1. Reviewing Investor Term Sheets: What You Need to Know
Radhika Raman & Kady Bruce
Boston University School of Law
Startup Law Clinic

2. It’s a contract, but it does not represent a legal promise to invest.
Outlines key terms of deal between VC and startup.
First step in the transaction, material terms are negotiated and agreed to.
More detail is better – helps lawyers draft actual documents in the future.
Most focus on deal.
Legal documents follow and are based on term sheet.
Stock purchase agreement, investors rights agreement, amendment to certificate of incorporation, ROFR & co-sale agreement, and voting agreement.
What is a term sheet?
Terms sheets are AKA = “Letter of Intent,” “Memorandum of Understanding,” “Agreement in Principle” A term sheet is a nonbinding agreement setting forth the basic terms and conditions under which an investment will be made. A term sheet serves as a template to develop more detailed legal documents.

3. Is a term sheet legally binding?
The term sheet is subject to the actual legal documents, due diligence, legal counsel, and other closing conditions. Parties usually explicitly state the term sheet is not legally binding.
But, if deal goes through, the deal terms match the term sheet.
Look to tenets of contract law and intent of the parties
Confidentiality – the startup cannot disclose even the existence of the term sheet.
Exclusivity – the startup cannot shop the deal around for a period of time (usually 1-2 months).
What parts are most commonly legally binding?
A term sheet WILL be legally binding if the parties state that it is legally binding. So be careful with how you word this. The only reason term sheets aren’t usually binding is because the parties explicitly say they aren’t binding. But if the parties do decide to make it binding, they’re free to write that into the term sheet (assuming all other reqs for an enforceable contract are there, such as definitive terms of offer).

4. Common for the only binding part of a term sheet to be a restriction that you don’t talk with other investors for some period of time after you sign the term sheet.
Reasonable because the VC is going to be paying lawyers to draft documents and perform due diligence on your company.
Be sure the time period is not too long – 30 to 45 days is plenty of time to finalize a VC investment in almost all cases.
Exclusivity

5. Types of early stage financing deals
Seed financing:
Convertible notes – structured initially as loans that are intended to become equity.
Series seed or Series AA – six-figure Angel or friends/family investments; generally not VC firms.
Series A – first significant round of VC financing.
Name refers to the class of preferred stock sold to investors in exchange for their investment.
Series B – second round of financing for a business through any type of investment including private equity investors and VC.
Traditional usage in the venture community considers a "Series A" or "real Series A" to be a substantial round of preferred stock financing, typically of $1-5 million, led by VCs rather than angels. Six-figure angel or friends-and-family deals are more commonly referred to as a "seed round," "Series AA," etc

6. Convertible notes How does the debt become equity?
Debt sits above equity in the “capital stack”.
Converts from debt to equity when certain events occur – usually upon a “qualified financing” (an equity financing of a certain size)
When should I use a convertible note?
General advice - $500k or less, use convertible notes
Consider future financing needs – if you’ll need more money, do a stock deal or build in a conversion of the notes at maturity
Delaying valuation – convertible notes allow you to treat smaller investment money fairly by delaying valuation
A convertible note is an investment vehicle often used by seed investors investing in startups who wish to delay establishing a valuation for that startup until a later round of funding or milestone. Convertible notes are structured as loans with the intention of converting to equity.
The primary advantage of issuing convertible notes is that it does not force the issuer and investors to determine the value of the company when there really might not be much to base a valuation on – in some cases the company may just be an idea. That valuation will usually be determined during the Series A financing, when there are more data points off which to base a valuation

7. Series A – Convertible Preferred Stock
What is convertible preferred stock?
Convertible = includes an option for the holder to convert the preferred shares into a fixed number of common shares, usually any time after a predetermined date.
Preferred = Sits behind debt (even convertible debt), ahead of common stock on dividends, distributions, liquidation, and redemption.
Value of convertible preferred stock is ultimately based on common stock’s performance.
When should I use convertible preferred stock?
If you can negotiate a substantial valuation at the seed round.
If you don't mind the extra legal expense of this transaction over a convertible note round.
Caution – the investor will own a part of your company, and may want to exercise control via board seats, veto power, forced sale, etc.
COMMON = VOTING RIGHTS
Preferred shareholders receive an almost guaranteed dividend; however, dividends for preferred shareholders do not grow at the same rate as they do for common shareholders. In bad times, preferred shareholders are covered, but in good times, they do not benefit from increased dividends or share price. This is the trade-off. Convertible preferred stock provides a solution to this problem. In exchange for a lower dividend, convertible preferred stock gives shareholders the ability to participate in share price appreciation.
At a certain price, convertible preferred stock can be converted to common shares. This price is called the conversion ratio. The conversion ratio is set by the company before the stock is issued. Convertible preferred shares priced at $100, with a conversion ratio of five, have a conversion price equal to the share price divided by the conversion ratio, or $20. This means the common share price needs to trade higher than $20 for the investor to gain value from the conversion.

8. Valuation
Pre-money valuation = the company's agreed-upon worth before new money is invested
Post-money valuation = pre-money valuation + the amount invested
Option = rights to buy shares of common stock in the future at a set price.
Pool = number of shares of common stock that you have reserved for options or other equity comp.
Restricted Stock Grant = an employer offers you shares of the company but places limitations on your ability to access or monetize the stock
Reserve stock to compensate and motivate existing and future employees.
Granted to employees, consultants, advisors, board members.

9. Pop Quiz! Pre-money valuation
An investor comes to you and says, “I’ll invest $5 million at a pre-money valuation of $10 million.”
What percentage of your company would the investor own after investing?
A: 33%
B: 50%
C: Stop quizzing me.

10. Calculating Ownership %
An investor comes to you and says, “I’ll invest $5 million at a pre-money valuation of $10 million.”
A. 33%
INVESTOR OWNERSHIP % = INVESTMENT AMOUNT ________________________________ PRE-MONEY VALUATION + INVESTMENT AMOUNT
O/S = outstanding
(% sold = % sold to new investor)

11. By the Numbers: Shares vs. Percentage
Remember: the number of shares you hold only tells half the story.
Warren Buffet – owns 350,000 shares of Berkshire Hathaway = 33.1% of company (1,060,000 total shares in company)
Google – 350,000 shares of Google = 0.1% of company (324,890,000)
An investor might ask: “If my money is buying me shares, then how many shares do I get, and what percentage of the company will I own right after my investment?”
Know your numbers!
Be careful of optics – for Warren Buffet, 33.1% of company sounds a lot better, for Google, 350,000 shares sounds a lot better.
By the Numbers: Shares vs. Percentage

12. Liquidation preference
Specify which investors get paid first and how much they get paid in the event of a liquidation event, such as the sale of the company.
When distributing liquidation proceeds, preferred stock has right to get a certain amount of money back before the common stock gets anything (the “preference.”)
Liquidation preference  - determines the payout order in case of a corporate liquidation.
Model out expected exit values so you understand the actual dollar differences between the liquidation preference formulas. 
Terms in Series A can carry over to Series B and beyond, so be careful what you agree to! This carry-over can be used as leverage in negotiations.
Defines the return that an investor receives in a sale of the company, and it can have a significant impact on the founder’s return. 
Liquidation preference

13. Types of liquidation preference
Multiples – 1X, 2X, etc. of investment amount if liquidation event occurs.
Accruing dividends – like adding an interest rate component to the preference (ex: 4% extra if liquidation event occurs in Q3).
“Preference overhang” = total amount of liquidation proceeds that go to the holders of preferred stock before the holders of the common stock begin to share in the liquidation proceeds.

14. Types of liquidation preference II
Non-participating preferred – preferred gets amount equal to the initial investment plus accrued and unpaid dividends upon a liquidation event.
Capped participating preferred – limits the amount received by the preferred stock to a fixed amount.
Uncapped participating preferred – preferred stock gets paid before common stock; no limit.
Remember that terms can carry over!
First part add on: Holders of common stock then receive the remaining assets.
Second part add on: Once fixed amount is met, preferred and common stock is treated the same.
Example for last one:
Example : a “participating preferred” for a small seed round might not result in a meaningful extra return for investor at exit (at least in absolute dollar numbers), but will be painful to founders if all future rounds include participating preferred stock.

15. Liquidation preference hypothetical
$5 million Series A investment at $20 million pre-money valuation (investors own 20%).
Company is sold for $40 million with no additional shares issued post-investment.

16. 3 Examples: No Liquidation Multiplier
Non-participating preferred
-Series A gets the greater of $5m preference or what they would receive if they converted to common stock (i.e., 20% of $40m, or $8m). Result: $8m goes to the Series A (20%); $32m goes to the common stock holders (80%)
Participating Preferred with a 2X Cap
– Series A gets $5m preference plus 20% of the remaining $35m up to a total 2X cap ($10m). Result: $10m goes to the Series A (25%); $30m goes to the common stock holders (75%)
Participating Preferred; no cap
-Series A gets $5m preference plus 20% of the remaining $35m, or $7m. Result: $12m goes to the Series A (30%); $28m goes to the common stock holders (70%)

17. What will the term sheet say?
In the event of any liquidation, dissolution or winding up of the Company, the proceeds shall be paid as follows:
Alternative 1 (Non-Participating Preferred Stock): “First pay the Original Purchase Price on each share of Series A Preferred. Thereafter, the balance of any proceeds shall be distributed pro rata to holders of Common Stock.”
Alternative 2 (Participating Preferred Stock with Cap): “First pay the Original Purchase Price on each share of Series A Preferred. Thereafter, Series A Preferred participates with Common Stock on an as-converted basis until the holders of Series A Preferred receive an aggregate of [two] times the Original Purchase Price.”
Alternative 3 (Participating Preferred Stock): “First pay the Original Purchase Price on each share of Series A Preferred. Thereafter, the Series A Preferred participates with the Common Stock on an as- converted basis.”
What will the term sheet say?

18. Important. Have discussion with VC about board makeup
Important! Have discussion with VC about board makeup. Be on the same page. Bigger isn’t always better.
Control of the Board can also affect the thinking on other issues, such as vesting.
Usually a preferred stock investor requires one or more board seats
Typical post-investment = three person board with one investor representative and two founders as representatives of the common stock.
Can have one+ independent directors (directors that don’t hold equity and don’t have any other material interest in company).
Can have a “board observer” rather than a board seat.
Rule of thumb for early-stage boards = investor’s and common holder’s representation on board should reflect the relative control of the cap table.
Board of directors

19. Protective provisions
Typical for investors to have a set of “protective provisions” (aka “veto rights”, “negative covenants”, “blocking rights”) over specified corporate actions.
Essentially a list of things the company can’t do without investors’ consent.
Ex: Veto right on declaration of dividends, modification of rights of stock issued to investors, veto rights on future financings or sales of company.
Hotly contested! Can be complicated.
Ex: “no creation of a new series of stock without our approval.”
Ex: “no amendments to the certificate of incorporation without our approval.”
These amount to saying “no financings without our approval.”
Examine relevant thresholds closely, and discuss with lawyer or other advisor.

20. Founder vesting Review and understand from the founder’s perspective.
Important things to understand are:
(i) When does vesting commence?
(ii) Does vesting accelerate upon termination without cause?
(iii) Does vesting accelerate (in whole or in part) upon a change of control or upon a termination of employment without cause within some period of time after (and sometimes before) a change of control (so-called “double trigger” acceleration)?
Radhika
Good to tell the audience that our clinic did a presentation on founder equity the previous week, and those slides are on our website.

21. Antidilution protection
Changes the conversion price used to calculate the number of shares of common stock issued when a share of preferred stock converts.
Protects investors in a future “down round” - when new money is invested at a pre-$ valuation (or price per share) that is lower than the previous round’s post-$ valuation.
Most VC deals have some form of antidilution protection to protect the VC from future sales of preferred stock at a lower valuation.
Types:
Full ratchet: conversion ratio shifts so that all investor shares now convert at the lowest per share valuation used in a subsequent round.
Weighted average : conversion ratio shifts so that we calculate a new price that drives investor’s down closer to the down round price, but less than on a full ratchet basis.
Antidilution protection
Weighted: Formulas available on NVCA website for calculating
Full ratchet vs weighted average – investors would actually prefer full ratchet – they get more shares/higher percentage if there’s a down round
Full ratchet – give a basic example. If Series A is $10/share, and Series B is $8/share, then Series A investor gets more equity based on lower share price.

22. The option pool shuffle
Investors may try to add option pool into pre-money valuation
What you hear: “I’m willing to invest $2 million on an $8 million pre-money valuation.”
BUT, the term sheet might say, “The $8 million pre-money valuation includes an option pool equal to 20% of the post-financing fully diluted capitalization.”
Both are accurate, but the option pool lowers your effective valuation!
What the investor is really saying: “Your company is worth $6M. But let’s create $2M worth of new options, add that to the value of your company, and call the sum your $8M ‘pre-money valuation’.”
$6M effective valuation + $2M new options + $2M cash = $10M post
The option pool shuffle
Fully-diluted = total number of outstanding shares remaining if all convertible securities were converted to common stock.
O/S = outstanding
(% sold = % sold to new investor)

23. How can inclusion of an option pool change the per share price?
Hypo: 6 million shares outstanding, $2 million investment
What you hear: “I’m willing to invest $2 million on an $8 million pre-money valuation.”
$8M pre-money ÷ 6M existing shares = $1.33/share
Term sheet says: “The $8 million pre-money valuation includes an option pool equal to 20% of the post-financing fully diluted capitalization.”
$8M pre ÷ (6M existing shares + 2M new options) = $1/share
O/S = outstanding
(% sold = % sold to new investor)

24. Pop quiz! : Option pools
Which option is better for the founders? 01
Pre-money valuation of $11 million, a $5 million investment, and a 20% post-money option pool 02

25. Option Pool Quiz Answered
Answer: Option 1 is better because the outstanding common stock is valued higher due to a smaller post-money option pool.

26. Co-sale (“tag along”) rights – contractual obligations used to protect a minority shareholder, usually in a venture capital deal.
Right of first refusal (ROFR) – Ability to purchase shares for sale by founders/management (and sometimes also other investors), before anyone else can.
Drag along rights – Enables a majority shareholder to force a minority shareholder to join in the sale of a company.
Pay-to-play – Investors can force each other to invest in future rounds.
Pre-emptive rights – Gives investor the right to maintain their % ownership of company by buying a proportionate number of shares of any future issue of the security.
Other key terms
Tag Along Right gives minority shareholders of the company the right to be tagged on the same terms and conditions with the majority shareholders in case majority shareholders are selling their stake to a third party. In other words, if the majority shareholders of the company have decided to sell their stake then the minority shareholders can use this right to get tagged with the majority shareholders and sell their stake on the same terms and conditions as well. Tag Along right becomes important for minority shareholders so that they can sell their stake along with the majority shareholders and they will not have to be forced to work with the new partner without their willingness

27. Example Term Sheet

28. Negotiating Tips Know your priorities Find common ground
Understand the VC/investor perspective
When in doubt, ask questions and research
Remember what is and isn’t binding
Negotiating Tips

29. Thank You! Law Clinic at: https://sites.bu
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