The most important clauses of the VC term sheet, explained

The VC term sheet is daunting for most entrepreneurs. The variety of different clauses and the legal jargon in which they’re presented can confuse even the smartest and most experienced entrepreneurs. Each VC has a different style, preferred deal structure, and set of specific terms that are important to them. In addition, each interaction between an entrepreneur and VC is governed by a different set of dynamics, which depend largely on the relative negotiating positions of each party. What are the entrepreneur’s other funding options, and if they have other options, how much do they really want to work with a particular VC because of the value add that they bring to the table? How much does the VC really believe in this specific entrepreneur, and how willing would they be to back another entrepreneur building a similar business if the terms were better?

These are just some of the questions whose answers influence the progress of term sheet discussions. However, despite the uncertainty surrounding the final form of each clause in the ultimate term sheet, certain terms carry much greater weight than others. More specifically, most VC’s agree that the most critical terms are those of valuation, right of first refusal, and liquidation preference. The composition of the board is also important, but much more so for later stage startups that have an established business and management team than seed startups where the management team is the business. Let me now explain each of these terms in greater detail.
The most critical term, that of valuation, is also the simplest. It essentially comes down to how much of the startup the VC’s investment acquires. For example, if the startup is valued at $4M prior to a $1M investment, we say that the pre-money (before investment) valuation is $4M, and the post-money (after investment) valuation is $4M + $1M = $5M. The VC therefore acquires $1M / $5M = 20% of the business in exchange for their investment. Just make sure to think about valuation and the resulting ownership in terms of the percentage of the startup’s shares that each party owns, rather than the absolute number of shares that a party has. Owning 1M shares is meaningless if you don’t specify whether the startup has 10M shares outstanding, in which case you have 10% ownership, or 100M shares outstanding, in which case you only have 1% ownership. There are also other financial instruments outside of equity, like convertible debt and options, which are commonly seen in VC term sheets. As an entrepreneur, your goal should be to determine the ownership stake of each party in the event that all of the financial instruments become equity. We call this your fully-diluted ownership. For example, this would include converting debt into equity and exercising options in the case of convertible debt and options respectively. Since your fully-diluted ownership stake depends on assumptions about the future conditions at which the conversions occur, it’s useful to build a few scenarios with a probability attached to each.
Another key term is the right of first refusal, which I covered in detail in an earlier post: Entrepreneurs and investors win when existing investors participate in future rounds. This term gives existing investors the right to participate in follow-on rounds, to the extent necessary to maintain their original ownership stake, at the same terms as new investors. It’s very important for investors, and especially early stage investors, because it gives them the opportunity to share in the future upside of a startup which they supported in an earlier round when other investors were not comfortable with its associated risks. The clause supports the economics of VC investments in general and early stage investments in particular. The right of first refusal is also beneficial for entrepreneurs as it signals to new investors that existing investors still believe in the startup. Existing investors have an informational advantage about the past history and hence future prospects of a startup, so their participation in the next round helps attract new investors.

The next key term is the liquidation preference. This essentially determines how a startup’s proceeds are split among the equity owners in the event of a cash distribution. For example, a 1X liquidation preference is designed so that, when a cash distribution occurs, the investor recoups their original investment before other equity owners, including the founders, start receiving cash. A 1X liquidation preference is necessary because, in its absence, a startup could simply take the cash from an investment, distribute it among the owners according to their percentage stake, and leave the business. As an example, consider a $1M investment at a $5M post-money valuation in which case the VC has 20% of the business. Since the startup now has $1M in cash, in the absence of a 1X liquidation preference, the entrepreneur could distribute 20% of the cash, or $200K, to the VC, take the remaining $800K, and leave. While the 1X liquidation preference is necessary to prevent such an outcome, a higher liquidation preference can be dangerous. For example, in the case of a 2X liquidation preference, the investor recoups twice their original investment before other equity owners start being compensated. This can encourage the entrepreneur to take unnecessary risks and swing for the fences in the attempt to create an outcome where there is sufficient money left on the table after the investor has been handsomely rewarded. The bottom line is that a 1X liquidation preference is necessary but a higher figure does more harm than good.

The final important term is regarding board composition. The board’s only decision making responsibility is to determine whether or not to continue with the existing CEO. Beyond hiring and firing the CEO, each of the board’s other roles are supportive, not executive, in nature. For example, the board offers advice for the startup’s strategy, but the CEO is ultimately responsible for deciding which course of action to take and executing in that direction. Since the board’s only executive role is to hire and fire the CEO, seed startups don’t need a formal board structure. The entrepreneur is the business at the seed stage so if a seed investor wants to fire the CEO, they shouldn’t invest in the startup in the first place. Board membership becomes more important for VC’s investing in later stage startups where replacing the CEO and other members of the management team may be necessary to support the startup’s transition from the early stages of creative growth to the later stages of operational growth.

This is by no means an exhaustive list of the terms that you’ll face in a VC term sheet. Although you should prioritize valuation, the right of first refusal, and liquidation preference for all startups, and also consider board composition for later stage startups, I recommend that you understand each term in detail before agreeing to a term sheet. Most important, don’t be afraid to ask a question if you don’t know what something means or why a particular clause has been included. Once you boil them down to their core, each of the terms should have a simple explanation and specific set of future outcomes which justify their inclusion. If, after digging in, a term is still too complex to understand, it’s probably not because you’re stupid but because it shouldn’t be on the term sheet.