ABCs of an Equity Term Sheet
If a venture capital fund or strategic investor plans to make an equity investment in your startup company, you will most likely be presented with a term sheet, which will serve as a starting point to the negotiations. A term sheet is a document which sets out all the important terms of a proposed investment. These terms will eventually make their way into the formal transaction documents.
Term sheets are often heavily negotiated between the potential investor and the investee company. The intention of the “front-loaded” negotiation is for the parties to agree on the major terms upfront and pave the way for a streamlined process in the drafting of the actual transaction documents.
It is helpful to categorize the terms of a term sheet into three separate buckets – (1) economic terms, (2) control terms, and (3) other terms.
For purposes of this article, I will provide you with an overview of the economic terms and control terms of a term sheet in connection with a proposed equity investment.
I. Economic Terms
Class of Shares
VC funds typically invest in preferred shares, which provides the preferred shareholders with preferential rights over the common shareholders. Founders typically own common shares, which would have been issued to them at the time of incorporation for nominal value.
The company, potential investor and existing investors will need to determine the amount of capital being raised in a particular financing round. The amount of funds being raised in a given round will determine the level of dilution that existing shareholders will face post-investment.
The pre-money valuation of a company will ultimately drive the issue price per share. The price per share would be calculated by dividing the pre-money valuation figure by the fully-diluted number of shares outstanding, which would assume the conversion of all convertible securities and the exercise of all options and warrants.
Preferred shareholders may be entitled to a fixed dividend, calculated as an annual percentage of the issue price (e.g., 8% per year). However, the reality is that startup companies do not pay dividends to their shareholders since all company funds will be used for business purposes. Therefore, the term sheet should provide the board with a discretionary right over the payment of dividends.
In the event of a liquidation, dissolution or winding up of a company, a liquidation preference entitles the preferred shareholders to be paid out first (i.e., receive proceeds of liquidation), ahead of the common shareholders.
The term sheet will stipulate the terms of the liquidation preference – (1) payment amount, and (2) participation rights.
It will indicate the amount that a preferred shareholder would be entitled to receive. For example, a preferred shareholder may be entitled to receive the greater of (i) one times the purchase price per share, and (ii) the amount per share eligible to be received on an “as-converted basis.”
The preferred shareholders may also have “full participation rights” which means that, after the preferred shareholders have received their initial payment, they would also be able to participate on an as-converted basis with the common shareholders with respect to the payment of the remaining proceeds of distribution. However, these full participation rights are not commonly granted. Typically, the preferred shares are “non-participating,” meaning that, after the preferred shareholders have received their initial payment, any remaining proceeds are distributed only to the common shareholders.
An anti-dilution right protects an existing preferred shareholder from a potential “greater than proportionate” dilution of its ownership stake in the event of a future “down round.” The anti-dilution provision provides for a downward adjustment to an existing preferred shareholder’s conversion price where there is a down round. This adjusted conversion price is typically calculated according to a weighted-average formula.
In almost all cases, a preferred shareholder will have conversion rights, which means that the preferred shareholder will have the option to voluntarily convert its shares into common shares at a pre-determined conversion price at any time. The term sheet would also stipulate certain scenarios (e.g., IPO) under which the preferred shares would automatically convert into common shares.
II. Control Terms
The term sheet will describe the voting rights attached to each class of shares. Preferred shareholders will typically vote together with the common shareholders as a single class for most matters. There will be certain situations where shareholders of a particular class will vote separately as a class.
The holders of preferred shares will have approval rights over certain corporate actions to be taken by the company. These rights are referred to as the “protective provisions.” In essence, the protective provisions protect the economic and legal interests of the preferred shareholders. For example, the preferred shareholders would have to approve, among other things, (i) the creation of a new class of preferred shares which would rank senior to the existing classes of preferred shares, (ii) payment of dividends, (iii) borrowing of money, and (iv) adoption of an equity incentive plan.
Board of Directors
The term sheet will specify the number of directors to be elected to the board of directors of a company. A large investor will often be given the right to nominate a director to the board. A board may be comprised of founder directors, investor directors and independent directors. It would be prudent to limit the size of the board at the early stages of the company since the number of directors will invariably grow over time as the company completes successive funding rounds.
Preferred Director Approval
The board of directors will need to approve certain business decisions. Preferred shareholders will often require that any board approval must include the affirmative vote of the preferred director(s). Business decisions that require board approval may include, among others, (i) related-party transactions, (ii) borrowing of money, (iii) capital expenditures, (iv) executive officer hiring and compensation decisions, and (v) adoption of annual budgets.
The preferred director approval requirement adds another layer of control rights for the benefit of the preferred investors on top of the protective provisions. Having said this, it is important to note that, under Canadian corporate law, a preferred director must act in the best interests of the corporation in performing his or her duties as a director. A preferred director cannot simply be the mouthpiece of a nominating shareholder when performing his or her duties on a company board.
Although I present an overview of standard economic and control terms in an equity investment term sheet, it is important to understand that all terms and conditions of a term sheet are negotiable. At the outset, a VC fund or strategic investor may present a term sheet which is highly favourable to the interests of the new potential investor. It will then be up to the various stakeholders (e.g., company, founders, existing investors and new investor) to negotiate and reach an understanding which balances the competing interests and which, ultimately, satisfies each stakeholder.
This article is for informational purposes only and does not constitute legal advice.
 An equity investment refers to an investor’s purchase of common shares or preferred shares in the capital of a company. Venture capital funds will typically invest in the preferred shares of a company.
 For purposes of this article, I refer to the model term sheet (November 2020 version) produced by the CVCA Venture Capital Model Transaction Documents Working Group. The terms and conditions described in this article are not exhaustive.
 “As-converted basis” assumes the conversion of a preferred share into a common share at the then-existing conversion price per share.
 A “down round” is a financing round in which a company issues shares to investors at a lower company valuation than a previous financing round.
 A “preferred director” is a director nominated to the board of directors by a preferred shareholder with a board nomination right. The affirmative vote requirement may stipulate that a certain number of preferred directors must vote affirmatively in connection with any board approval.