A term sheet is a non-binding document that lays out the proposed terms and conditions under which an investor will make an equity investment in a company. Essentially, a term sheet sets out the key points of a potential deal – a framework for negotiating the final agreement. The contents and clauses of the term sheet vary from transaction to transaction. The main aspects of a term sheet are outlined as follows:
- Pre-Money vs. Post-Money Valuation
- Preferred vs Common stock:Common stock is the most common type of stock issued and entitles shareholders to share in the company’s profits through dividends and/or capital appreciation. Common stockholders are usually given voting rights, with the number of votes directly related to the number of shares owned and have “preemptive rights” to maintain the same proportion of ownership in the company over time. If the company circulates another offering of stock, shareholders can purchase as much stock as it takes to keep their ownership comparable. On the other hand, preferred stock does not have voting rights, as common stockholders do, but they have a greater claim to the company’s assets. Preferred stock shareholders receive their dividends before common stockholders and these payments tend to be higher. Shareholders of preferred stock receive fixed, regular dividend payments for a specified period of time, unlike the variable dividend payments sometimes offered to common stockholders.
- Pro-Rata Rights provide investors the right to participate in future rounds in order to prevent ownership from being further diluted.
- Anti-Dilution Clause refers to how future investments will dilute the ownership of existing investors, including the owners. Sophisticated investors will typically require an anti-dilution clause to protect them from future rounds at a lower value.
- Right of First Refusal is a provision in the term sheet that permits investors to accept (or refuse) the purchase of equity shares offered by the company, before third parties have access to the deal. So when considering future capital raises, any existing investor with right of first refusal gets to decide whether they would like to participate in the round before the offer is opened up to outside investors.
- Drag Along right enables a majority shareholder to require a minority shareholder to join in the sale of a company in order to ensure investors and founders will have full power in the sale of the company.
- Option Pool represents the amount of stock set aside for different reasons, including compensation for employees as an incentive to attract and retain talent. Usually, 10% is reserved for the option pool.
- Liquidation Preference entitles investors to receive, upon company liquidation, the return of the amount of capital invested at a minimum (1x). This helps reassure investors of possible business failures and protects their capital investment. Investors may additionally have the option to convert their preferred to common shares, thus allowing them to receive their percentage ownership payout in cash.