Understanding Term Sheets for Startups

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Understanding Term Sheets
By
Tomi Davies

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Content
• The Financial Life of a
Startup
• Investment Types (Equity vs
Debt)
• New alternative instrument:
SAFE
• Difference between
instruments
• Instrument specific terms
• What is a Term Sheet?
• Key Terms to Understand
• Term Sheet Structure
• Offer Terms
• Compliance Terms
• Shareholding Terms
• General Terms
• Creating Win-Win
• Case Studies
• Equity Term Sheet
• Convertible Notes Term
Sheet
• Q&A

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The Financial Life of a Startup
• Financial Stages of a
Startup
• Founder
• Family, Friends (& Fools)
• Grants & Competitions
• Incubator/Accelerator
• Angel Investor(s)
• Venture Capital Series A
• Growth Capital Series B-Z

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Investment Types
Equity
• Series Seed
• Series A, B, C….
• Ordinary Shares
(Common Stock)
• Preferred Shares
(Preferred Stock)
• Convertible Equity (e.g.
SAFE)
Debt
• Convertible Debt
• Capped Convertible Debt
• Promissory Note
• Secured Promissory Note

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New Alternative Instrument: SAFE
• SAFE = Simple Alternative to Future Equity
• https://www.ycombinator.com/documents/
• Pays off on sale or liquidation
• Converts on a preferred financing
• No minimum trigger
• Valuation cap with/out discount
• Converts into shadow preferred
• No Term, no interest rate
• Return investment or convert at cap on sale
• Unique Features
• Never expires
• IPO – cash out or convert to common at valuation cap

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Difference Between Instruments
Equity
• Establishes company
valuation
• Increases investor control
• Mitigates investor risk
• Dilutes founders
Debt
• Unless capped, defers
Pricing decision
• Less expensive to create
legal documentation
• Faster to negotiate;
• simpler terms
• Usually no board seats
given
• Less certainty for
• investors
• Can affect cash flow

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Instrument Specific Terms
Equity
• Liquidation Preference
• Dividends
• Economic Antidilution &
Registration Rights
• Protective Provisions –
minimum protections
Convertible Debt/Equity
• Maturity/Outside Date
• Conversion
• Conversion on Qualified
Financing
• Definition
• Discount
• Cap
• Liquidation Preferences

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What is a Term Sheet?
• A Term Sheet outlines the material terms and conditions by which
an (Angel) Investor will invest in a Startup Company.
• It acts as a template which, when agreed by both parties, is used
as a reference point to develop a detailed set of legally binding
documents.
• In angel investing, term sheets are given to successful
candidates by a Lead (Angel) Investor once a Syndicate or
Network has agreed to begin the investment process and due
diligence
• The idea is that once the term sheet is agreed and signed, the
only scenario when an investment would not occur is if the
founders have misrepresented the company and this is
uncovered in due diligence.

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Key Terms to Understand
During term sheet negotiations, there are two main elements
that must be considered:
1. Economic conditions refer to the return on investment (ROI) for
investors in a liquidity event.
• Example: Pricing, Valuation (and percentage ownership)
• The company’s valuation, along with the amount of money invested, determines the
percentage of the company the new investors will own. This is one of the most crucial
components of the term sheet, because it has the most direct impact on who owns
what and how much cash each shareholder receives when the company sells. Many
other terms flow from it.
2. Control conditions refer to the mechanisms that allow investors to
influence the strategic direction of the company.
• Example: Board and Information Rights
• Outlines details of who serves on the Board of Directors or as an Observer; also
determines what information you receive from the company and how often you
receive it

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Structure of a Term Sheet
Using the principles of
Economics and Control
Conditions, Term Sheets
can be broken down into a
series of clauses in 4 key
areas:
• Offer Terms
• Compliance Terms
• Shareholding Terms
• General Terms

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Offer Terms - 1
• Closing Date
• Whilst not usually a specific date, this
section implies, as the name suggests,
that once negotiations have concluded
amiably, that both parties are aware of the
next, legally binding steps.
• Investment Amount
• The cash amount being offered by the
Investor in exchange for equity.
• Price Per New Share
• Dictates the price being paid for the equity
being bought by the Investor. This is
usually derived from the capitalization of
the company, which is a table attached to
the term sheet.
• Pre-Money & Post-Money Valuation
• To ensure this valuation is accurate, most
term sheets will insist on defining a fully-
diluted pre-money valuation, as well as a
fully diluted post-money valuation price-
range, depending on the size of the
investment. This is done to provide a
comparison between the valuations, given
the size of the equity reserve, and the
expected multiplier impact of the capital
raise.
• Note!
• The phrase “fully-diluted” means that
the valuation put forward by the
startup company is the price of the
equity stake derived assuming all
possible and outstanding convertible
notes and share options are
exercised.
The Offer Terms lay out the basic framework for the prospective deal, and include some of the most important elements
of the term sheet.

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Offer Terms - 2
• Capitalisation
• This clause requires a fully
prepared Cap Table to
succinctly demonstrate the
capital structure of the
business before and after
the investment.
• Founder(s)
• For legal and business
purposes it is essential both
parties know who is in
charge and the founders are
defined. As clauses such as
“Founder Vesting” will ask
for the founder’s shares to
be locked in for a period of
time so they do not leave the
company soon after the
investment.
• Share Class
• Investors (especially lead or
anchor investors) will usually
expect preference shares,
which entitle them to a
minimum return (unless
otherwise negotiated), and
whose payment in a
liquidation event (sale of the
company) takes priority over
that of ordinary share
dividends.
• Expiration of Term Sheet
• This is a safety measure to
ensure parties cannot retain
term sheets for extended
periods of time and attempt
to re-engage in negotiations
at a later date.
The Offer Terms lay out the basic framework for the prospective deal, and include some of the most important elements
of the term sheet.

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Compliance Terms
Representations, Warranties &
Indemnities
• This clause usually concerns
itself with what the Startup
Company is expected to provide
the Angel Investor(s) with,
including, but not limited to:
• Warranties in relation to capital
structure
• Corporate capacity
• Title
• Intellectual Property Rights
• Tax
• Litigation
• Solvency
• Employment
Conditions to Closing
• This clause sets out the necessary
conditions that must be fulfilled
before a final offer can be put
forward. These include, among
other things:
• Obtaining regulatory approvals
• Satisfactory completion of financial
and legal due diligence
• Key executives entering into
satisfactory employment
agreements
• Requiring the Startup Company
and the shareholders to enter into
a shareholder’s agreement
• Intellectual Property Assignment
agreement to assign all intellectual
property related to the business to
the Startup Company
The Compliance Terms are for ensuring that all parties are on the same page when it comes to the legal and financial
aspects of the business.

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Shareholding Terms - 1
• Board of Directors
• Most lead investors, will request a
seat on a Company’s Board of
Directors so they can add value to
the company and have some
positive influence over decisions
made by the startup, whilst having
some measure of protection over
their investment. It is up to the
entrepreneur to decide how they
wish to establish their board; and
they must constantly weigh up the
potential expertise and value of
their investors and directors.
• Board Matters
• This clause simply stipulates how
often the board must meet.
• Liquidation Preference
• Following pricing, liquidation is the
next most important term to
consider, especially for the
investor. Liquidation preferences
detail how the proceeds of the
business are divided up following
a liquidity event, such as the sale
of the company or a majority of its
assets, or its acquisition where the
shares of the company will be fully
liquidated by the new owners. In
most cases, liquidation preference
pertains only to money invested in
a particular series (or funding
stage), ahead of common shares.
This is another form of reward for
the increased risk taken by early
stage investors.
The Shareholding Terms deal with the control aspect of the business, to ensure both parties are aware of the possible
changes to the company’s board of directors, strategic direction and future decisions.

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• Dividends
• Ensures parties agree on the
rights to dividends for shares.
Generally, most high-growth
early-stage companies do not
pay dividends.
• Anti-Dilution
• Preventive measures
implemented to protect investors
in the event the company issues
equity at a lower valuation than
in previous rounds. Often, a
startup valuation is predicated
on “blue sky” and if this blue sky
proves to be inaccurate or the
founders perform poorly, then
the investors have some
protection.
• Matters requiring Shareholder
approval
• A mandate normally put forward
by the investor as a means to
increase control, which stipulates
that the Company must not,
without consent of an aggregated
super majority of shareholders
perform specific tasks including,
but not limited to:
• Liquidate the company
• Mergers and Acquisitions
• Amend, alter or repeal any
element of the Shareholders
Agreement
• Increase or decrease the size of
the Board

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• Matters requiring Board of
Directors Approval
• This clause is concerned with
decisions that could seriously
impact upon the future of the
company which must receive
approval from the board of
directors. Decisions affected
include, but are not limited to:
• The creation or issuance of new
equity
• Approval of, or alterations to, the
business plan
• Making any investment
inconsistent with any investment
policy approved by the board
• Creating any indebtedness to
other parties over agreed limits
• Hiring, firing or changing of
compensation for senior
executive officers over an agreed
annual compensation rate
• Director & Officer
Indemnification
• Angel investors can request the
Company take extra precautions
by virtue of insurance, to protect
their investment and safeguard
the future of the business.
Director & Officers (D&O)
insurance reimburses the
company for the loss, by death
or accident for example, of any
key senior executive of the
company.
• This also insures against
liabilities incurred by any director
or office of body corporate on
behalf of the Company.

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• Future Rounds
• This clause is concerned with the
ability for shareholders to
participate in subsequent issues of
shares, with access to these
rounds dependent on the
percentage stake in the business.
Sophisticated lead investors will
often ask for special rights to
allocations of shares in future
rounds of funding, to ensure they
can participate and not be diluted
down.
• Redemption Rights
• This clause addresses the right of
investors to sell their shares back
to the company if management
wants to continue running the
company but investors want out.
• Information Rights
• Information Rights define the type
of information the Company is
legally obligated to disclose to
investors, and the time frame in
which it needs to be delivered.
Such information includes, but is
not limited to:
• Annual, quarterly and monthly
financial statements
• Comprehensive annual operating
budgets forecasting revenues,
expenses and cash position on a
month-to-month basis for the
upcoming year
• Access to the company’s premises if
required

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• Founder Shares Buy Back
• This clause sets out how shares
held by the founder(s) can
become eligible to be bought back
by the Company, should the
founders leave the company
prematurely, for illegal behaviour or
misconduct (bad leaver).
• Employee Share Option Plan
• This clause stipulates that the
Founders must hold a reserve of
shares (usually around 10%
issued before the investment) and
offer them to key employees as
reward and incentive. This is
accounted for as a percentage of
the fully diluted capital shares.
• Lock-In Period
• This clause is subject to what is
decided regarding the buy back of
Founder shares, as it is concerned
with the length of time that the
Founders cannot sell their equity
stake in the company after closing
the deal with the angel investor.
This is done to ensure that after
the investor has bought into the
company, the Founders are
committed to maximising profits
and ROI, as they retain equity in
the business.
• Exit
• In the event of a successful exit (as
defined by the Shareholders
Agreement), 100% of the
Founder’s shares will be released
from buy-back rights.

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• Bad Leaver
• In a situation where a founder of the
Company terminates their employment
voluntarily, or is dismissed due to a
legal or contractual breach, then a buy-
back will be enacted.
• However, there is usually some impact
on the valuation of the available
shares, for example, a common Bad
Leaver policy stipulates that vested
shares can be bought back at market
value minus a % discount rate per
share upon negotiation
• Good Leaver
• On the contrary, if a founder leaves the
Company due to acceptable family
matters, death, compulsory retirement,
ill health or disability
• Vesting
• Around 50% of founder’s shares are
often subject to the buy back at a low
value in the case of a bad leaver
• Typically, the other 50% will be
awarded back to the founders over 4
years
• If a founder is a good leaver (i.e. they
leave for family reasons or an
emergency, they will be given 100% of
their shares or it can be bought at
market rate
• If a founder leaves the company for no
good reason they place additional risks
on the investor’s capital and they are a
bad leaver
• If there is a bad leaver, the company
then buys back some of that founder’s
equity in order to recruit replacement
talent

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• Pre-Emption on Transfers
• This clause is usually implemented in
an attempt to limit access that 3rd
parties have to the Company’s shares.
Investors and the Board of Directors
will enforce this rule as a means of
ensuring shareholders that want to
transfer shares to other parties must
offer it to existing shareholders first.
• Before a shareholder is eligible to sell
Company shares to a 3rd party, they
must first offer these shares to current
shareholders on a pro rata basis at the
same price offered to the 3rd party. The
external 3rd party interested in buying
the shares sets the offer price, and if
the current shareholders do not accept
the price, only then will these shares be
available to the 3rd party.
• Drag-Along Rights
• A drag-along right is one that enables a
majority shareholder to force a minority
shareholder to join in the sale of the
company. The majority owner doing the
dragging must give the minority
shareholder the same price, terms and
conditions as any other seller. This is
often set at a threshold of 60-80%.
• Tag-Along Rights
• On the other hand, tag-along rights
enable the minority investors to choose
to follow a sale of shares to a 3rd party,
by a majority of other shareholders, if
they choose. The trigger for this is
often set at around 50% total
shareholding.

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General Terms - 1
• Non-Compete & Non- Solicit
Agreement
• This clause normally targets
Founders and key employees of
the Company, and dictates a
negotiable length of time in which
they are prohibited from selling
similar products and services or
using similar techniques and
business models, either locally or
globally. This is done to protect the
interests of the company against
future damage.
• No Shop & Confidentiality
• This clause is designed to
temporarily prevent the Company
from using an investor’s term
sheet to shop around and find
other investors that will offer better
terms. This is a show of good faith
to the lead investor in regards to
working towards a closing. This
clause will usually include a
mandate to promptly notify the
Investor of any inquiries by 3rd
parties
• Nondisclosure
• This clause stipulates that the
current Founders and employees
must enter into a non-disclosure
and proprietary rights assignment
agreement with the Company in a
form acceptable to the Investor.
General Terms are mostly legal issues and compliance costs and also contain some essential elements of the Term Sheet
that must always be carefully considered!

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General Terms - 2
• Preparation of Legal Documents
• This clause gives an assurance that
the Investor’s legal counsel will
prepare the necessary documentation,
including, but not limited to:
• The Subscription Agreement;
• A new Shareholders Agreement that is
aligned with the term sheet; and
• Any company resolutions to approve the
issue of new shares.
• Governing Laws
• This clause provides the country under
whose laws the agreements will be and
which courts have jurisdiction over it.
• Costs and Expenses
• This clause dictates who is responsible
for any costs and expenses incurred
throughout negotiations. Usually,
negotiations in good faith will see each
party pay for their own expenses and
fees (including legal fees) incurred in
connection with all aspects pertaining
to the negotiation and drafting of the
legal agreements.
• Legally Binding Obligations
• Whilst Term Sheets themselves are
rarely legally binding, this final clause
clarifies the nature of the Term Sheet
and any individual clauses which may
or may not be legally binding. Such
clauses may include:
• No shop and confidentiality
• Costs and expenses
General Terms are mostly legal issues and compliance costs and also contain some essential elements of the Term Sheet
that must always be carefully considered!

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Advice to Founders
• Don’t be aggressive on asking for
a high valuation as this is the #1
killer of investment deals
• Money without connected
investors to help the company
grow is bad money. Look for
smart angel investors that can
add value, get them in early at a
lower valuation and then work
with them to maximise valuation
later
• Investors are investing alongside
you to ensure success so find an
acceptable mid-point between the
raise target, valuation and the
level of ownership you’re willing
to forego
• Ensure you make no
commitments of guaranteed
returns to investors in the event
of liquidation (that is, on top of
any sort of equity financing
agreed upon)
• Always use early stage deal
accountants and lawyers as they
understand the terms of the
current financing rounds and can
introduce you to funding sources
• Founders should maintain a
controlling stake in the business
through multiple rounds of
funding!

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Advice to Angels
• Angel investors take a big risk when investing in startup companies, and
as such, should always ensure you align your interests with the
strategic direction of the company.
• Throughout negotiations, as an angel investor, you should always
keenly seek to ensure
• alignment on desired exit valuation as that may influence the valuation at the
time of investment.
• investors have the appropriate level of protections and controls over the
business such as a Director position and top quality shareholders agreement
prepared by experienced startup investment professionals.
• founders and key members of the team are committed to the Company for the
long term and are constantly adding value to the investment.
• If writing the term sheet price the shares to reflect your risk premium
• If you are participating in a convertible note round, a capped note is best
• SAFEs are not investor friendly
• Debt financing may be viable for some companies

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Creating Win Win
• Be efficient with legal
costs
• use standard forms and
terms
• Avoid customisation
• Consider impact of
economic and control
terms on angels in future
rounds
• Choose terms that create
incentives for founders

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Case Studies
Masterclass Attendees Only
• Equity Term Sheet
• N165M equity raise term sheet
• Convertible Note Term Sheet
• N20M convertible note term sheet

Understanding Term Sheets for Startups

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