Term sheet
There is hardly any way around signing a term sheet when seeking financing for a start-up. A term sheet outlines the basic terms and conditions of a financing round (such as the amount of investment, valuation mechanics, share classes, anti-dilution protection, liquidation preferences, board composition, etc.).
Although a term sheet is typically not legally binding (with only a few exemptions, such as clauses on confidentiality and exclusivity), it is perhaps the most important document in the financing process. A signed term sheet serves as a blueprint for negotiating and finalising the definitive long-form legal documents and it demonstrates the commitment of the parties to closing the deal on such terms. Requests for substantial deviations from the term sheet are mostly not accepted (or traded against other requests) when negotiating binding long-form documents and a requesting party risks losing credibility vis-à-vis the other party and ultimately the contemplated investment. Thus, be careful when signing a term sheet, even if it is legally not binding.
A term sheet typically refers to a broad variety of venture capital concepts without defining them in detail. Considering the importance of the term sheet, it is crucial to be familiar with such terms and concepts before signing one. For example, it may have a huge economic impact on the founder whether the term sheet refers to "full ratchet" or to "broad-based weighted average" anti-dilution protection.
Of course, not every clause in a term sheet needs to be negotiated and fought for. Engaging an experienced VC lawyer at an early stage of a financing round can help founders focus on the important aspects of the term sheet and avoid common pitfalls.
Note: the principal difference between a term sheet, a letter of intent (LoI) and a memorandum of understanding (MoU) is only the document style. While a term sheet is the most widely used document type in the venture capital world, key terms of a financing round can also be agreed in a non-binding way in an LoI or MoU.
Anti-dilution protection
Anti-dilution protection is a mechanism designed to protect an investor's ownership percentage in a company from being diluted in a future share issuance. Typically, the protection applies only in case of a so called "down round", i.e. a share issuance below the valuation that was agreed with the protected party.
When an investor invests in a company, they typically receive a certain number of shares or ownership percentage in exchange for their investment. However, if the company issues more shares in the future to raise additional capital or as part of an acquisition, the investor's relative ownership decreases, even though they haven't sold any of their shares. Commonly, each shareholder has a right to participate in each share issuance (subscription right or pre-emptive right). However, for down-rounds, investors often seek protection beyond subscription rights.
Anti-dilution protection can help prevent down-round dilution by adjusting the investor's ownership percentage to account for any new shares issued in the future. This can be done in a few different ways, but common methods are called "weighted average anti-dilution" and "full ratchet anti-dilution".
These anti-dilution protection methods have in common that
investors only pay the nominal amount of the anti-dilution shares
(rather than the full subscription price).
Weighted average anti-dilution
The basic concept of weighted average anti-dilution is calculating
a weighted average share price that ends up somewhere in between
the share price that was paid by the investor (usually the share
price in the last financing round) and the share price that will be
paid in the down round. Essentially, the investor's initial
purchase price is adjusted downwards to reflect the fact that the
company is now worth less per share due to the new shares being
issued. This means that the investor will receive additional shares
to compensate for the dilution. The actual number of shares issued
to the investor in the anti-dilution financing round depends on the
application of the agreed formula. Commonly, one of the two
formulae is applied: "broad-based" or
"narrow-based" weighted average. The difference between
these formulae essentially lies in the number of shares to be
weighed against the shares to be issued. "Broad-based" is
typically more founder-friendly.
Full ratchet anti-dilution
The basic concept of full ratchet anti-dilution offers investors the most protection. Essentially, the investor's initial purchase price is effectively "reset" to the new lower price for the purpose of calculating their ownership percentage in the company. In other words, the investors are put in a position as if they had invested at the lower share price.
Full ratchet anti-dilution protection is less common than weighted average anti-dilution protection. It is typically applied only in specific situations, e.g. if the valuation agreed with the investor is (from the investor's perspective) too high and is to be adjusted in certain circumstances (e.g. if an agreed minimum financing volume is not reached within a certain time).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
