5 Legal Things to Consider Before Signing a Term Sheet

A term sheet is a short letter or memo that outlines the terms upon which an investor will infuse money into your company. It is most often used by VC funds, but more angel groups are using them now as well. The term sheet process is a great opportunity to get to know your investors before you tie the knot. Here are five things you should look for before signing it up.

1. Does it contain the standard terms and conditions?

There are certain terms – valuation, liquidation preferences, blocking rights, board compositions, restrictions on founders’ shares – that we would expect to see addressed in any equity term sheet, often in a standard order and within standard parameters. Even though these terms favor investors over the entrepreneur, you want to see them addressed at the term sheet stage. They are certainly going to be addressed in the final documents when you are much further down the road. It is better to get them on the table now.

2. Is the sheet in standard NVCA format?

In the same vein as point 1, note that VC firms almost universally use a version of the standard National Venture Capital Association term sheet. You can see it at www.NVCA.org (no, I don’t know why a society of VCs gets .org status – seems counterintuitive). You want to see that your investors are using that form, because then the final documents will track those forms as well. It is in your interest to keep the deal terms as standard as possible. It saves legal time and money and also keeps you and all your current and future investors on the same page. Drafting of legal documents is the one place in the entrepreneurial process where creativity is a negative.

3. What type of anti-dilution formula is being proposed?

Anti-dilution protection means that if you sell shares to an investor at a certain price, and you later sell to another investor at a lower price, the first investor gets the benefit of that lower price, and effectively gets additional shares to make up the difference. The issue is that there are two different formulae for calculating how many new shares the first investor gets. One formula (“full ratchet”) simply reprices all of the first investor’s shares at the lower price, no matter how many shares you sold at the lower prices. So if you first sold a million shares at a $3 million valuation, and a few months later sold a hundred shares at half that, for a $1.5 million valuation, the first investor gets an extra million shares. The second formula (“weighted average”) takes into account how many shares were actually sold at the lower price and gives the first investor far fewer new shares. The take-away for you is that if the first draft of the term sheet proposes a full ratchet anti-dilution preference, you have just learned something about your potential investor, haven’t you? So be warned.

4. Check your employment and vesting provisions.

You are an entrepreneur, but once you get investors, you are an employee as well, albeit at the C-level. It’s flattering that someone thinks enough of you to invest in you. The flip side, though, is that the investor needs for you to stay, and will make it painful for you if you leave. One way an investor disincents you from losing interest and leaving is to make it clear that you will forfeit all or some of your stock if you do leave. Some of the forfeiture terms and circumstances are the most hotly negotiated terms in the term sheet and the final documents. Focus on them now, setting the ground rules and the tenor right from the start.

5. Make sure you can stand your investor.

I’ve worked on thousands and thousands of pages of venture deal documents all containing hundreds of clauses, terms, protections and provisions. But more important than the documents is the ability of the entrepreneur and the lead investors to communicate effectively. Your lead investor is the person who pushes you along and keeps the pressure on, but should also be the person you can turn to for advice and, sometimes, reassurance. The rule of thumb to entrepreneurs, is this: If you couldn’t stand to sit down and have a drink with your lead investor, you should think long and hard before you take the money. Because all those carefully negotiated and constructed legal documents won’t help you build the company if you can’t get the ideas and the money on the same page.

Richard E. Honen is a partner with Phillips Lytle LLP. He focuses his practice in banking, corporate and venture capital law, and commercial litigation. He provides corporate counsel to a broad spectrum of companies with a particular emphasis on emerging growth and startup companies. He can be reached at [email protected] should you have any questions.

Editor ‘s Note: The 43North team is tapping into key sponsors, like Phillips Lytle LLP, to offer up tips for entrepreneurs and startups.