What does a Series A term sheet look like?

Takeaway: Term sheets are generally 1-3 page documents that outline the major terms of a financing, which include valuation, investment amount, liquidation preference, board structure, and various other investor rights. The NVCA puts out a standard term sheet that is often used as a starting point.

As a startup founder, securing a Series A investment can be a significant milestone in your company's growth journey. The term sheet is a critical document in the fundraising process that outlines the terms and conditions of the proposed investment. While not legally binding, it serves as a basis for further negotiations and the drafting of definitive legal agreements. In this post, we will explore the key components of a Series A term sheet and provide an overview of what founders can expect during this process.

Valuation and Investment Amount

One of the most important aspects of a Series A term sheet is the valuation of the company. This can be expressed in terms of pre-money valuation (the value of the company before the investment) and post-money valuation (the value of the company after the investment). The term sheet will also specify the total investment amount being offered by the investors.

Liquidation Preference

Liquidation preference is a key term that determines the payout order in the event of a liquidation event, such as an acquisition, merger, or IPO. Preferred stockholders (Series A investors) often receive a liquidation preference, which ensures they are paid before common stockholders (usually founders and employees) in a liquidity event. This preference can be structured as a multiple of the initial investment (e.g., 1x, 2x) or as a percentage of the proceeds and can be either participating or non-participating. Most deals are structured as 1x non-participating, which means the investors get the better of (i) 1x their money back before the common stockholders or (ii) the amount they would receive if they converted all of their preferred stock to common stock before the sale of the company.

Dividends

Dividends are payments made to stockholders as a return on their investment. The term sheet may specify whether dividends are to be paid to preferred stockholders and at what rate. Dividends can be cumulative (accruing over time if not paid) or non-cumulative (not accruing if not paid). In most cases, dividends are non-cumulative and do not actually get declared by the Board or paid to the investors.

Conversion Rights

Conversion rights allow preferred stockholders to convert their preferred shares into common shares, usually on a one-to-one basis. This can be particularly important in the event of an exit, as it allows investors to participate in the upside if the common stock value exceeds the preferred stock value. The term sheet will outline the conditions under which investors can exercise their conversion rights.

Anti-Dilution Provisions

Anti-dilution provisions protect investors from having their ownership stake diluted in subsequent financing rounds. The term sheet may include provisions for weighted-average anti-dilution or full-ratchet anti-dilution. Broad based, weighted-average anti-dilution adjusts the conversion price based on the price and size of the new financing round, while full-ratchet anti-dilution adjusts the conversion price to the lowest price per share issued in the new round. Broad based, weighted-average anti-dilution is much more common and results in less dilution for existing stockholders.

Board of Directors and Protective Provisions

Series A investors often negotiate for representation on the company's board of directors. The term sheet will outline the composition of the board, including the number of investor-appointed directors, founder-appointed directors, and independent directors. Additionally, the term sheet may include protective provisions that grant investors certain veto rights over major corporate decisions, such as issuing new shares, altering the company's capital structure, or entering into significant transactions.

Pre-emptive Rights and Right of First Refusal

Pre-emptive rights give existing investors the right to participate in future financing rounds to maintain their ownership percentage. The term sheet will outline the conditions under which investors can exercise these rights. Additionally, investors may negotiate for a right of first refusal, which allows them the first opportunity to purchase any shares being sold by other stockholders, usually on the same terms offered to a third party buyer.

Drag-Along Rights

Drag-along rights enable a group of stockholders (usually a majority of the common stock and a majority of the preferred stock) to require the other stockholders to sell their shares in an acquisition. This ensures that majority stockholders can sell the entire company without being blocked by minority stockholders. The term sheet will outline the conditions and procedures for exercising drag-along rights.

Legal Fees and Expenses

The term sheet may also specify the allocation of legal fees and expenses associated with the Series A financing. Typically, the company is responsible for its legal expenses and also the investors’ legal expenses, up to a negotiated cap.

Conclusion

A Series A term sheet is a crucial document that sets the foundation for a successful fundraising process. By understanding the key terms and provisions included in a term sheet, founders can better negotiate with investors and secure favorable terms for their company. While the fundraising process can be complex and challenging, a well-structured term sheet can pave the way for a strong partnership between founders and investors, ultimately contributing to the long-term success and growth of the startup.