Understanding Investor Term Sheets
A Term Sheet is a nonbinding agreement summarising the key deal terms of the funding round. It’s one of the main negotiating tools between founders and investors.
This article explains the core deal terms that are negotiated that will define your round.
These deal terms can shift power in favour of either the investor or founder, so the art of Term Sheet negotiation is getting the balance right to safeguard everyone’s interests but do so in a way that your round closes quickly and efficiently (we’ve seen rounds still open for months, with founders and investors haggling over some totally trivial deal term – that’s not the way to scale your business).
The Term Sheet serves as a summary of the more details investment agreements (the Shareholders Agreement and Articles of Association) in the funding round. And while it’s not legally binding, all investors will typically agree and sign the Term Sheet first, before the remaining agreements are generated.
Although there is a huge range of permutations the deal terms could take, at SeedLegals we’ve seen hundreds negotiated, with the outcomes falling into clearly defined norms – and below you’ll see what’s happening in the vast majority of UK funding rounds.
You can easily create your term sheet on the SeedLegals platform. Sign up free or book a call with a member of the team to learn more.
1. The valuation
The company valuation is simply how much equity is being given away in exchange for the investment amount. Deciding the valuation of an early stage company is often seen to be more of an art than a science, especially if the company is pre-traction or pre-revenue.
At SeedLegals we’ve decoded the factors that underpin early stage startup valuations, creating a quick cheat sheet to decide whether a valuation is in line with similar UK companies.
Our data shows that the mode amount of equity given away each round is 15%, and given that startups will usually raise enough to last the company for a 12-18 month runway, valuation can be extrapolated, and it’s within the norm if it falls within the following brackets (pre-money valuation):
Idea stage: £300k – £500k
Prototype: £300k – £500k
Launched: £500k-1m
Traction: £1m-£2m
Revenue: £1m-£3m
Scale: £3m+
Check out our more detailed article on how to value your startup.
2. Pre-emption rights
At every funding round, existing shareholders are diluted and the percentage of the company they own is reduced. This is because new shares have to be issued to give to new investors. To avoid being diluted, current shareholders may have the right to invest in the company and purchase additional shares prior to shares being made available to external shareholders. The right for them to do this is called a preemption right, and it’s contractualized in the term sheet.
Pro tip: Investors are almost always granted preemption rights in early stage UK funding rounds.
3. Drag, Tag & Co-Sale Rights
These are rights of majority and minority shareholders in different scenarios. Usually in early stage rounds, the investors are minority shareholders, with the founders owning most of the equity – so these are rights designed to represent potentially competing interests.
Drag-along: This provision is designed for when an offer is made to buy the company. If a specified percentage of shareholders want to go ahead, then all shareholders will be forced to sell at that price.
The rationale for this provision is that buyers will be usually looking to buy the company as a whole, and drag along rights helps the company in their dealings with potential buyers by ensuring it is not held hostage by a few shareholders who refuse to sell.
A typical drag along is 75% – so three quarters of shareholders needed (by voting right) to sell the business on behalf of all shareholders.
Tag-along: Inversely, the Tag-along clause protects minority shareholders. In the event of an exit share sale by a majority shareholder, Tag-along extends the sales right to other shareholders, so that they can also sell their shares at the same price as the majority shareholder if they want.
Almost all experienced investors will expect to see these rights in the term sheet.
4. Investor Consent
Investor consent is one of the most contested items on the term sheet.
Since founders are usually the majority shareholders after early stage funding rounds, they generally have free rein to run the company with little external control. However, given that investors have put a large amount of money into the company, Investor Consent gives investors the right to veto certain key decisions.
These decisions include payments and salaries over a certain amount, taking on debts for the company – but they can extend to almost all elements of the company’s business.
In the term sheet, it’s also decided which investors will have Investor Consent e.g. the new investors, the existing investors (and this also might change depending on the class of share they are subscribing to).
Pro tip: Investor consent is extremely rare in friends and family funding rounds. Conversely it’s extremely rare to have no investor consent provisions in angel / VC rounds.
5. Board members
Investors will often ask for a board seat, known as an Investor Director position. Founders need to decide whether or not to allocate investors a seat on the board or not, our data shows that founders end up giving Investor Director positions much more often than they initially planned to.
There are a number of factors that usually influence the appointment of an investor to the board, including whether all shareholders are represented and the value add of the investor’s experience to the board’s proceedings.
Angels:
After an angel round investors will normally have a significant shareholding in the company, and they more often than not will be an ally of the founder. However, if a founder is only giving away a small amount of equity and the chosen director will not provide a lot of value add – then it would not be advisable having them on the board at this time.
Funds and VCs:
Funds and VCs invest larger amounts and want to have more control over a company’s decisions and typically demand a board seat. They have a duty of care towards their investors’ money – so seek to both mitigate risk and ensure maximum return on investment.
Good VCs are experienced – so their expertise is often a welcome addition to the board and are generally aligned with the company – so with this power they can sometimes decide to steer the company in a different direction.
As with all investors – it’s like getting married with no means of divorce – so founders need to do their homework and the more they put into the company, the higher their demands are going to be.
6. Board approvals
Whereas the day-to-day running of the company is left to the CEO and Executive team, for some decisions the board’s approval is needed. In very early stage companies, the board is usually only comprised of the founders and the approval is by default. But in the case that the board is comprised of external people, the term sheet is where it’s outlined what range of activities will need board approval.
Pro tip: Board approval sits below investor consent, so a situation could arise where items are approved by the board, but potentially vetoed by investors with investor consent rights.
7. Preference Shares & Liquidation Preference
There are two main types of share in a startup: Ordinary shares and preference shares.
Simplifying massively the ordinary shares are – well – ordinary. They don’t get special treatment compared with other share types.
Preference shares are treated differently. The two main preferential rights they receive are liquidation preferences and anti-dilution.
A liquidation preference is all about what happens to the proceeds of a startup – be it through an exit sale or a winding up of the company.
If all shareholders own ordinary shares, the total amount raised from the sale is paid back equally to all shareholders, proportional to the number of shares they own.
However, if there are shareholders with preference shares, those investors get their money back first before the ordinary shareholders get paid – and sometimes even get twice or three times the amount they invested before any other shareholders see any proceeds.
Anti-dilution is protection against being diluted by new funding rounds. The most common anti-dilution provisions are around the company raising at a lower valuation for their next round – so their investment value remains the same and as a result their actual % in the company increases.
8. Founder Loans
Founders often put their own money into their business in the early days, as a founder (or director) loan. This is money that can repaid to the founder.
This forms part of the term sheet, which also specifies under which condition it will be repaid. There are several ways of it being treated – repaid now – or from the company’s free cash flow, converting into shares in the round are two such examples.
It can be difficult for a founder to convince an investor to repay their money – but as this money comes tax free – it makes sense for it to form part of the founders payments through the business.
9. Instant Investment
Instant Investment is a structure pioneered by SeedLegals which enables founders to accept a portion of their target raise now, and top up later using the same agreements.
This means that founders can get funds in now and not wait until all of their investors are lined up in the round – as some can join the party later.
A majority of founders on SeedLegals enable this in the Term Sheet to allow them flexibility with their fundraising going forward. It’s important for a founder to negotiate with investors the total amount of potential new investment, and for how long a founder can top up using the facility for.
10. Warranties: Liability Caps & Floors
When you complete a funding round you are making certain guarantees to your investors – for example that the cap table is correct, the business isn’t being sued – that it owns all of its own IP etc.
The Warranties come in if a founder breaks the terms in the investment agreement or fails to disclose some of those things above that might affect an investors willingness to invest.
What is a Warranties liability cap?
A cap is usually set per founder which basically outlines how much they would personally be liable for. It’s customary to cap the liability of the founders to 1x their annual salary – though if the founder isn’t being paid anything yet – then a fixed figure comes in – on SeedLegals normally around £20,000.
What is a Warranties liability floor?
A floor is the opposite of a cap. The cap limits your maximum liability, the floor is the level below which a claim is ignored. For example, if the floor is set to £10,000 and the investors want to make a claim against the company for £5,000, it would be considered too small to bother with, and dropped.