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Term Sheet Anatomy

Preferred Stock Term Sheet

A term sheet is typically a non-binding document that is either an offer from a prospective investor, or a proposal from a company seeking financing. For an equity investment, the term sheet typically describes the terms for the sale of Preferred stock — in other words, stock that has certain rights beyond the rights of the holders of Common stock.

A term sheet for Preferred stock will typically include:

  1. The amount being raised
  2. The pre-money valuation of the company
  3. The number of shares to be sold and the price
  4. The post-financing capitalization (capitalization table)
  5. The special rights associated with the Preferred stock
  6. The information rights associated with the Preferred stock
  7. Registration rights
  8. Requirement for an employee stock option plan
  9. Board of Directors composition (an angel-round term sheet may not include this)
  10. Legal expenses

An example of a term sheet for a venture capital round is included in our Downloads area. A term sheet for an angel round will include many of the same provisions.

Special Rights

Special rights may include features such as:

  • Dividends: language that states that Preferred shareholders are entitled to dividends if dividends are declared by the company’s Board of Directors in preference to Common shareholders
  • Liquidation preference: in the case of a liquidation or acquisition of the company, the liquidation preference describes what preferential treatment Preferred shares receive over Common shares. For example, from the proceeds of an acquisition, Preferred shareholders might receive the total amount of their investment (or even some multiple of that) before any funds are distributed to Common shareholders. All, of course, is subject to negotiation.
  • Anti-dilution Protection: This language protects the angel investor if the company sells stock to some other entity at a lower price than the price paid by the angel investor. There are usually carve-outs (exceptions) such as stock issued under the company’s stock option plan. A high level of protection for investors is the “full ratchet” wherein the investor receives the same low-price that the other entity received. Other (more company-favored) approaches would weight the adjustment. For example, if stock is sold at a lower price, but only a very few shares are sold at that price, then management would favor a formula that “weights” the transaction appropriately as per the proportion the lower-price stock represents of the total stock in the company. The result would be very little impact on the investor’s shares if just a few shares of stock are sold to another entity at a very low price.
  • Protective Provisions: These provisions basically give a veto to Preferred shareholder for major corporate transactions such as mergers and acquisitions or for the issuing of stock that has rights superior to those of the current investors.


Information Rights

The term sheet will state what information the company is required to provide to the angel investor. Typical requirements would be monthly, quarterly, and annual financial statements.


Registration Rights

Registration rights typically state that the Preferred shares, when converted to Common, will be considered to be “Registrable Securities” that can be registered to be sold on the public market in the event the company has a public offering. In some cases, term sheets provide that investors will have the right to force a public registration of stock (a requirement that management usually disfavors.)


Board of Directors

The term sheet may specify how the members of the Board of Directors is to be selected. Although this is more commonly seen in a term sheet from a venture capital firm, it may be part of an angel investment also.  Alternatively, the term sheet may call for an angel investor to have the right have observer rights on the Board of Directors (the right to attend meetings and receive Board materials, but without the right to vote.)


Stock Option Plan

The term sheet may require the company to either create a stock option pool or increase the size of the pool, if it already exists, prior to the investment occurring. The reason is that if the stock option pool is created or increased in size after the investment, then that act dilutes both the management team and the investors. By requiring the company to create or enlarge the stock option pool prior to the financing, the management team’s stock is diluted, but thee investor’s stock is not.

If the company has already created a stock option pool, then the question becomes: is the pool large enough to meet the company’s hiring needs from that point in time up until the next anticipated financing (when there may be another adjustment made to the pool).


Legal Expenses

The term sheet will specify who is responsible for paying the legal fees involved in the preparation and filing of the legal documents that are required to implement the investment. This will typically include the cost of:

  • Updating and refiling the Articles of Incorporation
  • Creating a Stock Purchase Agreement and an Investor Rights Agreement
  • Preparation of the stock certificates

In venture capital investments (but generally not angel investments) the company may be required to reimburse the investors for legal expenses up to some cap amount.