Term Sheets: Other Terms
In addition to the economic terms and the control terms, there are several other provisions in the term sheet. While most of these terms are standard and non-negotiable, it may be worth negotiating on certain aspects of some of these terms.
No Shop / Confidentiality
The "no-shop" and "confidentiality" provisions are standard term sheet provisions. Sometimes these provisions are separate clauses, sometimes there are lumped together in one clause. The no-shop term (usually between 30 - 60 days) is considered an engagement period during which it would be inappropriate (and a breach of the term sheet) to go shopping the offer to invest to other VCs. Whether the terms are enforceable is a gray area, however, VCs do talk to each other and presenting the terms to another VC fund could seriously damage the relationship and cause neither fund to invest. It's best to negotiate for a shorter no-shop period (no more than 30 days) to incentivize closing the deal.
The purpose of the term sheet is to reach a definitive understanding on the deal terms from which the financing documents will be drafted. If either party walks away from the term sheet after it is signed, it is possible that thousands of dollars in legal fees will be wasted (on both sides). The term sheet will include certain conditions precedent to financing which will need to be completed before the deal can go through. One of those conditions may be the approval of the fund's investors. Always ask to make sure the deal has been approved before agreeing not to pitch other lead investors.
Note: Even though the term sheet is nonbinding, the laws of certain states (DE, NY, D.C.) may actually be interpreted to create an enforceable obligation to negotiate in good faith to come to an agreement on the terms of the term sheet.
The conditions precedent to the financing are items that must be achieved before the deal can close. Generally, the investors will need to complete a due diligence review of the startup to ensure that: the revenue and liabilities have been stated accurately; the cap table is accurate and up to date and all equity grants have vesting schedules and transfer restrictions; the company owns the intellectual property; internal corporate governances has been maintained; contracts have been properly drafted and executed; and there are no current or pending law suits.
The executed term sheet serves as the foundation from which the financing documents will be drafted. The rights and preferences of the Series A Preferred Stock will also be set forth in the company's amended Certificate of Incorporation that will be filed with the Delaware Secretary of State.
A review of the Committee on Foreign Investment in the United States (CFIUS) may be warranted where the company deals with critical technologies, is located near critical US infrastructure, or contracts with the US government, and the financing would result in a foreign individual, entity, organization or government controlling of the company. If so, the deal must be submitted to CFIUS for review 45 days prior to the closing. The deal can still close while the CFIUS review is pending.
Right of First Refusal
The right of first refusal (ROFR) gives the investors the right to purchase any shares of common stock that a key holder proposes to transfer. A "key holder" is a person who owns a certain minimum threshold of the Company's common stock (usually more than 1%) and is typically a founder, an early hire, or a key employee who was granted a significant amount of equity.
The company will have the first right to purchase the shares from the key holder (so technically, the investors will have a secondary right of first refusal to purchase any shares the company decides not to buy). This creates a procedure whereby a key holder who wants to sell/transfer any common shares needs to present the proposed transfer details (including the purchase price, total shares to be transferred and proposed purchaser) to the company and the investors who can either purchase all or part of the proposed shares on the same proposed terms or waive the ROFR and allow the sale/transfer to take place.
The equity compensation documents (restricted stock agreement, stock option agreement, and/or stock option plan) or the company's bylaws typically include a provision where this ROFR is agreed to by the purchaser (even before the Series A). If this clause is not in those documents, those would need to be revised before the deal can close and could hold up the financing. For this reason among many others, it is very important to use adequate startup documents and work with a startup lawyer to the extent possible. In practice, the investors typically only exercise the ROFR for very sought after startups (e.g, SpaceX).
Note: Exceptions are usually made for key holders to transfer shares for estate planning purposes.
Note: Investors may also want a ROFR for transfers by other investors to obtain more ownership or to exclude investors not involved in the Series A financing.
The co-sale right gives the investors the right to participate in any sale of shares by a key holder. The investor would be able to sell up to a pro rata portion of its shares in place of the key holder. This term is usually not negotiable, however, it may be possible to carve out a minimum threshold for the right to apply. For example, if a key holder wants to sell a nominal amount of shares to pay for a life expense, the key holder should be able to do that without needing approval. This clause will cease to apply if the company goes public.
The registration rights give the investors the right to effectively demand that the company go public to give the investors liquidity (ability to sell their shares). Prior to public registration, the company's stock cannot be freely sold under securities regulations, which means the shares owned by the investors (and the common shareholders) are fairly illiquid. Although there are some exceptions under which stock can be resold without registration, but the investors shares may not meet those conditions. The investor's preferred stock would first be converted into common stock and registered with the SEC so that the shares could be listed on a public stock exchange. Investors typically also get "piggyback" registration rights to participate in the registration of any other class of shares.
Registration as a public company is a very expensive and time consuming process which significantly diverts the company's resources and requires ongoing reporting obligations. Therefore, the extent of the right should be negotiated down as much as possible. The earliest date for the demand should be at least 5 years after the closing. The number of times the investors can demand registration can be capped (typically 1 or 2 times). This right will also terminate upon a liquidation event when all of the investors' shares are sold.
The company will be required to enter into an indemnification agreement to protect any investors who will serve on the board of directors and to obtain directors and officers insurance (D&O insurance) or to update its current policy. This is the same type of indemnification agreements the company should already have with its existing directors and officers (usually the founders). It may be possible to waive the D&O insurance requirement for Series A investment rounds unless the VC fund's internal policies require all portfolio company to have the insurance.
The covenants are meant to protect the preferred shareholders by requiring certain policies of the company. These generally include that the company will: only grant equity compensation under documents that include standard vesting schedules, transfer restrictions, the company and the investor's ROFRs, etc.; ave all past, present, and future workers sign confidential information and inventions assignment agreements which include non-solicit and non-compete provisions.; maintain internal corporate governance and board meetings.
The covenants may also require the company to use a certain law firm and/or hire a CPA. The investors should not tell the company which law firm to hire (and if so, there may be a conflict of interest). However, the investors may appropriately require the company to hire a law firm of its own choosing in a certain tier in the interest of ensuring that legal is done properly.
Sometimes standard covenants are not included in the term sheet, only outlined in the Investors' Rights Agreement. Any non-standards or potentially controversial terms that the investor wants to include in the deal should be included in the term sheet and agreed to upfront.
If all of any founder's equity has already vested (or were not granted under a standard 4-year vesting schedule), the Series A investors will typically require the founder to enter into a buyback right / new vesting schedule. The new vesting schedule usually includes a 1-year cliff where the company can repurchase at least some of the founder's shares if the founder leaves the company. Those shares will then vest in monthly increments and be released from the company's right to repurchase them. This protects the investors from the risk they are taking in capitalizing the company by ensuring that the founder is incentivized to remain with and grow the company. The (re)vesting requirement will generally not be waived if all of the founders shares are vested at the Series A round, however, the portion of shares that will be subject to (re)vesting is negotiable.
Typically, the startup will pay its own legal fees and expenses related to the funding as well as the lead investor's legal fees and expenses, which is usually capped at between $25K to $30K (this is the maximum amount the startup will contribute toward the investor's fees, and the investor will pay its fees and costs above that amount). Usually the startup wires the money to the investor's law firm right after closing of the funding round.
There has been some pushback on this requirement in recent years considering that the funds will come directly out of the investment and the startup is giving up equity for that capital. However, the clause is still usually non-negotiable. At the very least, the startup should not be liable for the investor's legal fees if the deal doesn't go through unless the startup is the party that backed out of term sheet.
Unfortunately, there is not much the startup can do to save on legal fees in a priced round other than to use a law firm that is experienced in venture capital and offers a flat rate and require that the financing documents are based on the NVCA Model Term Sheet and Model Legal Documents. Many law firms will defer the cost of the Series A counsel and documents until the deal is closed.
Several factors that can increase the legal fees for the startup: due diligence cleanup of internal documents or outside partnerships/contracts; converting from a LLC or state other than DE into a DE c-corporation; chasing down intellectual property assignments from prior employees or contractors; registering intellectual property (trademarks, copyrights, or patents); ongoing negotiations of the Series A deal terms; if a stock plan has not yet been created and needs to be created directly prior to the closing and the number of convertible instruments that will be converting in the round.