Week 5 of VC School: Deal Execution and Term Sheets
“Week 5 of VC School: Deal Execution and Term Sheets” is part of a ten-week series from the interns at Bowery Capital. The series will cover lessons learned and concepts covered during the weekly “VC School” meeting, a program taught by the Bowery Capital team designed to teach interns the fundamentals of the venture capital space. This summer, we want to open our doors and share these lessons with the broader community.
Last week we wrapped up due diligence with a deep dive into the quantitative components of the due diligence process. This week we moved away from the pre-investment activities and covered a different side of venture capital by focusing on deal execution and term sheets. We stopped by the offices of Bowery Capital’s venture lawyers who walked us through the process of executing term sheets. When venture capital funds decide they are comfortable with their due diligence and are ready to make an investment offer, they will send over a term sheet to the founders. The term sheet summarizes the general details of the investment, but it’s important to remember that term sheets are not legally binding documents. Most aspects of the term sheet are fairly standard and non-negotiable, though there are some aspects that founders – and especially repeat founders – will be able to negotiate. The main segments of the term sheet that are discussed in detail below are Securities to be Issued, Price per Share, Voting Rights, Financial Information, Participation Rights, Rights of First Refusal, Drag Along Rights, Board of Directors, and Founder Matters.
1. Securities to be Issued. This section details what type of shares of the company will be issued during the investment. Most typically, venture investments are in the form of preferred stock. The main difference between preferred and common stock is that preferred stockholders have priority over common stock holders–in the case of a liquidation event preferred stock holders will be paid out first. Other types of securities issued during early rounds of financing are SAFEs and convertible notes. In these instances, money is invested in the company but there is no immediate valuation. Investors of SAFEs and convertible notes will own a percentage of the company based on its valuation during the next financing round. Often investors will include a valuation cap in these investments to assure their investment isn’t over diluted by a higher than expected valuation.
2. Price per Share. This section of the term sheet lays out the valuation of the company. Price per share is typically calculated by taking the pre-money valuation and dividing by the pre-money number of shares. Also included in this section and open for negotiation is the percentage of shares that will be included in the stock option pool. Typically investors will require companies to set aside up to 10% of the shares of the company for future employees. Usually (though sometimes negotiated by founders with leverage) the option pool will be calculated based on a fully diluted post-money percentage, meaning only the founders will be diluted.
3. Voting Rights. This section lays out all of the instances in which investors need to vote and approve decisions made by the company. Examples of these types of decisions include changing the number of shares, issuing any new securities or debt, and changing the number of directors.
4. Financial Information. This section details which investors will be entitled to receive quarterly and annual financial information to monitor the health of the company. Typically only major investors will receive this information and this section will lay out what the investment threshold is to be considered a major investor.
5. Participation Rights. This section will guarantee major investors the opportunity to participate on a pro-rata basis in future fundraising rounds to maintain their ownership percentage.
6. Rights of First Refusal. Since investors – especially in early-stage companies – are making a bet on the founding team, this section stipulates that investors can block the sale or transfer of founders’ stock to other parties. In addition, this section often provides investors with the rights to sell their shares on a pro-rata basis if the founders are selling their shares.
7. Drag Along Rights. Most companies have several small minority shareholders–advisers or early employees who could own fractions of a percentage of the company. Drag along rights are written to ensure that during a liquidity event these minority shareholders can’t block the sale. If a majority of the investors or shareholders agree to sell the company they are able to drag along all remaining shareholders during that sale.
8. Board of Directors. This section lays out the details of the board of directors and who will make up the board. Often time in seed deals there are three directors, at least one of which will be a member of the lead investor’s fund.
9. Founder Matters. The founding matters section is set up to ensure that founders are fully motivated and don’t walk away from the company soon after the investment. This section gives founders skin in the game by vesting their shares. This section can also be negotiated and is often based on how much work the founder has already put into the company. The vesting period usually lasts 2 – 4 years and can require that founders vest one half or a third of their equity (though sometimes can require they vest their entire stake).
1. Sample Term Sheet. YCombinator has published a standard and clean Series A term sheet to help founders make sense of what a “good” term sheet looks like.
2. Term Sheet Overview. This article from Forbes provides another overview of everything entrepreneurs need to know regarding term sheets.
3. Complete Guide to SAFEs. This blog post provides a full explanation of how SAFEs work and differ from other forms of financing.
If you liked “Week 5 of VC School: Deal Execution and Term Sheets” and want to read more content from the Bowery Capital Team, check out other relevant posts from the Bowery Capital Blog.