General Terms of Venture Company Fundraising
Here, take a look at the general housekeeping terms and terms that are generally settled in early conversations with investors before the term sheet is written. (Of course, if your investor insists on a specific set of terms in one part of the term sheet, she may be more flexible about another part of the term sheet.)
Type of investment
Are you offering equity or convertible debt? Briefly, convertible debt is a loan at a reasonable interest rate, typically 6 to 8 percent, with an option to convert to preferred stock at the next financing round. Convertible debt typically has a discount such as 20 percent, enabling debt holders to convert with a 20 percent discount on the stock price.
If the price is $1 per share, investors can buy in at $0.80 per share. If you choose convertible debt, define in your term sheet the convertible debt details like valuation caps, percent discounts, time to conversion, or events that cause conversion.
If you choose equity, which means that you are selling a percentage of your company to investors, then in this section of the contract, indicate whether the stock is common (like stock given to founders) or preferred (like stock given to VCs). Stock is offered in series. Each series has certain characteristics, like special rights for voting on big decisions and which investors receive cash first when the company liquidates.
Repurchase and redemption rights
Repurchase and redemption rights refer to the rights of shareholders to demand that the company buy back the investor’s shares. Typically redemption requires a majority vote of shareholders and may have a time-based trigger where a vote for redemption may come up after seven years.
Although redemption rights are almost never exercised, they can help an investor eliminate a company from his or her portfolio when the company is doing very poorly. This capability is important for an investor because occasionally companies can survive for long periods of time on small revenues but will never grow to make a profit for the investor. Redemption rights help an investor end the relationship.
Although redemption rights sound bad for the entrepreneur, a healthy company has nothing to worry about.
Plus, investors generally won’t do the deal without these rights in the contract, even though they are very rarely exercised (when an investor would want to redeem shares, there is typically not enough cash in the company to do so; after all, redemption rights are useful to the investor only when the company is about to go defunct anyway.)
Conditions to closing
Conditions to closing is a legal backside-covering section that lists all the things that have to happen before the deal can close. Most of these conditions fall into the category of complying with laws: Securities law has been followed, closing certificates have been delivered, certificates of incorporation have been filed, a certain number of shares have been sold, and the board has a specified number of people on it.
Fees and who pays them
You can accrue different kinds of fees when you close a deal: bills from a lawyer, bills from a broker, and bills from other service providers for work done to complete the deal. This section of the term sheet defines who is responsible for paying them.
The company should reserve some percentage of stock in an employee pool. Reserving up to 20 percent of your total stock for the employee pool is common. This unowned stock is offered as an incentive to new employees. Start-ups rarely are able to pay their employees a competitive salary, so stock is a way to make the position more attractive.
This section determines whether the series of stock issues allows for voting rights. These voting rights are general. Some stock or debt does not have voting rights, and this term defines whether all types of stock vote on the same terms, or whether special provisions exist.