The Anatomy Of The Term Sheet

A term sheet is a bullet-point document that provides the framework that will be used in a business transaction, particularly an investment of venture capital. This document contains terms and conditions that are used by legal counsel to execute the ‘master plan’ of the investment.

The term sheet itself is not necessarily binding. Once the parties agree about its terms, they are then ready for a formal contract.

If you are involved in an investment you will probably use a term sheet during the process, so you should become familiar with these documents to help you protect your interests in the deal and avoid getting taken for a ride.

Term sheets cover some complex issues. Founders and investors alike should ensure that they understand the business and legal implications of these provisions.

Binding Provisions


Confidential information is data that is restricted or meant to be kept secret.

Many deals involve a confidentiality agreement (CA) or nondisclosure agreement (NDA). You should not be afraid to sign one of these documents; they are merely meant to keep trade secrets and other confidential information away from the wrong eyes. However, you still have to understand the terms in the document.

A confidentiality agreement can also be referred to as a secrecy agreement (SA), confidential disclosure agreement (CDA) or proprietary information agreement (PIA).


An NDA is legal contract that is used to share information, confidential material and knowledge between parties while restricting them from disclosing the same to third parties. There can be serious repercussions for anyone who leaks this information.

NDAs are applicable on a personal and professional level depending on the information being disclosed. NDAs are used in some of the following contexts: product designs and schematics, inventions, trade secrets, client and customer information, and sales and marketing plans.

Regardless of what they cover, most NDAs have a particular structure that includes the following important issues:

  • Definitions of classified information
  • Commitment from all concerned parties
  • Time period

After reciting the parties to the agreement, the NDA normally states the categories of information that are covered, without going into details. The time period is normally up for negotiation, but in most deals the information must be protected for several years.

The NDA usually also states what should be done after the time period expires, specific cases in which information can be released, and the legal repercussions for breach of the agreement.

Consult a lawyer if you don’t understand any of the terms and stipulations used in an NDA.


This section of the term sheet identifies the party responsible for securing and paying for legal services related to the drafting of transaction documents.

No Shop versus Go Shop

Basically, a term sheet is meant to create a framework for all the forthcoming transactions between the parties involved in a deal. For acquisitions of startups and funding of other businesses, there are usually no clauses that bind the parties.

That being said, binding Go Shop or No Shop clauses are sometimes introduced. These clauses determine if a party is allowed to market the deal to third parties.

No Shop

When you’re seriously interested in acquiring a company, it’s ideal to ensure that your target cannot access other prospective buyers while you’re getting the deal set up.

The No Shop clause is usually introduced in the letter of intent. The funding and due diligence process that follows the signing of this document is quite tedious and costly. The No Shop clause therefore prevents the target from signing with anyone else while you are busy attending to these issues.

Most sellers are open to a No Shop provision as long as it includes an acceptable time limit. The seller wants to make sure that the deal moves quickly enough that he’ll still have time to find another buyer if things don’t work out.

Go Shop

The Go Shop provision allows the seller to market the deal to other potential buyers. This provision can be quite useful in some scenarios because it can smooth the transaction and eventually land you the deal.

The Go Shop clause is common when dealing with large acquisition targets. This provision gives the board of directors the freedom to look for the buyer who offers the highest price for the buyout.

In the case of small acquisitions, the Go Shop clause can be used by the target’s co-founders to establish the real valuation of their business. Co-founders sometimes overestimate the value of their business, but being exposed to different potential buyers will help them arrive at a realistic figure – that is, what the potential buyers are willing to pay.

For this reason, allowing your seller to shop around might be a good idea: he’ll get the real value picture, and you just might get a better price.

Board of Directors


A board of directors is a body composed of appointed or elected individuals whose main duty is to govern an organization or a company.

The board itself is governed and guided by a constitution that is drafted by the company. Among other things, this constitution specifies how many members the board will have, the number of meetings to be held, and the criteria to be used when choosing board members.

In a stock corporation, the board of directors is usually only answerable to shareholders. Although the board appoints the Chief Executive Officer (CEO), the CEO has increasingly become the main leader influencing the company’s strategic direction.

There is no standard for the size of a board; different numbers may be appropriate depending on the size of the company. A study by the Corporate Library shows that the average board of directors has 9.2 members, with most boards having from 3 to 31 members. Some noted analysts suggest that the optimal number of board members is seven.

There are two important and independent board committees: the audit committee and the compensation committee. Each committee should have at least three members in order to avoid overworking individual members.


In most organizations, shareholders hold a general meeting when they want to elect or remove members of a board. Shareholders may also opt to use a proxy statement for this purpose. In the United States, the directors of publicly traded companies are mainly selected by the nominating committee or the whole board.

Historically, even when the CEO has no position on the board, management has given its input to the nominating committee when it is making selections. Shareholder nominations are possible only in the general meeting or through mailing separate ballots.

In May 2009, the SEC proposed a new rule allowing shareholders who meet certain criteria to add candidates to the proxy statement. Despite this, the managers of publicly traded companies have remained key contributors in nominating the directors to be voted on by shareholders.

A director’s position can become empty through death or resignation. In some organizations, a director can also be removed by a resolution of the other directors.

In some cases, the board has the power to fill a vacant director’s position after death or resignation of the director. The new director can even be appointed as an addition to the existing directors.

In the process of conducting business, you will incur legal fees for services you receive from attorneys. Lawyers may charge a flat fee, contingent fee or hourly rate.

Entrepreneurs normally receive term sheets from the sponsors, and as an entrepreneur you should pay special attention to the section about the legal fees of the sponsor’s legal team. Focus on reducing the legal fee clause to ensure the money your company spends is manageable.

Pay-to-play provisions

This clause is meant to keep investors motivated to continue offering funds in the future. An investor has to keep funding the business in order to remain relevant in the company. Specifically, the investor protects his preferred stock from being turned into common stock.

A pay-to-play clause typically requires investors invest on a pro rata basis in subsequent financing rounds in order to protect themselves from losing some or all of their preferential rights (such as liquidation preferences, anti-dilution protection or certain voting rights).



Liquidation is when the company’s activities are disbanded by apportioning assets and ascertaining liabilities.

When a company undergoes liquidation, the assets are shared on the basis of the liquidation preference. The liquidation preference is composed of two elements: participation and the actual preference.

What the actual preference means is that a certain multiple of the original investment per share is returned to the investor before the common stock receives any consideration.


When dealing with liquidation, an entrepreneur should always consider whether the investor shares are participating. Most people understand ‘liquidation preference’ as both the participation and preference.

In reality, participation is divided into three parts: full participation, capped participation and non-participating.

Fully participating stock will share in the liquidation proceeds on a pro rata basis with common stock after payment of the liquidation preference.

In the case of capped participation, the stock shares in the proceeds of the liquidation using a pro rata foundation; this happens a when multiple return is achieved.


Dividends are the earnings that are dispersed to the shareholders when the company makes profits. They are usually paid in the form of stock or cash.

When companies are just starting off, dividends are rarely paid in cash. This is because the company is usually short on cash and may not have recorded any profits. If a young company does make a profit, the money is normally re-invested in order to boost the growth of the company. Stock dividends are usually dilutive, and this makes them problematic.

There are two types of dividends: non-cumulative and cumulative.

With cumulative dividends, the dividend is calculated for each fiscal year, and the right to receive the dividend accumulates until the right is terminated or cut short.

Cumulative dividends grow on the original issue price and are typically paid on liquidation of the startup or upon redemption of the preferred stock .Many companies that are in their early stages cannot afford to pay dividends, and therefore they pay after liquidation or redemption instead.

Non-cumulative dividends depend on whether the board of directors declares a dividend during a certain fiscal year. If this declaration is not made, then the right to receive the dividend is extinguished until the next fiscal year.



Protective provisions are special prohibitory rights that the investor has with regard to some company activities. These rights normally safeguard the interests of the venture capital investor.

The entrepreneur and the investor often get into a tug of war over the protective provisions. Venture capitalists look to have veto control over important aspects of the company, while entrepreneurs strive to reduce or do away with protective provisions. This battle for control usually hinges on the economic part of the deal, and the two parties usually find common ground eventually via negotiations.


A lock-up clause is inserted in order to control the transfer or sale of shares after the transaction happens. For instance, after an IPO, the shares of the initial business owners are usually frozen in order to prevent them from dumping them on the market following listing. This is important to ensure that the company undergoes a smooth transition as the new shareholders take over.

This clause is also common in private equity transactions, where the period for the lock-up is usually for the duration of the investment. Shareholders are therefore prohibited from transferring or selling their shares until an exit event is organized. Alternatively, the private equity investor can authorize the transaction.

If the private equity investor grants approval, the shares have to go through his hands first so as to respect his right of first refusal. If the private equity investor refuses to participate in the transaction, a sale to an approved investor will then be allowed.


Anti-dilution rights

Dilution is the situation where an increase in the number of outstanding shares results in the reduction of the percentage a shareholder owns in a company. An increase in outstanding shares can occur because of exercise of stock options or warrants, issuance of new shares to raise equity capital, etc.

In the case of a ‘down round’ – receiving stock at a lower, unwanted price – stockholders dash for the anti-dilution provisions in order to guard their investment. This provision adjusts the price at which preferred stock translates into common stock.

If you see the phrase ‘full ratchet’, talk to your lawyer.

Drag-along rights

A drag-along right (DAR) is primarily a corporate law concept. As the name suggests, this provision involves someone being dragged along: minority shareholders have to join the majority shareholder if he decides to sell his stake.

With regard to drag-along rights, founders should know which transactions will initiate the provision, which stockholder can trigger the provision, and the potential liability of stockholders.

The founders should also be aware of the criteria to be used when distributing proceeds, whether there are limitations on actualizing the provision, and whether the transaction has to receive the board’s approval.

Conversion rights

This is a privilege that lets the owner of preferred stock convert his stock to common stock. This normally happens after liquidation; in this situation the stakeholder leaves the liquidation preference and participating amount in favor of a pro rata common basis payment.

The conversion right is sometimes also exercised when the preferred shareholder wants to control a vote of the common stock on a critical issue. Remember that common stock cannot be converted back to preferred stock.

Future rights

As an entrepreneur, you should always pay close attention before agreeing to preemptive rights or consent rights involving future financing rounds.

If you have multiple angels, you can create a corporate governance regime that includes an independent evaluation of available alternatives and offers some protection against investor misfeasance or opportunism.

Information rights

The Investor Rights Agreement includes this provision, which gives power to the investor. The investor has the freedom to access financial statements and other documents from the company.

In most cases, the investor is also allowed to go through the company’s records, visit the company’s premises and discuss issues with officials.

Management rights

Management rights are rights that involve an operating company and the investor on the basis of a contract. These two parties influence the conduct of, or participate in, the management of the operating company.

A management rights letter, then, is intended to create these contractual rights so that the venture capital fund may legitimately avail itself of the exemption from plan asset rules described above.

These rights may not exist ‘only as a matter of form’; they have to be applied frequently, and the venture capital operating company must dedicate some energy to their implementation.

Preemptive rights

The provision gives the buyer the right to buy a company’s new shares before they are open to others.

According to the National Venture Capital Association (NVCA) term sheet, the standard preemptive rights should give the investor the freedom to contribute to later securities issuances on a pro rata basis. Preemptive rights may be restricted to investors who own a huge amount of preferred stock.

If an investor opts not to purchase his total pro rata share, the other investors get the opportunity to purchase the remaining shares pro rata. This clause is meant to protect the investors from dilution by letting them keep their original percentage ownership.

Just like some anti-dilution provisions, preemptive rights may include a ‘pay to play’ feature.

Redemption rights

This is another right that gives the investor the power to safeguard his money. The provision normally gives the owners of preferred stock the right to demand a refund for their initial purchase price, possibly including unpaid and accrued dividends. The provision is usually applicable after five years have passed.

As a company founder, you should avoid agreeing to a clause that keys in the redemption price using a different measure, for example the fair market value of the stock at the time of redemption.

The redemption price might be payable as either a lump sum or in the form of installments.

Although redemption rights are an issue every founder should consider before signing a term sheet, founders will be pleased to know that this provision is rarely used in real life situations. Most investors believe in the company’s potential and are willing to support it for the long term.

That being said, some unique situations might force the investors to recover their investment. For instance, they might exercise the redemption right if the company has stalled or is sinking; in that case they would rather invest somewhere else where they can get a bigger payoff.

Registration rights

Registration rights are a fairly standard part of a term sheet, and fairly harmless. This is one section you can pretty much leave to the lawyers.

Right of First Refusal (ROFR)

The right of first refusal is usually drafted to protect the interests of both the venture capital investor and the company. If a founder decides to sell his shares to a third party, the provision gives the company the first chance to buy the shares, based on the third party’s terms.

In the NVCA model term sheet, if the company fails to use its right of first refusal, the venture capital investors are then allowed to buy the shares on the same terms on a pro rata basis. The provision is thus drafted to give the first opportunity of buying shares to the venture capital investors, while still controlling the distribution of ownership of shares in the company among the parties.

The founder can sell his shares to the third party if neither the venture capital investor nor the company exercises their right of first refusal.

While the right of first refusal doesn’t directly limit the founders’ ability to transfer their shares, it can have that impact: Third parties may not spend the time to negotiate a deal with founders if they believe the company or venture capital investors will step in and take the shares via the right of first refusal.

Right of First Offer (ROFO)

The right of first offer is a provision that binds the owner of an asset to its rights holder. Before selling the asset to third parties, the owner has to consult the rights holder so that they can come to an agreement on the sale.

If an agreement is not forthcoming, or the rights holder does not want to buy the asset, then the seller can sell the asset. He has no further obligation to the rights holder. Therefore, this provision tends to favor the seller.

This provision provides an investor with a right to buy his pro rata percentage of issuance of new securities until an IPO.

If the seller is unable to find a third party buyer, he can always go back to the rights holder. However, this gives power back to the buyer, who is no longer bound by his original offer and will probably choose to lower it.

Tag Along Rights

As the name suggests, this provision is all about having the freedom to follow the ‘big boys’. If the majority shareholders decide to sell their stake to a third party, the right gives minority shareholders the opportunity to get in on the deal while enjoying the same terms and conditions as the majority shareholders.

Minority shareholders will not hesitate to trigger the tag along rights to protect their interests. Apart from selling their stakes at a favorable price, they are able to avoid working with the new owner against their will.

Voting Rights

Voting rights are applicable when dealing with venture preferred stock; these rights are dependent on the number of shares of common stock into which the preferred stock can be converted. A class vote is the criteria used by the preferred shareholders when dealing with circumstances like merger situations.

According to Delaware corporate law, each class of stock should vote and approve every time the organization makes changes to the corporation’s certificate of incorporation.

However, the NVCA model has a different take on this issue, recommending that all the shares vote in unison as a single class, on an ‘as-converted’ basis.

In most cases, venture capital investors will want to have the authority to fill several seats on the board of directors. Negotiations are conducted with regard to the number of these board seats, the size of the board, and the size of the company.


Valuation is a provision that is used to determine the monetary worth of a company; it can be divided into pre-money and post-money valuation.

The investor’s impression of a company’s worth before any investment is made is called pre-money valuation. Post-money valuation is equal to pre-money valuation plus the money raised in the round.

Investors and entrepreneurs pay close attention to this term because the percentage of the company’s ownership is determined by dividing the amount raised by the post-money valuation; this is done with regard to the round.


Vesting is a provision that prevents you from receiving stock in your company immediately after launch. You have to give your stock time to vest over a period of four years, with a ‘cliff’ of one year.

You will not get any stock over the course of your first post-launch year with the company. You receive 25% of the guaranteed stock immediately after clocking one year. After this, you will get 1/36 of your remaining stock every month for the next three years.

The vesting provision can be used to protect co-founders. For instance, suppose you are six months into a four-year vesting schedule with a one-year cliff and you realize that your co-founder is an underperformer. You can get rid of him without him taking half the company when he leaves (he takes away nothing).

Vesting is also important in protecting the interests of stakeholders. For instance, if a founder chooses to leave the company early, his stock that has not yet vested gets reabsorbed into the company and ‘reverse dilutes’ the remaining stakeholders. This situation is a definite advantage for founders, employees and VCs who decide to stick with the company.


So you have learned the basic terms you will come across on a term sheet. This article should put you in a better position to differentiate the provisions that work from the ones that might create some problems in future.

Forewarned is forearmed, so now you have no reason to be afraid of that deal. Always remember, though, to be on the lookout for hidden clauses designed to give the advantage to the other party. And by the way, this article should not serve as a substitute for legal advice; if you ever come across provisions in a term sheet that you don’t understand or aren’t sure about, please consult a lawyer.

We wish you success in your next deal!