Term sheet
⚡TL;DR
- A term sheet is (usually) non-binding. However, it is an important document as it is the basis of the future agreements of the financing rounds.
- Always start negotiating with a term sheet that includes all key terms from the beginning.
A term sheet is a (mainly) non-binding document between the company and the investors (or at least with the main investor). This document outlines the key terms and conditions of the investment, providing a preliminary agreement that sets the stage for later negotiations.
The term sheet is non-binding, meaning that it cannot be enforced as such. However, it plays an important role in the negotiation.
This is an important document as it lays the basis for the future Investment Agreement and Shareholders' Agreement (SHA).
Governance
- Board representation:
- Decide whether the investors get a board seat. It could be one per investor or one representative for all investors.
- Best practice during seed rounds is to give the lead investor the right to appoint a board member. This also benefits the company by increasing investor responsibility.
- Avoid granting "board observer" rights, as this limits investor involvement, making them passive participants.
- Veto rights:
- At the board level: Some investors might request the introduction of the concept of "Important Board Matters", which can in some cases mean that the express consent of an investor being a board member is required for specific questions. Founders sometimes forget that investors have no incentive to block a company because they have 'skin in the game' in a high amount. They usually won't block something unless they genuinely think it's a bad idea.
- At the shareholder level: Investors usually have smaller percentages than founders. To compensate for that, they are in some cases given the right to veto some decisions. In practice, we see the following:
- Change of the purpose of the company, because they invested in a specific project.
- Change of seat outside of Switzerland, because some organizational rules such as fund rules forbidding investment outside of Switzerland.
- Change of preferential rights shares, because it could mean that someone will be higher than them in the hierarchy. This usually requires a 2/3 shareholders majority.
- Information rights:
- Investors value clear reporting and long-term vision, and VCs say that good startups distinguish themselves by being able to produce the report asked by the VCs.
- To handle potential conflicts related to information rights, consider a purchase option allowing shareholders to buy out an investor involved with a competitor. However, this can be difficult to monitor and enforce due to vague definitions of competitive activities.
Money
- Valuation: Read this article to dive deeper into the distinction between pre-money and post-money valuations and avoid the valuation trap. It is important to be clear on these concepts as this will define how many shares the investor gets for their investment.
- Protection:
- Liquidation Preference: Investors with preferred shares get paid first during an exit or liquidation. This operates like a waterfall—other shareholders are only paid after investors' claims are fully satisfied. Read more details on our Investment Agreement page.
- Anti-Dilution: When new shareholders join, existing shareholders' ownership percentages decrease. Indeed, if A owns 100% of the company and B buys 5% in a financing round, A no longer owns 100% even though A still owns the same number of shares. Legally, each shareholder has the right but not the obligation to maintain their share if they are willing to pay for it, meaning to participate in each capital increase (Bezugsrecht / droit de souscription). Additionally, anti-dilution adjustments can be agreed upon, typically using a formula to protect investors from being economically diluted in future lower-value rounds.
Transfer Restrictions
- Right of First Refusal:
- If a shareholder wants to sell their shares, they must first offer them to the other shareholders under the same terms. Only if the other shareholders choose not to buy, can the shares be sold to someone else.
- Purchase Option:
- Purpose of Purchase Option: It serves two main functions: (1) penalizing certain behaviours (like criminal acts or being a 'bad leaver') and (2) preventing shares from being transferred to a third party in cases like a shareholder's death.
- Control Over Shareholder Structure: If a "trigger event" occurs, existing shareholders can buy the shares to maintain control of the company.
- Pricing Based on Event: The purchase price depends on the situation—either fair market value or nominal value for serious misconduct, like a crime against the company. "Nominal value" is usually lower than "fair market value".
- Tag Along:
- The tag along right protects the minority shareholders.
- If a shareholder sells a large portion of shares (e.g., more than 50%), other shareholders can demand the buyer purchase their shares as well, on the same terms. If the buyer refuses, the initial shareholder cannot complete the sale.
- Drag Along
- The drag along right protects the majority shareholder (or a group of shareholders) holding (typically) more than 50% if they want to sell their shares.
- These majority shareholders can require minority shareholders to sell their shares when they sell theirs. This ensures that 100% of the company is sold in such a deal.
Founders vesting
Founders are key people for a company. As such they need to be incentivized to stay with the company for as long as possible. Additionally, having "dead equity" that is owned by an ex-founder who left the company is a red flag for investors.
Therefore, the term sheet, and the subsequent shareholders agreement, usually include a founders vesting clause. Under this mechanism, the founders can keep their equity as long as they are still active in the company. If they leave before a given time, some of their shares will be forfeited.
A common term for early-stage companies where founders have been working prior to the financing round is that the founders get 12 months of vesting credit at closing and that the rest vest over 36 months.
Best practices
Dead equity: A founders' vesting and a purchase options are in place to avoid having dead equity with founders who left the company.
Liquidation preference: The liquidation preference topic is discussed and negotiated in the term sheet.
Board member: The lead investor is granted the right to appoint a board member.
Shareholders' agreement: Transfer restrictions are implemented in the Shareholders' Agreement (SHA).
The term sheet is the starting point of the negotiations with investors. It should include the key terms highlighted above.
This is important because, as time progresses toward the final documentation, the negotiation power will shift toward the investors as the company will need the money. Therefore, having a term sheet that sets forth the key elements of the deal from the beginning acts as a support to keep the deal balanced and in line with what was envisioned at first.