What does a successful equity financing actually look like? If your deal goes well, you’ll (1) agree on a term sheet that both the investor and the company will sign, and then if you still like each other, you’ll (2) create the whole bundle of financing documents, many of which will be signed by both the company and investor. This set of documents may consist of 10 documents, and altogether these financing documents amount to 100+ pages. There’s just a lot of paper. The term sheet, on the other hand, is usually 10 pages or less. The purpose of the term sheet is to foreshadow the investment terms of the 100+ pages to come. If the company and investor can’t agree on the term sheet, then there’s no point in drawing up the full set of documents.

Even in the term sheet, though, there can be dozens of terms. The standard Fidelity term sheet for a Series A financing, for example, has 38 terms. In a short negotiation process, it would be hopeless to attempt to focus on every last one of these 38 terms. Thankfully, there are some terms that are worth the time, energy, and legal spend to be thoughtful about, whereas others are generally non-controversial. Strategizing around which terms are important is half the game. Read on for a breakdown of which terms may be worthy of your attention.

Economic Terms (aka the Money Part of the Term Sheet)

These terms lay out the very basic elements of the financing: who is investing, how much is each person investing, how many shares does that get them, and what is the total amount of money being raised in the financing?

TERM: Target Amount for [Insert Series X]

• The target amount is important because it allows the investor to determine if they’re a big fish or a small fish. Let’s say a VC is thinking of investing $1,000,000 and wants to be the lead investor. They’ll look at the “target amount” to see where they would end up in the pecking order. If you’re raising $20,000,000, their investment would only be 1/20th of your total investment. Their investment would be relatively low in the overall investment context and they would have little control over the direction of the company. If the “target amount” is $2 million, on the other hand, then everything changes. This would make their $1,000,000 half the investment. They would have quite a lot of control as the lead investor. You see how it all hinges on the “target amount.”

• The amount of money you’re raising also signals what’s ahead for the company. The flurry of work that happens after a $2,000,000 investment is a lot different than the flurry of work that happens after a $20,000,000 investment. Investors would also expect company milestones at very different scales depending on the target amount (e.g., numbers of people hired, sales goals, and revenue goals).

TERM: Price per Share of [Insert Series X] aka The [Insert Series X] Original Purchase Price

• The price per share is the result of a great deal of negotiation around your company’s valuation. It's meaning is self-evident, and it's a key term that many other terms rely on (for example, the multiplier in the “liquidation preference” term).

TERM: Pre-Money Valuation

• This term will say something like,“The [Insert Series X] Original Purchase Price is based upon a fully-diluted pre-money valuation of $1,000,000 and a fully diluted post-money valuation of $2,000,000 (including an employee pool representing 4.972 % of the fully diluted post-money capitalization).”

• This matters because if you think the investor said they were investing $1,000,000 on a pre-money valuation of $10,000,000 when he actually said he was investing $1,000,000 on a post-money valuation of $10,000,000, then you thought he was saying his $1,000,000 investment buys 9.1% of your company, when it in fact buys 10% of your company—a whole 0.9% more.

TERM: Option Pool

• The employee option pool is critical. The size of the pool and whether any increase to it occurs before the investment (pre-money) or after the investment (post-money) can have a dramatic impact on the equity stake of existing stockholders, including founders. Essentially, the more shares everyone else has, the less you as a founder have. If you own a pie, and you give a fourth to investors, then you own just 3/4ths. But if the investor says they want to get a fourth after a fourth is allocated to the stock incentive plan, then you only have a half a pie left at the end of the day. For more about this, please see our dilution blog post, which explains this further.

TERM: Pro Forma Capitalization Table

• This will just be the cap table as it will look if the financing that’s being proposed in the term sheet actually happened and the investors got all of their shares. This helps investors get a handle on how big of a piece of a pie they have (are you seeing a trend here?). This will also reiterate the size of the option pool.

Rights of the Preferred Investors (aka Why It’s a Good Life Being a Preferred Holder!)

Much of the term sheet is not about controlling the company today as much as it is about making sure the investors have some sort of control when a sale (Amazon wants to buy you, for example) or another investment round comes knocking. These terms lay out what happens in these future circumstances.

TERM: Liquidation Preference

• This term will spell out what happens in a “liquidation event.” What is a liquidation event? A merger, sale, IPO, or shutting down the company are the most common types of liquidation events.

• Let’s take the sale as an example: say a year from now Amazon buys your company for $10,000,000. The “liquidation preference” term lays out how that sum of $10,000,000 gets distributed.

• Typically, the most recent investors in your company are paid out first (Series B, before Series A, before Common shareholders). A liquidation preference multiplier determines the return rate for the preferred holders and participation rights determines whether and how they will also receive a portion of the remaining proceeds. If your investor negotiates a 1x multiplier with full participation, they will be returned the same amount as their investment, plus a percentage of the distribution to Common stockholders.  

• The liquidation preferences can make the investment more appealing to your investor by possibly offering downside protection and opportunities for a larger payout, but you should be certain you understand how it will play out in various exit scenarios. For more details on what different types of liquidation preferences might look like, read our detailed blog post on the subject.

TERM: Anti-Dilution Provisions

• This term protects existing investors if the company has a down round. A down round is where a subsequent round of investment has a lower price per share than a previous round. If you look in the actual financing documents the anti-dilution provision has a complicated mathematical formula with a range of options, but I’m going to skip the formulas/options and give a simplified example instead.

• Let’s say your Series A investors paid $1 per share. Investor Bob specifically puts $500,000 down, and at $1 a share, this buys him a total of 500,000 shares.

• Next the Series B investors come along. This is not a normal Series B. The company isn’t doing so well and this is a down-round, i.e., the price for the shares has fallen. The Series B investors come along and pay $0.50 per share. The same $500,000 gets Sally the investor 1,000,000 preferred shares.

• If you have anti-dilution provisions in place, the price for the earlier round would be adjusted in this simplified example to the new price of $0.50 per share. This means the Series A Bob investor gets 1,000,000 shares for the same price that previously got him 500,000.

• Caveat: Bob doesn’t automatically double his Series A shares, he gets the most shares for his money in the liquidation event when all shares are converted to common. In other words, it is the conversion ratio of the preferred stock that is adjusted—how many common shares the investor will get for each share of preferred stock—and the Series A doesn’t get the anti-dilution benefit the moment Series B gets a cheap price. The Series A gets the benefit of the anti-dilution clause in the end when the money is finally getting divided up (or his shares are converted into common).

TERM: Pay-to-Play

• This term encourages an investor in the current round to invest in a later round. If they do not, then their preferred shares are automatically converted to common shares instead.

• Meet Bob. Bob has invested in Acme’s Series A. When the Series B comes around, Acme begs him to invest, but he doesn’t really feel like it, or believe in the company that much. He already has some preferred shares in Acme (the Series A), and he doesn’t really want more (the Series B). He refuses to invest. Potential Series B investors are scared to invest because if Bob doesn’t think it’s worth investing again, then why should they? Maybe Acme is a losing company? And maybe it feels wrong to the new investors that Bob still gets preferential treatment when he no longer wants to invest in the company? They are scared away and the investment falls through.

• However, if there’s a pay-to-play term, everything changes. If Bob refuses to invest in the Series B, then he LOSES his status as a preferred stockholder. His Series A preferred shares will automatically become common shares. See this blog article on why preferred shares are, well, preferred over common shares for investors. Bob wants to keep at least some preferred shares in Acme so he’ll also invest in the Series B.

TERM: Conversions

• There are two types of conversions: (a) Optional Conversion, and (b) Mandatory Conversion. Optional Conversion simply allows the investor to exchange its preferred stock for common stock at any time based on the specified conversion rate. Mandatory Conversion is where the shareholders have agreed ahead of time when the preferred stock will automatically be exchanged for common stock.

• Mandatory Conversion is usually triggered on an initial public offering (IPO) where the offering price has reached a target amount, or is triggered by the approval of a minimum percentage of the preferred investors, and these triggers allow the investors to assure themselves of a specific return on their investment. A mandatory conversion can also force a level playing field in situations where the majority but not all investors would benefit from having their preferred stock be converted to common, such as in a particular merger, and so the majority imposes conversion on the minority who may not want it.

• While the investors care a lot about the conversion terms, the company is usually agnostic about them so they aren’t often negotiated.

Terms Giving the VC Board Members and Shareholders Additional Power/Controls

These provisions are a smattering of miscellaneous important provisions that have one thing in common: if you as a founder don’t understand them, then you’ll be surprised how much control a venture capital firm can have over your company thanks to these terms.

TERM: List of Board of Directors

• A main investor will probably put at least one person from their firm on your board. If you have multiple rounds, you might end up with multiple board members from VCs. These are the board members that will determine the future of your company. Board members have to approve stock grants to employees, and to you, for example. And that’s not all—there’s usually a “matters requiring investor director approval” clause making sure their approval is required for critical company decisions. Read on!

TERM: Matters Requiring Investor Director Approval

• This section will actually list things that you can’t do with just the board of directors’ approval anymore. Now you must have not just the usual board approval, but specifically the investor director’s approval. Things that may require the investor director’s approval include hiring and firing executives, entering new lines of business, and entering in collaboration with other companies.

TERM: Board Matters

• Usually this term tells you that the board member the Series X investor just put on the board has to be on committees, the board has to meet quarterly, and the company will obtain Directors and Officers insurance.

TERM: Protective Provisions

• Not only will you have terms saying the board must be involved in big issues, and the board must include an investor board member, you’ll also have terms saying that the new owners of the Series X stock (shareholders) must be involved in big decisions. Usually they’ll have to vote yes on things like: liquidating or merging the company, issuing another class of preferred stock (i.e. the Series B have to vote to agree on you offering an investor a Series C equity financing), and increasing or decreasing the size of the board of directors (if the VC has 2 board seats on a 3 person board, they always have the majority and they’d likely want to be able to prevent the company from making it a 10 person board where they lose their majority). Increasing the Stock Incentive Plan shares or common shares usually also requires shareholder consent from the Series X shareholders, because this would dilute the VC.

Registration Rights

Registration rights allow the investors to force the company to register its shares with the SEC, which is required before shares can be sold publicly. Although these rights take almost a full page in most term sheets, it’s usually standard terms that are never mentioned or changed in the term sheet negotiation. I just mention them to ward off the misconception some founders have, which is if they take up so much paper, they must be important enough to waste negotiating time on them.

Terms That are Binding Even if the Financing is Never Completed

Most terms in the term sheet are NOT binding even if the term sheet is signed, as long as no official financing documents are signed afterwards. For example, if an investor says they will invest $1,000,000 in your company in the term sheet and signs the term sheet, this isn’t binding until the official Stock Purchase Agreement and Board Consent are signed. They don’t have to give you $1,000,000 after just signing the term sheet.

However, there are some terms that are binding even though the financing agreements (the Stock Purchase Agreement and associated documents) are never signed. These are possibly the most important terms in the term sheet, because if things turn sideways and you don’t sign the final deal, these terms could still bind you and constrict how you move on. You may find yourself paying the legal fees for how much it cost the lawyer to create and negotiate the unused financing documents and unable to talk to other investors for four weeks, for example. The typical surviving terms will be the “no shop/confidentiality” section and the “counsel” section (aka the “expenses” section).

TERM: No Shop/Confidentiality

• The founders have to keep the terms secret (except the founders can tell their lawyers/financing people/board), unless they get the investor’s permission to spread the terms. The company also agrees not to go out and try to seek other deals for the next four weeks. Some term sheets will also specify that if the company does another deal within the “no shop” period, they have to pay the investor a specified amount as damages.

TERM: Counsel/Expenses

• Typically, this term states that the company is going to pay all of the legal and other miscellaneous fees associated with negotiating this deal, even if the deal doesn’t go through, with an exception that the company doesn’t have to pay if the investors walk away without a good reason for doing so. The startup company is expected to pay not only for their own Company Counsel but also for the Investor’s Counsel.

• Although this term might seem unusual to a first time founder, it’s pretty standard. But it’s important to understand so you budget for this. Investor counsel can get pretty expensive, and since you don’t manage them (your investor does), you have no control over what sort of work they’re doing (which directly translates to what kind of fees they’re generating). For this reason, some financings will have a cap on the legal fees to be paid by the company.

This summary is just a brief introduction that helps explain the key terms in a term sheet to founders, but no company should be navigating these terms alone. Just as investors have their attorneys, so too should a startup have its own attorney. However, if a startup knows the basics before they embark on fundraising, it can make the process significantly easier in managing their lawyer and negotiating with investors.

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Third parties and Fidelity are not affiliated. Sample scenarios are for illustrative purposes only. Fidelity does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation.

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