that the sale can go through. As a hypothetical example, in Reliance’s acquisition of Urban Ladder, supposing that the investors (who cumulatively held 51% of the company) are in agreement to a sale, but the founders (who hold the balance amount) are not — then the investors who have a drag on the promoter’s shares are allowed to force them to sell their stake in order for the transaction to go through (Since Reliance will only go through with the purchase if they can wholly acquire the company — and not be satisfied with only 51%)
• Tag Along/Co-Sale: Now imagine a scenario wherein Reliance only wants to purchase 30% of Urban Ladder — and the promoters (who cumulatively hold this 30%) have negotiated a deal with Reliance. In such a scenario — the investor(s) that have a tag along right can simply “tag” along in this sale and offload their shares as well. The extent to which they can tag along is agreed beforehand. In an ideal scenario — if Reliance wants to purchase 30% of the company, then the investor’s decision to tag along should not affect the same. In that scenario, the promoter would have to compromise on the number of shares it offloads.

A slight digression since we have mentioned the hypothetical scenario of a promoter selling off their shares. In almost all scenarios, the VC investor will not want for the promoter(s) to exit the business. This is because, at the time of investment, they took a chance upon the founders as much as they did upon the company. Indeed, this is accounted for in the arrangement between the VC and the founders. Not only are the founder shares vested over a period of time, but they are also additionally subject to a lock-in period — wherein they are generally not allowed to sell more than a certain percentage of their shares (say, all founders will not be allowed to sell off more than 10% of their stake combined) for as long as the VC is invested in the business. Such clauses are waived off in scenarios like Drag along, tag along, etc. mentioned above since it is allowing for the VC to get an exit. Following are some other ways in which the VC can maneuver an exit:

• Right of First Refusal (ROFR): It is a right that necessitates that the selling shareholders (founders, or otherwise) first offer the shares to the existing investors at the same price at which the outside/third party investor is willing to purchase the shares. This is a fairly draconian measure since the outside investor is less incentivized to delve into a conversation to make a purchase if they know that the existing investors have a ROFR — since any price they set could be used by the existing investors to make the purchase.
• Right of First Offer (ROFO): This is a much more reasonable right from the seller’s point of view. It necessitates that the founders or whosoever are deciding to hit the market to sell their shares, first “offer” these shares to the existing investor. This offer essentially sets the price of the shares — and as long as the seller does not find a better price in the market, the shares will be sold to the existing investor.

The final way in which the investor can achieve an exit and attain nirvana is in the event of liquidation of the company. This is different from a stake sale as the entire company is being bought out for a set price (that is negotiated between buyer and seller), instead of the purchase of individual chunks of the business. It is here that the true power of the preference shares is felt and exercised — since preference shareholders are given liquidation preference over the common stockholders i.e. the preference shareholders are paid before the common stockholders. There are two facets that have to be negotiated by both parties while deciding upon this clause:

• Times Return to Investor: In the event of a liquidation an investor will argue for X times the return of his initial investment from the proceeds of the sale. As an example, an investor could argue that he is provided 2 times his original capital invested — which would result in the investor having a 2x liquidation preference.
• Participation: In addition to the above return, the investor may argue that he have a “participating” liquidation preference, meaning that the investors first get X times their investment back and then participate in the remaining amount along with all the other shareholders, prorata to their shareholding. Early stage companies generally have a 1x Participation Liquidation preference — since the higher risk taken by early stage investors merits a higher reward. Growth and late stage companies usually have a 1x Non-Participating Liquidation Preference.

Although there are several other clauses in the term sheet, and subsequently in the definitive documents — I have covered those I find salient. The term sheet is a very logical document, data from which can be analysed to draw insights about the overall investment landscape. For example, the number of down rounds during the coronavirus pandemic can help us understand how the startup industry (country wise) was impacted by the pandemic. While the nature of individual transactions may be confidential — at an aggregate level there should be some way to work with this data. Liquidation preference can tell us how demanding investors are in general — it might shed light about the demand and the supply of capital in each country. If supply of capital is short — investors will always have the upper hand in negotiations. This is never an ideal scenario, and a strong supply of venture money (that can be reflected through these agreements) is conducive to the growth of the startup ecosystem.

This piece has been collated using the following resources:

The Secrets of Sandhill Road by Scott Kapur
Inc 42 GuideBooks
Guidance from the esteemed legal team of attorneys at Pier Counsel
My own experiences as a venture capital analyst