Term Sheets can be really scary for new startup founders; the biggest fear being not knowing the clauses that are used in it or the possibility of wrongly interpreting the terms involved. There is a high chance that you may not be able to negotiate from a position of strength if you are not aware of exactly what the term sheet is offering you. This being said, it doesn’t necessarily has to be complex. The key is knowing what to expect, knowing what you want out of a term sheet, knowing what you won’t bend to, and of course having good representation to review all of the fine print involved in it. In this article, I intend to cover some of the clauses that might be a slight bump in the road to successful negotiation. By understanding them, you can avoid some of the pitfalls involved and come out on top with most of the information needed to succeed. But before diving into clauses let us take a look at what exactly is a term sheet.

Term Sheet

‍‍A term sheet is a non-binding, bullet point document highlighting terms and conditions under which the investor will invest. It details what you as the start-up are giving, and what you are getting in return for the sacrifice made. Then it lays out the guidelines of how both parties will act to protect the investment. After its execution, it guides the legal counsel in preparation of final agreement. It’s found to be one of the most challenging aspects of fund raising.

Below are some things to pay attention to when you are presented with a term sheet in front of you.

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Liquidation preference

‍‍‍‍The term sheet involves clauses that state; in the event of liquidation; in what order the concerned parties will be paid. Suppose you are an investor entitled to 1x liquidation preference. Then it means that you will get the preference over common shareholders to get 1x of your initial investment back in the event of liquidation. Similarly, a 3x preference would raise the hurdle too thrice the investment that you made initially. For values lower than the initial investment of the preferential investor it provides a safety net by extracting all the returns, leaving common shareholders with no return  

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Anti-Dilution provisions ‍

‍‍In the case of a “Down Round” the company is forced to offer additional shares at a price lower than what was being sold at in the previous financing round. This happens when the company runs out of financing and needs to raise finance and discovers in the process that their valuation has fallen down as compared to the previous round of financing.  Due to this event it leads to dilution of ownership stake of investors thus reducing their strategic influence over the company.  To mitigate these risks they can insert anti-dilution clauses that will readjust their stake if the need arises. Main methods used to apply this are:
‍Weighted Average- This accounts for all equity previously issued and currently undergoing issue, taking into account both price and magnitude of new issuance. The company will then adjust the value of preferred shares to a new weighted average price in subsequent rounds of financing using the method.  
‍Full Ratchet- The term refers to a contractual provision designed to protect the interests of early investors (anti-dilution provision) for any shares of common stock sold by a company after the issuing of an option (or convertible security), applies  the lowest sale price as being the adjusted option price or conversion ratio for existing shareholders. It considers only effect of new price. This is actually an extreme and uncommon measure. Thus , from the above two descriptions its clear that weighted average measure is more founder friendly as it takes into consideration more factors over full ratchet method. Also, application of Full Ratchet can actually result in investors increasing their ownership percentage. This is because a Full Ratchet will trigger a repricing of all the clause-holders’ shares, even if just one new share is priced at a value below theirs.

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Super Pro-rata Rights

‍Pro-Rata rights is an option and not an obligation given to initial investors to invest in future rounds so that they can maintain their stake (in %) which otherwise gets diluted. This gives them certain benefits which they can exercise if they feel that the startup is achieving success and be rewarded for their initial faith in the business.  Super Pro-Rata rights on the other hand gives them the right to increase their stake (in %) in further rounds of financing Why is that bad? The simple answer is that those super pro-rata rights might scare off other investors and make it difficult for you to get funding in the next round. If the existing investors exercise this right, they leave no room for new investors as not enough equity is left but if they don’t exercise their right; the fact that he isn’t stepping up for more than his existing ownership despite having the right to do so is one big red flag for new investors, which may lead to the share price taking a hit. Try to negotiate from this as there is a huge possibility that this may cause problems further ahead.
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Option Pool‍

‍‍It involves setting aside shares reserved for employees of a private company. Employees who get into the startup early usually receive greater percentage of option pool then the ones who arrived later on. With this, an important question that pops up is that are they included in pre or post money valuation? If term sheet states that the pre money valuation includes option pool valued of its post money fully diluted capitalization, then in this case the pool option is funded by owners before seed round occurs. This is done to decrease price per share. VC’s thus have a legitimate interest in specifying an option pool and taking it into account in pricing the round. Rather, it should be that option pool is created post financing which results in new and old shareholders sharing delusion in their respective shares. So a good approach is to try to figure out a realistic number for the option pool (given founder’s specific hiring plans), agree on that, and then negotiate price both the parties think is fair, with that option pool as a given. If you start with the valuation and then think about the option pool, someone is going to feel ripped off.