Today I start a new series, Anatomy of a Term Sheet. I’m going to take a fairly standard term sheet for a Series A venture capital funding, and explore the various provisions in detail. There are a variety of complex issues lurking in these term sheets, and it is important for founders to have a good understanding of the business and legal aspects of these provisions.
The term sheet I will use is a model term sheet from the National Venture Capital Association, which you can find here.
The NVCA is a trade association for venture capital firms, so as you can imagine, the term sheet is going to reflect venture capital interests more than founder interests. That is fine for purposes of this series, because the model term sheet will probably be fairly similar to what a founder gets from a potential VC firm.
So without further ado, join me for Part 1 of our series…
The first paragraph of the Term Sheet reads as follows:
This Term Sheet summarizes the principal terms of the Series A Preferred Stock Financing of [___________], Inc., a [Delaware] corporation (the “Company”). In consideration of the time and expense devoted and to be devoted by the Investors with respect to this investment, the No Shop/Confidentiality [and Counsel and Expenses] provisions of this Term Sheet shall be binding obligations of the Company whether or not the financing is consummated. No other legally binding obligations will be created until definitive agreements are executed and delivered by all parties. This Term Sheet is not a commitment to invest, and is conditioned on the completion of due diligence, legal review and documentation that is satisfactory to the Investors. This Term Sheet shall be governed in all respects by the laws of [______________].
The first item to note is that the VC’s are going to be purchasing preferred stock, rather than common stock. Preferred stock, as the name indicates, is a separate class of stock that provides its holders with preferential terms over common stock. We will go into those terms in greater detail later, as they come up in the Term Sheet. Also note that the startup will have to amend its certificate of incorporation and bylaws to create this new class of preferred stock.
The second item to note is that while the Term Sheet as a whole is not binding, certain provisions are considered binding even if no financing occurs – namely, the No Shop/Confidentiality provisions, and possibly the provisions regarding attorney fees. The “no shop” term essentially states that for a certain period of time after acceptance of the Term Sheet, the startup will not solicit other investments from other potential investors. The confidentiality term prohibits the startup from disclosing the terms of the Term Sheet with anyone other than its officers, directors, accountants, attorneys, or other pre-approved investors. The provision regarding counsel fees states that the startup will pay all the legal fees associated with the Series A financing, including the VC investors’ attorney fees. This is a standard practice for VC financing. Just because the startup is paying the VC’s attorney fees, however, does not mean that the startup should use the VC’s attorney, or even an attorney recommended by the VC. There is a huge conflict of interest there, and the startup is well-advised to pick its own attorney to represent it.
A third item to note is the final sentence, regarding what state law will govern the Term Sheet. This can be a very important provision, as some states (Delaware and New York) may impose an enforceable obligation to negotiate in good faith to come to an agreement based on the Term Sheet.
Next, the Term Sheet lays out the basic offering terms:
Closing Date: As soon as practicable following the Company’s acceptance of this Term Sheet and satisfaction of the Conditions to Closing (the “Closing”). [provide for multiple closings if applicable]
Typically a deal will take about 30 days to close, sometimes longer. The investor will want to conduct due diligence on the startup, and the closing will be contingent on the results of the due diligence. The startup may have to take a variety of actions to clean up its books and records. We can go into greater detail on these matters when we look at the Conditions to Closing, in a later part of this series. Also note, there may be multiple closings, depending on the number of investors as well as other factors.
Investors: there may be multiple investors in this round of financing.
Amount Raised: $[________], [including $[________] from the conversion of principal [and interest] on bridge notes].
This is the total amount to be invested in the company, but note that it may include the amount of an angel investment made as a convertible note. Typically, the convertible note provides that the angel investor can convert the note into preferred stock in a Series A financing, at a price per share that is more favorable than what the Series A investor is paying. This price discount compensates the angel for the higher risk associated with making that earlier investment.
I am going to conclude Part One here, because the next sections, which cover price per share, pre-money valuation, and the option pool, are pretty complex in their own right.
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