Series A Term Sheet in Plain English
We wanted to translate into plain English what a term sheet really means for you. While reading a term sheet founders need to know what to negotiate for, what is normal and what can backfire against them. You can a save a lot of time and stress by understanding these terms.
Valuation means how much your company is worth and for how much you are selling equity in your unicorn. Founders want a higher valuation, while investors want a lower valuation and potential for up rounds and target returns. The valuation the investor sets reflects the company’s risk profile and the probability of delivering a X 10 return in the view of the VC. Relevant terms that derive the discussion here price per share, percentage of ownership and investment amount.
Liquidation preference means how much an investor can pull out at exit and when. Remember investors get paid first then founders and then employees. Usually the liquidation preference is a dollar amount that is the greater of the amount of investment or the percentage of ownership taken. This is called a non-participating liquidation preference, because the investor gets paid only once. If an Investor can get paid back his initial investment and then participate with the founders in the next level of payments this is called a participating liquidation preference. A participating liquidation preference is rarely seen at the series A stage. The liquidation preference allows the investor to model its return and improve exit value. Liquidation preference are not normal if there is multiple on the liquidation preference.
Dividend is the right to receive a cash or non-cash payment from the company. Most investors don’t expect to get any dividends, however, sometimes term sheets require a percentage interest on money invested. For example, 8% per year on money invested. Other term sheets add cumulative dividends, which cumulate interest. Cumulative dividends means that a payment grows on top and increase yearly. A dividend means that the company has to pay out to investor the liquidation preference and then top it off with an extra payment. These are standard provisions but are negotiable. Dividends can decrease the amount of “pie” for founders and employees.
Anti-dilution is mechanism that protects the investor from the loss of value in future financings. If there is a future financing at a lower valuation then the company has to issue more shares to the investor to minimize the lower valuation based on the value of the lower financing. Most Series A deals have a weighted average formula, which looks at the “big picture” before triggering dilution. Most founders don’t read this provision until there is a down round and are surprised how anti-dilution can negatively impact their equity holdings. Later stage deals have full ratchet provisions, which mean that any “down” price differentiation can cause anti-dilution.
Preemptive rights give the investor the right to buy more shares of the company. This allows the investor to buy additional shares in the future if the company is doing well. This is a normal investor right and is rarely negotiated. Items that are negotiated is the time frame and amount of pro rata that can be exercised.
Drag-along is the right of the majority of investors to force a sale of the company. Drag-along can be only activated by an affirmative vote of the majority of investors together with the majority of founders. This is a market term and it can be used against minority founders. This term is rarely negotiated.
ROFR gives the investor the right to purchase founder stock if the company does not buy them back. Usually company has a primary right of first refusal and investors a secondary right. If the founders decide to sell their shares and the investors don’t exercise their ROFR, the tag-along gives the investors the right to sell their shares with the founders. These rights are pretty standard and most lawyers don’t waste their time on negotiating the substance of the provisions.