Term Sheets: Other Terms
In addition to the economic and 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 as explained below.
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 execution, thousands of dollars in legal fees spent on drafting the financing documents may be wasted.
No Shop / Confidentiality
The "no-shop" and "confidentiality" provisions are standard term sheet provisions. Sometimes these provisions are separated and sometimes they 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 other VCs. Whether the no-shop is legally enforceable is a gray area, however, VCs do talk and presenting the terms to another VC could seriously damage the relationship and cause neither fund to invest. It's best to negotiate for a shorter no-shop period to incentivize closing the deal (30 days or less).
The term sheet will also include certain conditions precedent to financing that 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 actually been approved by the fund before agreeing not to pitch other lead investors.
Even though the term sheet is nonbinding, the laws of certain states (DE, NY, D.C.) may be interpreted to create an enforceable obligation of the parties to negotiate in good faith to come to an agreement on the terms.
The closing conditions 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; all equity grants have vesting schedules and transfer restrictions; the company owns its 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 if 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 key holder proposes to transfer. A "key holder" is a person who owns a certain minimum threshold of the 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 to purchase any shares the company does not 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. Exceptions are usually made for key holders to transfer shares for estate planning purposes.
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 on a public stock exchange). Prior to public registration the company's shares are fairly illiquid (unless it is a very sought after startup). 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 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 consuming process which significantly diverts the company's time and 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 as well (typically 1 or 2 times). This right will also terminate upon a liquidation event when all of the investors' shares are acquired.
The company will be required to enter into an indemnification agreement to protect any investors who will serve on its board of directors and to obtain D&O insurance (for directors and officers) 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 of its portfolio company to have the insurance.
The covenants protect the preferred shareholders by requiring the company to implement certain policies. Typically, the company can only grant equity compensation under documents that contain standard vesting schedules, transfer restrictions, and ROFRs for the company and investors; must have all workers will sign confidential information and inventions assignment agreements (or similar); and must 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 (as this is a conflict of interest). However, the investors may appropriately require the company to hire a law firm of a certain tier in the interest that legal is done properly.
Sometimes standard covenants are not included in the term sheet, only outlined in the Investors' Rights Agreement. Any non-standard or potentially controversial terms that the investor wants to include in the deal should be stated upfront in the term sheet and agreed upon by the company.
If any founders have equity that has already fully vested (or was not under a standard 4-year vesting schedule), the Series A investors will typically require the founder to enter into 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 before the first year. Those shares will then vest in monthly increments and be released from the company's repurchase right. 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 amount 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 fundraise as well as ca capped amount of the lead investor's legal fees and expenses (typically between $25K to $30K). The investor will pay its fees and costs above the capped amount. Usually the startup wires the money to the investor's law firm right after closing of the funding round.
This requirement to pay the VC's legal fees has received pushback 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 company is the one 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 specializes 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 financing documents until the deal is closed.
Several issues can increase the legal fees for the startup with respect to the Series A round, including: due diligence cleanup of equity, contracts, or corporate governance; need to convert from a LLC to a c-corporation or from a state other than DE; 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 in place and needs to be created directly prior to the closing; and the number of convertible instruments that will be converting in the round.