In the introductory post to my term sheet guide, we covered a general introduction to term sheets and the trade-off between high valuation and complex investment structure, while the second one focused on the basics of a convertible loan.
The goal of this post is to shed some light on terms in a standard equity round term sheet and provide some context as to how we at Credo Ventures look at each of them.
Our term sheets try to mimic what we consider a standard set of rights used by U.S. venture capitalists. By using a “Western” structure since the very early days in its lifecycle, a startup can in our opinion improve its likelihood of raising future rounds from Western investors.
Right after the investment size and valuation (topics I’ve already covered) you will typically find the investment tranches. In order to protect his downside, investor can split the investment into multiple tranches and include conditions/milestones (customers, revenue, product, etc.) under which each of the tranches will be released.
In the seed and Series A level, we tend not to tranche the investment too much, since it is very hard to set meaningful milestones in such early stages. In seed, we tend to give the whole amount at once or sometimes have it divided into two tranches. Series A is very similar; if it is a larger investment we might include an extra tranche.
Stock options plan
Timing of creation of the SOP is important: if the term sheet says the plan should be created before the transaction is closed, the equity will go from the stake of original shareholders. If the SOP will be created after the transaction, the investor will get diluted as well.
Board of directors
This one is tricky and pretty important, because some investors (especially the non-standard ones or occasional business “angels”) may use the board to usurp the control of the startup.
Since we try to add value by being hands-on in our companies, we typically nominate one director to the board by Series A at the latest. We have some seed investments with no board of directors or with a board consisting only of management. We have never taken majority in a board at seed or Series A level; i.e. the management should, in our opinion, always keep the majority of the votes (by having more directors than the investors have) at this stage.
Our boards of directors typically meet monthly. Beware of investors that want to take majorityor an equal number of seats as management in the board by Series A.
Important caveat for European entities: board of directors is not always a statutory body of the firm supported by legislative framework in a given jurisdiction; the board can bea newly created body backed up by the transaction documentation of the investment.
The board has a list of items that it must approve (e.g. expenses greater than XX EUR, hiring of key people, sale of shares in the company, etc.), some unanimously, some by majority of the vote. The item list is also part of the term sheet.
They limit founders’ ability to sell their shares without consent of the investor. The investor invests in the people — why would he want to be part of a company in which the founders can sell their shares and leave at any moment?
Tag-along / co-sale right
Based on a similar logic as the lock-up rights, tag-along clause describes the right of an investor to tag along in a sale of the firm if the founders choose to sell a larger portion of their shares. Example: if the founders decide to sell 10% of their stake to a third-party, investor will have a right to sell his entire stake under the same terms as the founders. If the buyer does not want to buy investor’s stake, he can’t buy the founders’ stake either.
Right of first refusal
Another right in the same class as the lock-up and tag-along rights. Right of first refusal states that before any shareholder sells his stake to a 3rd party, he must offer his stake to existing shareholders at the same terms. The selling shareholder can only sell the stake if remaining shareholders don’t want to buy it the stake.
Pre-emption / pro rata rights
This clause essentially reserves the right to participate in the future financing rounds. Typically this includes a pro-rata right: let’s say that an investor owns a 20% stake in a startup, which is about to receive additional EUR 5,000,000 investment. A pro-rata right allows the investor to invest EUR 5,000,000 * 20% = EUR 1,000,000 at the same terms as the rest of the investors.
In our seed investments, we sometimes include more than a pro-rata right to make sure that we can deploy more capital into really promising companies.
This one can also get very tricky, and some investors use it to limit their downside risk. The anti-dilution clause describes how each shareholder gets diluted in a “down round”: a future investment round with a lower valuation than the current investment round.
There are two basic concepts: full ratchet and weighted average anti-dilution. While full ratchet essentially means that only the founders will get diluted (i.e. investors don’t get diluted at all), weighted average approach assumes dilutions of both investors and founders. If you want a deep dive on the technicalities of the anti-dilution clauses, check out this post by Brad Feld.
Credo has to my knowledge never used full ratchet, since we consider it very entrepreneur-unfriendly.
I think we have covered more than half of the standard terms. In order for the post to not get too lengthy and complicated, I will cover the 2nd half in the next post in two weeks.
Just one closing remark: I strongly recommend resisting the urge to invite a lawyer to review the term sheet, especially if it is not a Silicon Valley lawyer who has executed hundredsof similar transactions.
Most of the local lawyers don’t understand startup investing but want to have as much input as possible so they can clock in (and bill) more hours. Things can get very counter productive very quickly; unfortunately, we had to walk away from a couple of transactions where the startup invited their friend-lawyer to review the term sheet, which resulted in a total mess.
If you want advice on a term sheet, read blogs of other VCs like mine, or get help from respected startup mentors, which any accelerator or angel can recommend. Just please avoid inexperienced lawyers who are more interested in billing their hours than helping the startup succeed.