Mastering key legal terms in a VC term sheet

Mastering key legal terms in a VC term sheet

This is taken directly from my book The Entrepreneurial Bible to Venture Capital, which brings together advice and stories from over 40 VCs. This blog post should help entrepreneurs, VCs and angels understand the key issues worth fighting for in a term sheet and hopefully minimize your legal bill so you don’t need to ask your lawyer what this all means while paying $600 to $1,200 per hour and go back and forth among startup – lawyer – investor – repeat loop. I also find many VCs don’t have a great handle on all of these terms and so I wanted to just put this out on the web. My book gets into a bit more detail on this, but nothing beats Brad Feld’s book Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist and blog Ask The VC and Feld Thoughts. I’d also like to thank Nic Brisbourne, Managing Partner of Forward Partners, for his contributions to this chapter of my book and this blog post. Check out Nic’s essential blog The Equity Kicker. You can meet Nic who will participate at both of our investor only and VC-entrepreneur events in London June 9 and June 11, 2014.

First up, some categorization. The “terms” in “term sheet” can be put into four buckets:

  • Terms that drive the economics of the deal—the most important of which are valuation, liquidation preference, and anti-dilution
  • Terms that pertain to control of the company post investment—the most important of which are board structure and protective provisions
  • Clauses that are legally binding on signature of the term sheet—the most important of which are exclusivity and costs
  • Everything else . . . which usually doesn’t matter much.


There are five numbers associated with the valuation: pre-money valuation, amount raised, post-money valuation, share price, and dilution. They are linked by the following equations:

  • Pre-money valuation + Amount raised = Post-money valuation
  • Share price = Pre-money valuation / Number of shares in issue pre the round
  • Dilution = Amount raised / Post-money valuation

So, if a company is raising $5 million series A round at a $10 million pre-money valuation (sometimes shortened to “$10 million pre-money” or even “$10 million pre”) then the post-money valuation will be $10 million + $5 million = $15 million and the dilution will be $5 million/$15 million = 33 percent. If our hypothetical company had 1 million shares in issue before the round, then the share price will be $10 million/1 million = $10.

The dilution, also equal to the new investors’ stake, is the amount by which the existing shareholders see their percentage stake fall—so if prior to the deal our hypothetical company had four founders, each with a 25 percent stake, then their percentage holdings would all fall by 33 percent to 17 percent. However, even though the percentage stake held by each of the shareholders would drop, the cash value of their holding may well have risen, as the value of the holding equals the number of shares they own multiplied by the share price.

In this example, each of the founders owns 250,000 shares (one quarter of the shares in issue before the round); at a share price of $10 their stake is worth $2.5 million. After the round, when their percentage holding has dropped to 17 percent, they still own 250,000 shares that are still worth $10 each and $2.5 million in total. At least on paper.

Moreover, if the share price of the investment round is higher than a previous round, the value of each shareholder’s stake will have increased despite the fact that the percentage stake has dropped.

The important thing is that during a VC round new shares are issued and, because the value of a stake is a function of the number of shares held and the share price, that value may have increased even though the percentage stake has dropped. The percentage stake remains an important way to quickly estimate the value of a holding in an exit scenario when the number of shares in issue remains constant, although any liquidation preference will have to be taken into account.

This decoupling of value and percentage stake is very important but a somewhat counterintuitive point for many, but it is a crucial one to understand for anyone who aspires to raise VC.

Many term sheets will include a cap table, which describes the share structure after the round, capturing much of the information and logic described above. The post-investment cap table in our hypothetical example would look like Table 1.

Table 1 Post-Investment Cap Table


series A





Founder 1




Founder 2




Founder 3




Founder 4




New investor









Other key economic terms include liquidation preference and anti-dilution, the most important control terms; board structure and protective provisions; and exclusivity and cost. With these terms understood you should be able to tell whether a term sheet is attractive or not, but there is a lot that isn’t covered here and there is no substitute for a good lawyer.

Liquidation Preference

Most venture capital investments come with a liquidation preference, which means that on exit the investor gets her money back before the other shareholders get anything. Liquidation preferences come in two flavors, participating and non-participating. If the investor has a participating liquidation preference, she gets her money back first and then shares in any remaining proceeds according to her equity percentage. If she has a non-participating liquidation preference, then she has to choose between getting her money back or getting a pro-portion of proceeds equivalent to her equity percentage.


Anti-dilution terms compensate the investor if there is a subsequent round of investment done at a lower share price, often called a down round. The mechanism by which anti-dilution works is a retrospective adjustment of the share price so that the investor gets more shares, as if she had originally invested at a lower share price. There are three flavors of anti-dilution to be aware of:

  • Full ratchet anti-dilution, in which the investor’s share price is adjusted all the way down to the share price of the new round
  • Narrow-based weighted average anti-dilution, in which the investor’s share price is adjusted partway down to the share price of the new round, depending on a formula that considers the amounts invested
  • Broad-based weighted average anti-dilution, similar to narrow-based, but reduces the share price slightly less, thus favoring the entrepreneur

Full ratchet anti-dilution is very favorable to the investor. Most term sheets have one of the two weighted average formulas, with broad-based being the most common.

Board Structure

Most term sheets stipulate the structure of the board post investment. Most good investors want to ensure a well-functioning board, which is small enough to act quickly and where every member will make a meaningful contribution. Four to seven people is a good size for a board, and generally speaking, the smaller the better.

Voting control of the board, and who has it, is important. Voting control can come either from having the right to appoint directors who will presumably vote as directed by their appointer, or by giving multiple votes to a single person. Mark Zuckerberg famously controlled the Facebook board by insisting that he be given three votes. Typically, each major VC will want a vote, the CEO will have one, the chairman will have one, and the founders will have one or two (some of these could be the same person). As the company grows and raises more money, the number of VCs on the board typically rises and the number of founder votes typically declines, so at the early stages the founders will control the board but at later stages that control will pass to the investors.

Whether the investors or the founders have the right to appoint the chairperson can be a swing factor in who has de facto control of the board.

Protective Provisions

Most term sheets have a list of 10 to 15 actions that the company will only be allowed to complete with the explicit approval of the investor. These terms are designed to make it impossible for the management of a company to go off-piste and neglect or ignore the agreements they have made with their investors. Typically you would expect to see operational provisions like “approval of the annual budget,” “material expenditure outside of plan,”“sale or disposal of all or part of the business” on the list. Often, just a signature or e-mail approval from the investor director is sufficient to cover management’s actions.

You would also expect to see shareholder related provisions including “change of the company’s articles of association” and “issue of new securities with superior rights” on the list. These are more important as they mean that the company won’t be able to raise more money without the consent of the investor.

All the protective provisions listed above are pretty standard, and I don’t know many VCs who would invest without them.

Exclusivity and Costs

Every term sheet that I can remember, and certainly every term sheet I have ever issued, contained a paragraph at the top saying it was not legally binding except for the clauses relating to exclusivity and costs (and sometimes confidentiality). Exclusivity and costs are important to the investors because they are about to start spending significant sums on legal fees and maybe other advisors, and they want to know that the company is serious about taking their money.

By agreeing to the exclusivity clause, the company shows it is serious enough to forgo conversations with other VCs, typically for an initial four- to eight-week period, which can be extended.

The cost clause is more evidence that the company is serious about taking investment. It usually stipulates that if the company pulls out of the investment it will cover the VC’s costs up to an agreed cap, usually of $30,000 to $70,000 for a venture investment, depending on the legal complexity and the advisors the VC intends to use.

The company and entrepreneur should also expect that the VC is serious, and shouldn’t be shy in seeking to understand how far through their due diligence process the investors are, what extra work they need to do (beyond legals), and whether they see any reason why the deal shouldn’t complete. Some investors list out the extra work they need to do as “conditions precedent” to completion. If there are any material doubts on behalf of the investors, then it is probably better to get them resolved before signing the term sheet.

Here are some very basic fundraising concepts that entrepreneurs should master:

  • Pre-money valuation (pre)
  • Round size (round)
  • Post-money valuation (post)
  • Percentage to the new investors
  • Liquidation preferences

Add the round to the pre-money to get the post-money. Calculate the percentage of the company sold to the new investors by dividing the size of the round by the post, or by dividing the small number by the big number (most cases). When fund raising, keep an Excel spreadsheet open all day showing this small calculation; that will help you see what percentage of the company would go to investors at different size rounds and at different pre’s.

If the company sells 33 percent of the share capital to new investors, then the pre is exactly twice the size of the round. So if the round were $2.5 million and the company sells a third of the company, the pre would be $5 million and the post would be $7.5 million. For quick “in your head” math you can just double the size of the round to calculate the pre, assuming 33 percent dilution. For IT deals, dilution on a series A is typically 20 to 40 percent, the amount of the share capital (equity in the company) that has been sold to the new investors.

When things are going well, the series B (or next round) is raised at a higher valuation, the size of the round is larger, and new investors join the syndicate. Same for series C and D. Life is not always ideal, so one sees flat and down rounds as well as up rounds.

Other legal terms are important, but every entrepreneur should understand liquidation preferences. This is the money you must repay the investor from the liquidation (sale or IPO) of the company before the entrepreneur gets his or her pro rata ownership share.

If you want to come to Europe this summer there is no better place to be in June than Stockholm and London. Join us!

Stockholm – The Future of Raising Angel & Venture Capital Funding – June 3

Stockholm – The Future of Angel & Venture Capital Investing – June 4

London – The Future of Angel & Venture Capital Investing – June 9

London – The Future of Raising Angel & Venture Capital Funding – June 11

Twitter: @RomansVentures


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