Term sheets are an important, if not crucial, part of any investment negotiation. While most of the terms aren’t binding, they can provide security (and sometimes headaches!) for both founders and funders as the process continues.
This means term sheets are important to get right. Because when they’re not done properly, they can turn toxic – for both parties.
When it comes to avoiding toxic term sheets, knowledge is power. But unfortunately, there is an obvious information asymmetry between some types of investors and pre-seed founders.
In many cases, pre-seed VCs, SEIS funds and angel networks will have done hundreds of deals, they’ll potentially have a lawyer as part of the team, and they’ll know how to push investment terms to the limit. On the other hand, founders will often have very limited resources for legal support, may never have raised money via equity funding before and be desperate for the cash.
On the bright side, if you are raising under SEIS/EIS then the legislation surrounding these schemes prevents investors from making use of some of the most ‘founder unfriendly terms’ (more on those below).
To help avoiding things turning toxic, we’ve created a Q&A on the most commonly asked questions about term sheets. I hope that this article helps address the imbalance by empowering founders with the knowledge they need to understand what an exploitative term sheet looks like and what is ‘market standard’.
Hat tip to Martin Barnes for the devil picture. Also, Andrew Scott and Michael Jackson for inspiring this article with their posts.
As always, if you have any questions – shout!
NOTE: For the purpose of this article we are ignoring valuation, which might seem odd but valuation is a commercial negotiation that you’ll have with any type of investor. Sure, if someone is offering you £50k for half of your business, then it’s probably not a great deal (looking at you, Dragons!). However, it’s easy to test if your valuation is normal for your sector / stage by reference to Beauhurst, the Berkus method and numerous other methods.
Q. The basics: what is a term sheet?
A term sheet is a short document – usually 4 or 5 pages - that summarises the key deal terms and is designed to be much more accessible than the formal documents of a funding round, which usually add up to more than 100 pages of dense legalese.
As such, the term sheet can be considered a commercial rather than a contractual tool, because it:
- Serves no enduring or useful legal function.
- Has (mostly) no legally binding impact.
- Doesn’t oblige an investor to invest or a Founder to accept the investment.
So, if it’s not contractual, you might ask… why does it exist? Here are three key reasons:
- Speed and focus: Distilling 100+ pages into 4 or 5 pages speeds up negotiations and focuses attention on the ‘interesting’ stuff without being bogged down by detail.
- Aids alignment: Aims for alignment between founder and investor(s), i.e., what company will the investment be in, how much, what valuation etc., and serves as an anchor for both parties as the process continues.
- Signals intent: From the founder’s side, it demonstrates you are genuinely ready to take on investment and have made yourselves ‘investor ready’. From the investor’s side, signing a term sheet is a sign of commitment to a funding round. While it’s not binding, and lots can still go wrong, it’s a clear statement of intention and it would be hard for either investor or founder to go back and renegotiate something that has already been agreed in principle in the term sheet.
Back in the bad old days, you’d want to agree to all of the interesting details before you throw £10k at a lawyer to take the term sheet and turn it into Subscription and Shareholders Agreement, Articles etc. Of course, with FounderCatalyst these other documents are created at the same time as the term sheet anyway, with no additional time or cost implications.
Q. Who produces the term sheet?
In early-stage deals where angel investors are participating, the term sheet (along with the documents that implement the deal, as summarised in the term sheet - the articles of association and investment agreement / shareholders agreement) are usually produced by the founder(s) on behalf of the investee.
For later-stage deals, where investment is coming from venture capital (or some SEIS/EIS funds, even), these documents will be created by the lead investor for you (and your legal team) to review and negotiate.
Some angel groups and SEIS/EIS funds may provide an investment offer letter, which is the equivalent of a term sheet produced by an investor rather than an investee, detailing their terms.
Q. What makes up the contents of a term sheet?
For simplicity, we can break a term sheet into three different elements:
- Facts - this would typically include the legal entity the investment would be made in, the founders of the business, whether the investment is SEIS or EIS compatible and the current cap table. By their very nature, these facts aren't up for negotiation.
- Boilerplate - typically, these are the legally binding elements we discussed earlier - confidentiality obligations, no third-party rights, jurisdiction and similar clauses. Some sections of the boilerplate (such as confidentiality, jurisdiction, third-party rights) are legally binding. However, neither the founders nor investors should be legally obliged to proceed with the anticipated transaction once the term sheet is signed.
- Deal economics - valuation, expected raise amount, minimum ticket size and any authority to issue further shares in an 'agile' round will be detailed here.
- Negotiable items - these are the material elements of the proposed investment, where founders and investors will spend their time negotiating. We cover these key deal terms throughout the rest of this article, and we have split these negotiable items into two separate categories: those compatible with SEIS/EIS and those that aren't.
Q. Is a Term Sheet more Founder-Friendly or Investor-Friendly?
Generally, the terms that we mention below are a zero-sum game - a ‘win’ for an Investor, a gaining of a right or protection, is a ‘loss’ for the investee, where they lose flexibility or a right themselves.
Sometimes, terms are ‘founder friendly’ - they give relatively weak rights and protections to investors…and sometimes it’s the opposite.
Q. What about different share classes, how do they fit in?
To cut to the chase, at an early stage of a business’ life it’s usual to issue Ordinary shares in your company to shareholders, founders and investors alike. This is partly because a different class of share with enhanced rights is unlikely to be eligible for S/EIS relief. In very rare circumstances, we’ve seen investors holding a share class without voting rights, but most investors are unlikely to accept that arrangement.
There are two main reasons why you may need to move away from ordinary shares:
To vary the ‘prescribed particulars’. Shares can benefit from the following three specific rights:
Voting rights: the right to participate in a vote of the members. It’s worth keeping in mind that greater than 50% / 75% are sufficient to pass an ordinary and special resolution, respectively – and therefore greater than 50% / 25% are sufficient to block those resolutions, too.
Dividend rights: the right to receive, or not, a dividend from distributable reserves.
Capital rights: the right to receive part of the proceeds from an exit. In standard cases, every shareholder will receive a payment pro-rata to their shareholding. In some instances, an investor will hold a “liquidation preference”, which could mean that they benefit disproportionately to their percentage shareholding.
To carve out a right, protection or consent for a specific investor. For example, if a specific investor negotiates to have consent rights specifically related to them rather than all investors, they may have ‘A Ordinary’ shares and attach the consents to this share class specifically.
94% of all FounderCatalyst customers just issue Ordinary shares to shareholders, founders and investors alike.
Q. Has there been an impact from the downturn?
Broadly speaking, we’ve not seen any change in terms in most groups due to the change in economic circumstances. Angels seem to be more sensitive to valuation, and investors are generally doing a little more due diligence, but that’s about it.
Well, that is, apart from VCs - they have additional levers to pull, and we are seeing the anti-dilution and liquidation preference terms being amended to be (even more) investor friendly.
Q. Are there a set of standard ‘solo’ angel investor terms I can expect?
You’ve fundraised the hard way: met a substantial number of angel investors and negotiated and corralled them into investing.
EVERY vaguely sophisticated investor is going to require the following standard rights and protections:
- Pre-emption rights - the right (but not obligation) of existing shareholders to maintain their proportional ownership in a company when new shares are issued.
- Drag / Tag - Drag-along rights allow majority shareholders to require minority shareholders to sell their shares along with them in the event of a company sale, ensuring a unified sale process. Tag-along rights, on the other hand, protect minority shareholders by granting them the option to sell their shares on the same terms as the majority shareholder if the majority shareholder decides to sell their stake.
- Customary undertakings - specific commitments made by the founders of a company as part of a shareholders' or founders' agreement. These undertakings outline the responsibilities, obligations and restrictions imposed on the founders to provide rights and protections for investors.
- Warranties - statements or assurances made by the founders of a company regarding the accuracy, condition, or legal status of certain aspects of the business.
- Restrictive covenants - provisions that impose certain limitations and restrictions on the actions and activities of the founders, both during their involvement with the company and after they cease to be a shareholder or leave the company. These covenants are designed to protect the company's interests and prevent potential conflicts of interest or competition.
These may feel onerous, but they are about as founder friendly as things get.
It is worth mentioning that most future investors will take the pre-existing set of rights and protections in your shareholder documents and add a few more for good measure.
Q. What terms are typically associated with a standard angel network investment?
Before we see some horrors, let’s take a look at a normal set of terms from a reasonable Private Equity Club (“Club”) or angel network. This investment group may have a legal person who helps with negotiations and will probably have their ‘standard terms’ in the form of an investment offer letter. Oh, and it’s worth noting that they also have the benefit of investing a (usually) larger investment amount that gives them a bit more negotiating clout.
It’s also worth noting that the fee structures for these groups are very variable:
- A fee to get you pitch ready. Fairly rare, but this is a thing.
- A fee to pitch.
- A fee (payable from the investee to the Club), typically calculated as 5% of the investment, from the Club members.
In addition, Clubs will also potentially earn via:
- Member fees: £200 or so per member, as an example.
- Charge a 10% outcome-based fee ("carry") from members - ie if a member invests £10k and the business exits and returns the investor £100k, then the Club will be paid £9k (10% of the £90k profit) by the Club member.
Then again, some groups - for example the amazing Milton Keynes Investor Group, are 100% free.
Anyway, to the terms:
- Investor Director or Board Observer position, so long as the Club members hold, say, >5% shareholding in the company. This won’t usually be chargeable to the investee company.
- Information Rights. An obligation to provide routine (usually monthly or quarterly) updates on the company’s progress to investors. More than 90% of our founders choose to include information rights in their paperwork.
- Investor Consents around certain key actions. For example, issuing new shares, changing the company’s articles of association, liquidating the business, etc - there are usually 30 or so individual consents. It’s typical for consents to require 50% of investors to approve an action before the company can implement it . Keep in mind that this is an investor consent, so the 50% excludes votes from founders and other non-investor shareholders. 58% of our customers include some kind of consents in their legal paperwork.
- Identical ‘Ordinary’ shares for investors and founders with equal voting, dividend and capital rights.
- A restriction on founder share transfers.
- IP Assignments from founders to the company. This is a letter confirming that specific intellectual property rights have been assigned from the founding team into the company. The reason for this is fairly obvious, but thankfully Adam Neumann gives a great example to why investors are firm on this kind of thing.
- Founder share vesting over a period of, say, 3 years.
These may look weighty – and compared with just taking investment directly from angel investors, they probably are – but this is very much market standard.
So, why would you even consider taking investment from an angel network? Well, for me, they are the sweet spot: the fees are usually more reasonable versus other options (other than just individual angels), the terms ditto…and you can potentially close your round speaking to one or two groups rather than speaking with hundreds of individual angels…For most founders, this trade-off is one worth making.
Q. What should I be aware of if I’m using a SEIS / EIS Fund?
When I first started investing, I assumed that SEIS/EIS is a great leveller. These schemes are AMAZING for investors and, as an added benefit to founders, they aren’t compatible with some investor friendly (and therefore founder unfriendly!) terms such as anti-dilution, non-dilution and liquidation preferences. Investors can choose to use those protections OR benefit from the tax breaks in SEIS/EIS. Almost all angels choose the latter, so all good.
But when you see enough Investment Proposals, it becomes apparent that the terms on offer from investors under the SEIS/EIS schemes range from completely reasonable to what some may describe as highway robbery.
Some funds take all of the previous items and, for good measure, mandate items such as some / all of the following - this is where things can get less ‘pleasant’:
- Capitalising all directors loans - in short, making the founders turn all director loans into equity in the round at the current valuation.
- A 10% rather than a 5% 'arrangement fee'. And you need to pay VAT on top, of course.
- A liquidation priority. Hang on, didn’t we say that liquidation preferences are incompatible with SEIS and EIS? They are, but particularly demanding investors weren’t going to leave it there - they have developed a ‘liquidation priority’. In short, in an exit scenario the investors get their money back first. In a ‘champagne exit’ scenario, this won’t make any difference in practice - the liquidation priority is equivalent to an 1X non-participating liquidation preference, and all parties will end up with their pro-rata proceeds. However, in a less successful liquidation, the investor holding the liquidation priority will get their money back ahead of other stakeholders (actually, that’s not quite right - a small fraction of the proceeds go to deferred shareholders and ordinary shareholders too, to satisfy the SEIS/EIS conditions). Using a liquidation priority is certainly having your cake and eating it (and not in the spirit of SEIS/EIS), but thankfully is rare.
- The mandatory creation of a 10% employee option pool before the investment.
- A requirement to maintain a bank balance of at least a certain amount.
- £2.5k fees to cover legal documentation and filing of SEIS compliance certificate.
In terms of fee structures, the amazing EIS Association is running a process to openly publish EIS Fund Fee Transparency.
Spot the difference: a very standard VC
At least you know what you are getting with a VC, I guess. The following is fairly standard, now that the market has tightened a bit:
- Investor Director - they’ll almost certainly want to assign a statutory director to your board.
- Liquidation preferences - this will be another article from me, for sure, but in short this gives the VC their investment back first (and sometimes much better than that) before any other investors get anything. Liquidation preferences come in various flavours, non-participating vs participating, 1x, 2x, 4x, etc. None of these items are founder friendly, and it’s almost certain that (non-SEIS/EIS) investors who come after the first investor with liquidation preferences will want the same - or better.
- Antidilution rights - a mechanism to protect existing investors from the negative effects of a future financing round that occurs at a lower valuation than the previous round. Thankfully, not compatible with SEIS/EIS, but very common in VC rounds. Again, these come in various flavours (such as "Full Ratchet", "Narrow-Based Weighted Average Ratchet" and "Broad-Based Weighted Average Ratchet").
- Creation of an option pool - nearly every VC will insist that you create an option pool of 10% or so before the funding round. They want you to create the option pool before the round, because it’s optimal for them – they don’t get diluted by it. The alternative is for you to close the round and then ask for an option pool straight afterwards, which would dilute the newly invested VC.
- Investor consents - we’ve mentioned these before…they are very standard for VCs. Sometimes it will be a generic ‘Investor Consent’ (across all investors), but sometimes a VC will expect that you need to specifically get their consent.
- Legal costs up to £20k + VAT
- An exclusivity Period - when you start negotiating, you’ll be tied in to the negotiation and you’ll be in breach of contract if you start negotiations with anyone else within a specified period of time.
And sometimes all for an investment of just £150k. Yikes.
Q. What else should I watch out for?
This is by no means an exhaustive list - you could write a book on negotiating terms…and it would be out of date by the time it was published.
We did think, however, that it would be useful to highlight some other challenging terms seen ‘in the wild’:
- We are aware of an incubator which currently takes 12.5% non-dilution shares. No sane investor would invest in a business with this sitting on the CapTable – I’m not sure that making an entrepreneur uninvestable should be in an incubators’ brief!
- An SEIS fund takes a 5% warrant which is exercisable at any point during the 7 years following the investment on a cashless basis at the valuation of the original investment. Ouch.
- Startup studio Fractal took an eye watering 47.5% equity stake. This lead to any start-ups involved with Fractal being automatically blacklisted.
Q. How can FounderCatalyst help?
FounderCatalyst can help you in several ways throughout your funding journey, but when it comes to term sheets – here are three things we can help with:
- Send in your investor terms / offer letter and we'll undertake a free review.
- We'll continue to call out other unusual things we spot - so keep checking back on this article.
- You can create a free term sheet when you create a Founder account on FounderCatalyst.