What is a Term Sheet? What are the important terms to note in the Term Sheet?

As a document summarizing important agreements between startups and investors, serving as the basis for all future implementation processes, understanding the important terms in the Term sheet is extremely important to ensure benefits and fairness for both parties. In this article, let's ThinkZone Let's decode those terms!

* The article uses many English terms because there are no similar terms in Vietnamese.

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WHAT IS TERM SHEET? 

Term sheet is a non-binding agreement, including basic terms and conditions, often used by startups during negotiations with investors. The term sheet serves as a template and is the basis for more detailed, legally binding documents that will be executed after the term sheet agreements have been finalized, e.g. SSA (Share Subscription Agreement) good SHA (Shareholder Agreement).

* SSA and SHA contracts will be specifically introduced by ThinkZone in the following articles.

 

WHEN SHOULD TERM SHEET BE MADE?

The investor and startup will start making the Term sheet after both parties have agreed on some important terms in the investment deal, such as valuation, investment structure (deal structure), shares,...

Although there is no specific convention for which party will prepare the Term sheet, the Term sheet will usually be prepared by the VC and then sent to the startup for agreement..

 

WHAT PROPERTIES DOES TERM SHEET HAVE?

Below are some properties of the Term sheet: 

➤ Not legally binding: In theory, neither startup nor VC has a legal obligation to follow the terms stated in the Term sheet, but in reality, when the Term sheet is signed, more than 90% of investment deals have been finalized between the two parties, and are only canceled if an unexpected event occurs (war, natural disaster,...);

➤ Tick Consensus of the parties: The term sheet ensures that the parties involved have agreed on most relevant aspects, helping to limit unnecessary misunderstandings or disputes and not incur expensive legal fees related to the contract later.

 

IMPORTANT PROVISIONS IN TERM SHEET 

Important terms in a Term sheet can be divided into 2 main groups as follows: Economic terms and Control terms.

 

1. Economic terms

Economic terms are agreement terms related to the economic aspects of the investment deal, including some of the following important terms.

 

Valuation

Valuation is the value of the startup, and is expressed through another important index Price Per Share (Price per share). With Number of shares issued (including Outstanding Shares - existing shares, and Newly Issued Shares - newly issued shares), startup valuation is calculated according to the formula: 

Company valuation = Price per share at the time of investment x Number of shares issued

 

In the Term Sheet, there are 2 types of valuation you need to distinguish: Pre-money Valuation (valuation of the company before investment) and Post-money Valuation (valuation of the company after investment). During the negotiation process, startups should clarify the type of valuation they are referring to to avoid unnecessary confusion.

The relationship between Pre-money Valuation and Post-money Valuation is as follows:

Pre-money valuation = Post-money valuation - New investment

 

➤ Learn about startup valuation through the article: Startup valuation using the Discounted Cashflow method

Liquidity Preference

Liquidity Preference is the next important economic term in the Term sheet, regulating the amount of cash proceeds from a liquidity event, such as M&A or sale of company assets, in what order will it be distributed to shareholders, and at what multiples compared to the initial investment price.

This provision is considered a clause that protects investors against risks when investing in startups, specifically, they will have priority to receive money back before remaining shareholders in liquidity events.

 

For example: 

Series A investor invests 5 million USD in startup A, with 2x liquidity preference terms. Suppose startup A is sold to corporation B for 13 million USD, Series A investors will have priority to receive 2x their investment back, or 10 million USD, and the remaining 3 million USD will be divided between co-founders and angel investors.

In case startup A is only resold for 7 million USD, this 7 million USD will belong to Series A investors, while co-founders and angel investors will not receive anything.

 

Founder Vesting Period 

To avoid the risk of founders leaving the company early with a large amount of shares, vesting is a popular method to ensure the founder's level of commitment to the company. The Founder Vesting Period regulates the amount of time it takes for a member of the company to gradually vest. 

For example: Mr. A is the co-founder of startup

- After the first year with the company, Mr. A will receive 20% of the shares.

- For each year after that, Mr. A will receive 30%, 40%, and 50% of the shares respectively.

Companies often implement a vesting cycle of 4 years, in which the first year is called "cliff", implying that if Mr. A leaves in the first year, Mr. A will not have any shares at all. Vesting helps ensure that the co-founder will stay with the company for at least 1 year, and motivates them to stay long-term.

 

With the Vesting Period clause in the Term sheet, VCs will be more confident that the founder team will make a long-term commitment to the company, reducing the risk of co-founders giving up.

Options Pool

Option Pool is a term used to refer to the number of shares available to key employees of a company. Option Pool is considered a gift for employees who have contributed greatly to the development of each startup, motivating them to contribute more. Members who join startups early, building startups from the early days, will often receive a larger number of shares than those who join later.

However, the meaning of Option Pool goes beyond motivating employees but also has strategic significance for VCs. Specifically, VCs can benefit by dealing a higher option pool ratio in pre-money pricing.

 

For example: Fund A invests in startup B and holds 20% of the shares. Suppose before investing, startup B has an Option pool of 10% that has not been allocated to any employees (unallocated). Then, with the deal that startup B's Option pool increases to 20% after receiving investment, the shares of co-founders and other investors will be diluted, while not affecting the shares of fund A, increasing the role of fund A in startup B's decisions.

 

Anti-dilution Protection (anti-dilution clause)

During the growth process, startups often issue more shares, attracting more investors to mobilize capital for their next plans. However, issuing additional shares can lead to dilution of shares of current shareholders, meaning that old investors will have their ownership ratio and influence in the company reduced. 

Therefore, the Anti-dilution Protection clause is set to protect old investors in case the startup issues new shares at a lower valuation than previous capital raising rounds.

Anti-dilution Protection is divided into 2 types: Weighted Average Anti-dilution and Ratchet-based Anti-dilution.

➤ Weighted Average Anti-dilution: This method means that if the company issues additional shares at a lower price than the previous price, the shares are revalued according to the following formula:

 

In there:

- NCP (New Conversion Price) - new conversion price

- OCP (Old Conversion Price) - old conversion price

- CSO (Common Stock Outstanding immediately before the new issue) - common shares outstanding immediately before being issued at the new price

- CSP (Common Share Purchased if the round wasn’t a down round) - common shares are purchased if the new share price is not lower than the previous capital round's share price

- CSAP (Common Shares Purchased because the round is down) common shares are purchased if the new share price is not lower than the previous capital round's share price

 

➤ Ratchet-based Anti-dilution: This method is used when the company issues shares in a new round at a lower price than the previous round, then the price of the shares in the previous round will be calculated according to this lower price.

 

2. Control terms

Control terms are terms regulating the control rights of shareholders in the company.

 

Board Of Directors

Board Of Directors (BOD, or Board of Directors) is the highest team holding decision-making authority for all activities of the company.

One of the important contents about the Board of Directors in the Term sheet is the regulations on the process by which members of this board are selected, the number of seats, and board meetings. BOD members include co-founders, CEOs, representatives from VCs, and should be balanced in decision-making power, ensuring that the co-founder team should hold key decision-making power to maintain momentum in operating and developing the company.

Many startups fail because there are too many members with many different development orientations in the BOD, and the founders cannot protect their orientation. 

* Read more in the article: Lessons from the failure of MySpace and Friendster against Facebook.

 

Drag-along Agreement

This is also an important control term in the Term sheet. In some situations, the company will not want a shareholder to be able to use their shares to vote in any direction they want, at the risk of shareholders not being on the BOD. (eg advisor, employee,...) Shares are not always used in the most beneficial way for the company.

For that reason, the Drag-along Agreement was born with the stipulation that shareholders own the majority preferred shares can pull, or require, other shareholders, including the founder, to make a certain decision, or even carry out liquidity operations for the company.

 

Protective Provisions (Some protective provisions)

As the name implies, this provision is designed to protect investors, because they are shareholders who do not have the main decision-making power for the company. 

In general, these protective clauses provide that without the investor's consent, the company is not allowed to:

➤ Change ownership ratio, liquidity preference or investor priorities;

➤ Increase, decrease or issue new shares;

➤ Buy back common shares;

➤ Selling shares;

➤ Change business registration license;

➤ Change the scale or structure of the BOD;

➤ Pay dividends to shareholders;

➤ Declared bankruptcy;

➤ Company franchising;

➤ ...

 

3. Some other terms

In addition to the main terms related to economic aspects and corporate control, some other terms that may be encountered in the Term sheet include:

 

Dividends (Dividends)

Dividends are amounts of money paid regularly by a company every quarter to shareholders from the company's profits. While most of the private equity fund (PE fund) Making money from dividends, VCs don't care much about dividends.

The Dividends clause in the Term sheet usually stipulates that the VC will receive annual dividends, from 5-15% of the amount that the VC invests. However, this is not a common provision with early-stage startups, because these startups often do not have profits, and if they do, those profits will be prioritized for reinvestment in the company instead of paying dividends to shareholders.

 

Redemption Rights

Redemption Rights are a provision that allows investors who own preferred shares to request the company to buy back the investor's shares after a period of time, at a price equal to the stock price when the VC invested, plus unpaid dividends. (if any).

This provision is designed to address the risk that startups will not be able to help investors divest capital through M&A or IPO, thereby helping investors feel more secure about their ability to divest capital.

 

Pro-Rata Rights

This provision allows investors the right to participate in the startup's next round of capital calls in the future, with the purpose of continuing to maintain their shares in the company without dilution when the startup issues new shares. 

For example: Startup A issued 100,000 shares, of which VC B holds 10,000 shares, equivalent to 10% of the company's shares. In the next round of capital calling, startup A issues 500,000 more shares, then VC B will have the right to buy 50,000 shares, at the same price as other new investors, to maintain their 10% ownership in the company.

Note that Pro-Rata Rights are rights, not obligations, of investors. One of the situations where investors do not want to exercise their Pro-Rata Rights is when the startup has a bad business situation, making investors not want to spend more money to keep the same amount of shares.

 

SUMMARY

Above is an overview of the Term sheet along with some important terms that startups need to understand before finalizing the Term sheet with investors. Hopefully this article will help startups and investors have reasonable and fair investment deals for both parties.