When raising funds from angel investors or venture capital firms (VCs), the offering terms are often summarized in a term sheet prior to consummating the deal. Term sheets negotiated with angel investors are typically less complex than those proposed by VCs, but there can be considerable overlap between the two.
Negotiating with Angel Investors
When dealing with angel investors, it is typical for the company to produce the initial draft of the term sheet. There are variations by region and it is not uncommon to see an angel investor or angel group prepare the initial draft of the term sheet, especially if the company has not already prepared one. If an angel investor or angel group has taken on the role of lead investor, it is common to see the term sheet negotiated. In such cases when a term sheet has been negotiated, it is important that the company communicate that fact with subsequent prospective investors to avoid further negotiations and different terms.
Elements of an Angel Investment Term Sheet
In an equity financing with angel investors, the terms of the deal are often rather straightforward. Typically, the security being offered is either common stock or a stripped down preferred stock. The angel investor term sheet will typically contain at least the following:
- A description of the security being sold
- The price for the security
- The company pre-money valuation
- The minimum (if any) and maximum amount to be raised
- Basic information about the issuer (e.g., whether it is a corporation or limited liability company, the state of incorporation/organization)
- The current capitalization table
- Any applicable security transfer restrictions
The term sheet may also contain other provisions that address issues such as board representation, veto rights over certain types of transactions or conduct, co-sale or tag-along rights, drag-along rights, dividends, put rights, piggyback registration rights, and anti-dilution provisions.
Once the term sheet is “finalized” for the equity financing with angel investors, it often becomes an important element of the issuing company’s private placement memorandum, if one is used.
Negotiating with VCs
When dealing with VCs, in almost every case, it is the VC who prepares the initial draft of the term sheet. Unless the deal is very small, VCs commonly invest in small groups or syndicates (e.g., two or three firms), with one VC acting as the lead. The lead VC will typically present the term sheet, and the company will have a relatively short time period to accept it or negotiate its terms (in an attempt to prevent the company from “shopping” the deal).
Elements of a Venture Capital Term Sheet
Venture Capital term sheets are usually complex. Below is a list of issues that are often included or addressed in a VC term sheet. This list is in addition to the items listed above for an angel investment term sheet.
- Conditions to closing the investment
- Closing date
- Identity of investors.
- Dividends (the percentage and whether cumulatve or not)
- Liquidation preference (e.g., amount (multiple) and whether the security is participating preferred stock or not)
- Board representation (e.g., single board member or control of the board)
- Protective provisions (veto rights over certain types of transactions or conduct)
- Conversion rights
- Anti-dilution provisions (weighted average or full ratchet)
- Pay-to-play provisions (assuming more than one VC is participating)
- Redemption/put rights (requiring the company to buy back the investors’ shares on a given date)
- VC’s attorneys’ fees (shifting costs over to the company)
- Demand registration, S-3 registration, and piggyback registration rights
- Management and information rights
- Participation or preemptive rights
- Employee stock or equity incentive requirements and limitations
- Tag-along (co-sale) and drag-along rights
- Confidentiality and no shop requirements
There can be a variety of other provisions and requirements included, such as a tranche or milestone funding process.
Upon acceptance of the term sheet, the VC’s attorney steps into the process (if he or she had not already done so at the initial due diligence stage). The VC’s attorney typically produces the initial drafts of the investment documents.
Term Sheet Forms
There are many good resources on the Internet with sample venture capital term sheets. Likely the best known is the one published by the National Venture Capital Association (NVCA). The NVCA form term sheet contains many good explanations of the various provisions in a VC term sheet. However, as you might have guessed with the authors of the form (VCs and their lawyers), the NVCA term sheet is generally drafted in favor of the VCs.
A version of the NVCA term sheet form that contains more company-friendly terms and more detailed discussions of the various negotiating points was prepared by those of us on the American Bar Association (ABA) Private Equity and Venture Capital Committee. The ABA Comments to the NVCA term sheet form is intended to do the following:
- Generate more options and alternative provisions, including many that are more company-friendly
- Provide more detailed explanations concerning key provisions and negotiating points
- Elaborate on current case law and the implications of various provisions
- Identify which of the alternative provisions are more frequently used
Using resources such as the NVCA term sheet and the ABA Comments can help prepare companies to negotiate effectively (and more efficiently) with angels and VCs.