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November 4, 2024

Term Sheet Review: A Comprehensive Guide to Analyzing and Negotiating Term Sheets

By
Ani Matevosyan
,
Director, EVCA

The EVCA recently hosted an in-depth workshop on term sheets, led by Andrew Harper and Hilarie Sexton from Goodwin Procter LLP, Dragan Manoev of Ernst & Young Capital Advisors LLP (EY), and moderated by Emily Zhen of Zeal Capital Partners, who’s currently co-leading EVCA’s Healthcare vertical. The session unpacked the mechanics of term sheets with a practical lens on their impact on investor relationships, control dynamics, and strategic growth for early-stage companies. Here, we’ll break down the critical elements of term sheets and the reasoning behind structuring each component effectively.

The Foundation of a Term Sheet: Setting Clear Investment Parameters

Term sheets are the blueprint of venture investment, detailing the core terms that will govern the investor-founder relationship. Emerging VCs benefit from a well-structured term sheet by establishing clear, mutual expectations that align all stakeholders from the outset. For example, a shorter, more flexible term sheet may expedite deal timelines but risks ambiguity that could lead to disagreements or renegotiations down the line. On the other hand, a more comprehensive term sheet allows for a more streamlined, conflict-free process in later stages, as both parties have a well-documented understanding of crucial terms. 

Several core components dictate the economic and operational dynamics in a term sheet, each contributing to the sustainability of the partnership and the company’s growth potential.

1. Pricing and Valuation Structure

Valuation can be approached through either pre-money or post-money methods, each with distinct implications for share dilution and ownership calculation. Post-money valuations often offer simplicity by fixing the total valuation after investment, which reduces disputes over ownership dilution calculations. However, pre-money valuations, while common, require careful calculation, particularly for shares reserved for future rounds or in an option pool. Emerging VCs must analyze these factors closely to ensure that the pricing model chosen supports the company’s goals and the VC’s return expectations, aligning both parties toward sustainable growth.

2. Liquidation Preferences: Balancing Risk and Reward

Liquidation preference clauses ensure that investors recoup their capital before other shareholders in an exit event, typically through a 1x non-participating preference. This setup safeguards investor capital without overly complicating the company’s cap table or discouraging new investors. In some cases, especially at later funding rounds, preferences can extend to 1.5x or even 2x, offering additional downside protection for investors in tougher markets. However, excessive preference multiples can create “liquidation overhang,” which can dampen founder motivation and hinder future fundraising by making the cap table less attractive to potential investors. For emerging VCs, finding a balance in liquidation preferences is essential to secure their own interests while preserving company value.

3. Voting Rights and Protective Provisions

Voting rights and protective provisions play a key role in ensuring that investors retain influence over significant company decisions, like approving new funding rounds, company sales, or strategic shifts. By setting a clear voting threshold early on, investors can help streamline decision-making and minimize potential conflicts down the road. For example, some investors specify that approval for major decisions—such as a Series B financing round—must include a majority vote from Series B shareholders, providing them with meaningful sway over key outcomes.

It’s also worth noting that different classes of common shares, like Class A and Class B, often carry different voting power. Understanding these distinctions is essential when structuring a term sheet, as they shape how control and influence are distributed among shareholders.

Protective provisions add an extra layer of oversight by giving investors the ability to veto or approve critical company moves. Emerging VCs, in particular, should align these provisions with their strategy and stage of investment. For instance, requiring board approval before issuing new preferred stock can help guard against unexpected dilution. Ultimately, well-defined voting rights and protective provisions set valuable guardrails, helping to protect both the investment and the company’s direction at pivotal moments.

4. Board Composition and Control

Board composition terms in the term sheet dictate the structure and influence of investors and founders on the board. For early-stage companies, the founder’s ability to retain influence over board seats is often crucial to their long-term vision. Investor board seats, on the other hand, allow VCs to guide the company’s strategic decisions. Structuring board seats based on service requirements, stock ownership, or specific expertise creates a balanced governance structure that serves both founder and investor interests.

Additionally, companies may introduce “springing board seats” that automatically grant new seats in later rounds, allowing a flexible approach that aligns with evolving business needs. Emerging VCs must consider the dynamics of their involvement, selecting board structures that preserve founder autonomy while securing a voice in high-stakes decisions.

Accounting and Reporting Requirements for Scaling Companies

As companies transition from seed to Series A or B, financial accountability becomes a priority. Reporting requirements, often built into term sheets as information rights, are designed to ensure consistent updates on financial health and KPIs to investors. Regular reporting, including audited financial statements at later stages, provides transparency and enables investors to make informed decisions. Non-GAAP measures, such as annual recurring revenue (ARR), can be especially insightful for growth tracking but require clear definitions to avoid misinterpretation.

These requirements are not only essential for portfolio monitoring but are increasingly demanded by LPs for valuation and performance tracking. Early-stage VCs should emphasize robust accounting frameworks that evolve alongside the company’s growth, ensuring both regulatory compliance and data-driven insights that inform strategic decisions.

Pro Rata Rights: Securing Future Investment Opportunities

Pro rata rights, another crucial component, allow investors to maintain their ownership stake in future rounds. Term sheets may specify these rights, granting investors the option to participate in subsequent rounds to prevent dilution. Structuring pro rata rights carefully is essential, particularly in cases where future lead investors might attempt to waive these rights. By establishing clear terms, emerging VCs can safeguard their continued involvement and potential for returns as the company scales.

In conclusion, a well-structured term sheet balances investor protections with founder-friendly terms that support long-term growth. For emerging VCs, understanding and negotiating these components enables them to secure meaningful influence, align with founders, and drive sustainable value creation. As the venture landscape grows increasingly complex, a thoughtful approach to term sheet structuring is vital in building resilient and successful partnerships.

With a global network of over 1,350 members from 500+ venture firms, Emerging Venture Capitalists Association (EVCA) stands as a significant force in the venture capital community. Known for its comprehensive industry research, influential summits, and community-building events, EVCA has become a hub for emerging venture capitalists. We believe in the power of collaboration to elevate the careers of emerging venture capitalists. We are committed to building a community that supports each other’s growth, shares knowledge, and actively engages in driving progressive changes within the industry for the greater good. Join us today.