Venture Capital Term Sheet (VC)

VC Term Sheet Definition

The VC term sheet is a non-binding legal document that forms the basis of more enduring and legally binding documents, such as the Stock Purchase Agreement and Voting Agreement.

Although short-lived, the VC term sheet’s main purpose is to lay out the initial specifics of a VC investment such as the valuation, dollar amount raised, class of shares, investor rights and investor protection clauses.

The VC term sheet will then flow into the VC capitalization table, which is essentially a numerical representation of the preferred investor ownership specified in the term sheet.

Guide to The VC Capitalization Table

Funding Rounds in Venture Capital (VC)

A VC term sheet is created at each investment round, which is usually designated by a letter:

Historically, deal counts tend to favor earlier stage investments as shown below. In the last few years, however, there has been a noticeable move towards deals of larger magnitude.

Deal Count by Size (Source: PitchBook)

As you would expect, the average deal sizes are significantly larger for later-stage investments, but early-VC investments have been trending up across the board.

Median Valuations by Stage (Source: PitchBook)

Pros / Cons of Fundraising

From the perspective of an entrepreneur and existing investors, there are several advantages and disadvantages of raising outside capital.

We have listed some of the most important considerations in the table below.

VC Capital Raising Timeline

While time to investment can vary from a few weeks to a few years, the venture capital timeline for an early-stage company has six discrete steps:

• 1) Start-up Formation: formulation of the idea, core team hiring, intellectual property filings, MVP
• 2) Investor Pitch: “roadshow” marketing of start-up, feedback on the idea, the start of diligence
• 3) Investor Decision: the continuation of due-diligence, final investor pitch, venture partner decision
• 4) Term Sheet Negotiation: deal terms, valuation, cap table modeling
• 5) Documentation: complete due-diligence, legal documentation, government filings
• 6) Sign, Close and Fund: fund, budget and build

Setting the Stage Between Investor and Entrepreneur

The investor and entrepreneur have different objectives that will play out in any term sheet negotiation.

Investor Objectives

• Maximize the financial return of each investment while mitigating risk
• Govern the portfolio company’s financial and strategic decisions (i.e. have a seat at the table)
• Provide additional capital if the investment is progressing well
• Obtain liquidity through eventual sale or IPO
• Return a high rate of return on their fund and leverage success to raise an additional fund

Entrepreneur Objectives

• Prove the validity of the business idea
• Raise funds to operate the business with more flexibility
• Maintain majority control of the company while sharing some risk with financial backers
• Establish operational success for the company
• Lead to the next stage or repeat the start-up process with a new venture

Potential Sources of Conflict

As a result, the potential sources of conflict, which will be negotiated in a term sheet, include:

• Valuation: What is the worth of the business today?
• Definition of Success: What does success look like in the future?
• Control Rights: Who has control of the company’s future?
• Time to Achieve an Outcome: How long will it take to monetize their VC investment (i.e. IPO, M&A)?
• Share of Returns: How will proceeds be split between the investor(s) and the management?

VC Term Sheet Example 

So what does a VC Term Sheet actually look like?

In this section, we are going to break down the 7 common sections of a VC Term Sheet. Before we do though, it’s helpful to actually see what a few actually look like:

Sample VC Term Sheet. Source: YCombinator

Breaking Down Key Sections of the VC Term Sheet

We’re now ready to analyze the key sections of the typical VC Term Sheet.

1) Offering Terms

The offering terms section includes the closing date, investor names, amount raised, the price per share and pre-money valuation.

The offering terms section establishes a new class of Preferred Investor (generally named after the round like Series A Preferred, with certain rights (e.g. dividends, investment protection & liquidation rights) that supersede those of common shareholders.

2) Charter

The charter shows the dividend policy, liquidation preference, protective provisions, and pay to play provisions

1. Dividend Policy: clarifies the amount, timing and cumulative nature of dividends
2. Liquidation Preference: represents the amount the company must pay at exit (after secured debt, trade creditors, and other company obligations). The liquidation preference is perhaps one of the most important clauses found in a term sheet. While most entrepreneurs focus on the valuation, the VC focuses on the structure of the liquidation preference.  Read about how Liquidation Preferences work here.
3. Anti-Dilution Protection: protection for VCs in case of a down round, so that their conversion ratio to common stays equal to new investors
4. Pay to Play Provision: preferred shareholders lose anti-dilution protection unless they invest in the next round at a lower price (“down round”); normally preferred will automatically convert to common in such a case

3) Stock Purchase Agreement (“SPA”)

The SPA includes initial clauses on reps & warranties, foreign investment regulatory stipulations and legal counsel designation for the eventual Stock Purchase Agreement.

4) Investor Rights

The investor rights section highlights registration rights, lock-up provision, information rights, right to participate in future rounds, and employee stock option specifics

1. Registration Rights: right to register shares with SEC so that investors can sell on the public market
2. Lock-up Provision: establishes the timing limitations for sale in case of an IPO
3. Information Rights: right for preferred shareholders to get a copy of quarterly and annual financials
4. Right to Participate: existing investors have the right to buy shares offered in subsequent financing rounds
5. Employee Option Pool: the percentage of stock reserved for key employees (existing and new hires) and timing of vesting of the options

5) Right of First Refusal / Co-Sale Agreement

The right of first refusal (ROFR) provision gives the company and/or the investor the option to purchase shares being sold by any shareholder before any other 3rd party.

A co-sale agreement provides a group of shareholders the right to sell their shares when another group does so (and under the same conditions).

6) Voting Agreement

Establishes the future Voting Agreement, with callouts of Board composition and drag-along rights

1. Composition of Board of Directors: usually a mix of founders, VCs, and outside advisors (~4-6 people on average)
2. Drag Along Rights: all shareholders must sell if the board and/or majority shareholders approve

7) Other

Other terms could include a no shop/confidentiality clause, the term sheet’s expiration date, and a copy of the pro-forma cap table.