Investment Term Sheet Essentials: What Every Startup Founder and Investor Should Know

Table of Contents:

• Introduction

• Company Information

• Investor Information

• Type of Security

• Investment Amount

• Price Per Share

• Valuation

• Vesting

• Liquidation Preference

• Dividend Rights

• Voting Rights

• Anti-Dilution Provisions

• Board Representation

• Conversion Rights

• Exit Rights/Strategy

• Confidentiality and Exclusivity

• Closing Conditions and Dates

• Representation and Warranties

• Covenants

• Drag-Along Rights

• Tag-Along Rights

• Right of First Refusal (ROFR)

• Co-Sale Rights

• Management Rights

• Indemnification

• Conditions Precedent

• Term and Termination

• Dispute Resolution

• Governing Law

• Assignment

• Expenses

• Information Rights

• Key-Person Clauses

• Non-Compete Agreement

• Founder Vesting / Reverse Vesting

• Lock-in Period

• Down round Protection

• Regulatory Compliance

• Subscription Agreement

• Expiry Date

• Miscellaneous

A term sheet in an investment context is a non-binding agreement setting forth the basic terms and conditions under which an investment will be made. The term sheet serves as a template and basis for more detailed, legally binding documents. Here are some of the typical headers you might find in an investment term sheet:

Introduction

Overview of the term sheet, parties involved, and general context of the deal.

Company Information

Basic details about the company seeking investment.

Investor Information

Details about the prospective investor(s).

Type of Security

Specifies the type of security being offered (e.g., common stock, preferred stock, convertible notes).

Investment Amount

The total amount of money being invested.

Price Per Share

The price per share at which the investment is being made.

Valuation

The pre-money and post-money valuation of the company.

Pre-Money Valuation: This is the valuation of a company immediately before it goes through an investment or financing round. It's essentially how much the company is worth before new capital is injected into the business. This valuation is determined through negotiation between the entrepreneurs and the investors, taking into account factors such as the company's past performance, its growth prospects, market conditions, and other relevant elements.

Let's say a company is raising $1 million in investment and the agreed pre-money valuation is $4 million.

Post-Money Valuation: This is the valuation of a company immediately after it goes through an investment or financing round. It's calculated by adding the amount of new capital (the money just raised) to the pre-money valuation.

Continuing the above example, the post-money valuation after raising $1 million would be $5 million (the $4 million pre-money valuation plus the $1 million investment).

The concept of pre-money and post-money valuations is important because it determines how much equity the investor gets for their investment. In the example, an investor providing $1 million at a $4 million pre-money valuation would receive 20% ownership in the company (since $1 million is 20% of the post-money valuation of $5 million).

Remember, valuation is an art, not a science, and it's subject to negotiation and perception of the company's worth. It's essential for both entrepreneurs and investors to understand these concepts as they can significantly impact ownership percentages and potential returns.

Vesting

Details on any vesting provisions applicable to the shares.

Vesting Schedule: Vesting usually happens according to a pre-determined schedule. A common vesting schedule for startups is four years with a one-year "cliff". This means that if an employee is granted 1,000 shares with a four-year vesting schedule and a one-year cliff, they won't earn any shares until they've been with the company for one full year (the cliff). At that point, they'd vest 25% of their total shares (250 shares in this case). After the cliff, the remaining shares typically vest monthly over the remaining three years. If the employee leaves before the one-year mark, they wouldn't receive any shares.

Accelerated Vesting: In some cases, vesting can be accelerated. This is often triggered by specific events, such as the sale of the company. Accelerated vesting can occur in two forms: "single trigger" and "double trigger". Single trigger acceleration happens when one event (such as a merger or acquisition) causes the shares to vest faster. Double trigger acceleration requires two events (such as a merger followed by the termination of the employee) for the acceleration to occur.

Vesting for Founders: Founders often have vesting schedules as well. Even if they started the company, they may agree to a vesting schedule to show potential investors that they're committed to the company long-term.

Vesting and Stock Options: Vesting also applies to stock options granted to employees. The employee can only exercise their option and buy company stock according to the vesting schedule. If an employee leaves before their options vest, they typically forfeit those options.

The details of vesting schedules and their implications are typically outlined in a company's stock plan or in individual grant agreements. Both employers and employees should fully understand vesting rules as they have significant implications for employee retention and compensation.

Liquidation Preference

Defines who gets paid first and how much they get in case the company is sold or liquidated.

Preference Over Common Stock: Liquidation preference primarily gives preference to holders of preferred stock (usually investors) over common stock (usually founders and employees). If a company is liquidated, preferred shareholders get their money back before common shareholders.

Multiple of Investment: The liquidation preference is typically expressed as a multiple of the initial investment. For example, a '1X' liquidation preference means that in the event of a liquidation, the investor is entitled to receive the amount of their investment back before any proceeds are distributed to common shareholders.

Participating vs. Non-Participating: In some cases, investors may have 'participating' preferred stock, which means they first get their money back (per the liquidation preference), and then also participate in the distribution of the remaining assets, just like common stock holders. This can be beneficial to the investor but potentially detrimental to the common stock holders. Non-participating preferred stock, on the other hand, means that the investor must choose either to receive their liquidation preference or convert their shares to common stock and receive a proportionate share of the total distribution.

Seniority: In cases where there are multiple rounds of investment, there might be a seniority structure. This means that investors from later rounds would get paid back before those from earlier rounds. This is often negotiated on a case-by-case basis.

In general, liquidation preference is a key protection for investors that ensures they get paid back first in the event of a company's sale or liquidation. However, it's also an area where founders need to be careful, as overly generous liquidation preferences can greatly diminish their share of any payout in an exit event. It's important for both parties to fully understand and negotiate these terms.

Dividend Rights

Describes any rights the investor has to receive dividends.

Voting Rights

Details the voting rights associated with the securities.

Voting rights are an essential part of corporate governance and a fundamental right of shareholders. These rights allow shareholders to participate in the decision-making process of the company by voting on certain matters.

Here's a detailed explanation:

Basic Principle: Voting rights give shareholders the ability to vote on key corporate matters. These typically include electing directors, approving significant transactions such as mergers or acquisitions, changes to the corporate charter or bylaws, issuing new securities, and other major business decisions.

Common vs. Preferred Stock: Voting rights can vary depending on the type of stock. Holders of common stock typically have one vote per share. Preferred stock, on the other hand, often comes with different voting rights. Some preferred stock may have enhanced voting rights (multiple votes per share), while others may have no voting rights at all unless certain conditions are met.

Voting vs. Non-voting Shares: Some companies issue non-voting shares, which do not grant the holder the right to vote on corporate matters. This is often done to raise capital without diluting the control of the existing shareholders.

Majority and Supermajority Votes: Some decisions require a simple majority (more than 50% of votes), while others may require a supermajority (such as two-thirds or three-quarters of votes).

Proxies: Shareholders who cannot or do not wish to attend a shareholders' meeting in person can often vote by proxy, which means assigning their voting rights to another person to vote on their behalf.

Implications: The allocation of voting rights can significantly influence the balance of power in a company. It's an important consideration for both entrepreneurs and investors, as it affects control over strategic decisions.

The specifics of voting rights are typically outlined in a company's bylaws and in the shareholders' agreement. These details can vary greatly, and it's important to consult with a legal professional to understand these rights fully.

Anti-Dilution Provisions

Specifies protections for the investor in case the company issues more shares at a lower price in the future.

Full Ratchet Anti-Dilution: This type of anti-dilution protection is more investor-friendly and can be quite severe for the company and its common stock holders. In a full ratchet anti-dilution provision, if the company issues even one share at a price lower than what the investor paid, the price of the investor's shares will be adjusted down to this new lower price, regardless of how many new shares are issued. This can drastically increase the number of shares the investor owns, and dilute the ownership of other shareholders, if a "down round" occurs.

Weighted Average Anti-Dilution: This is a more common and less severe form of anti-dilution protection. Instead of adjusting the price of the investor's shares to the new lower price, it adjusts the price based on a weighted average of the price the investor paid and the price at which the new shares are issued. The weights are based on how many new shares are issued relative to the total number of outstanding shares. This type of provision is less dilutive to other shareholders compared to the full ratchet method.

No Anti-Dilution Protection: Some agreements might not have any anti-dilution provisions, particularly in "up rounds" where the company is doing well and shares are being issued at a higher price. In this scenario, while the investor's percentage ownership in the company might decrease, the value of their investment would still increase because of the higher share price.

Anti-dilution provisions can be quite complex, and they significantly affect the dynamics of future financing rounds and the distribution of ownership in the company. Both entrepreneurs and investors should fully understand these provisions before entering into an investment agreement. As always, legal advice should be sought when dealing with such matters.

Board Representation

Details any agreement about the investor's representation on the company's board of directors.

Board representation is a critical element in an investment agreement, as it offers investors a direct line to influence the strategic decisions of a company. The investor’s representation on the company’s board of directors is often a condition of their investment.

Here's a detailed explanation:

Basic Principle: Board representation outlines the right of an investor (or investors) to have a seat on the company's board of directors. This can be the investor themselves or a representative they choose. Having a seat on the board gives the investor the ability to participate directly in the governance of the company and influence its strategic direction.

Types of Board Seats: The investor could have a full seat on the board, with voting rights equal to other board members, or they could have a non-voting observer seat, which allows them to attend and participate in board meetings but not vote on decisions.

Purpose of Board Representation: Investors often seek board representation to protect their investment and ensure their interests are considered in major decisions. It gives them insights into the company's operations and strategic planning and allows them to contribute their expertise.

Implications for the Company: From the company's perspective, investor board representation can bring valuable insights and experience. However, it also means the investor will have a say in strategic decisions, which may not always align with the founders' views.

Legal Aspects: The details of board representation, such as the number of seats, voting rights, and the process for appointing and removing board members, are typically outlined in the shareholders' agreement and the company's bylaws.

As with all aspects of investment agreements and corporate governance, the specifics of board representation can be complex and should be thoroughly understood by both the company and the investor. Legal advice should be sought when dealing with these matters.

Conversion Rights

Specifies the conditions under which preferred shares can be converted into common shares.

Conversion rights are a key feature of preferred shares in many companies, especially startups. They give the holder of the preferred shares the right to convert their shares into common shares under certain conditions.

Here's a detailed explanation:

Basic Principle: Conversion rights provide a mechanism for preferred shareholders to convert their shares into common shares. This conversion is often at a pre-determined ratio (for example, one preferred share might convert into one common share).

Voluntary Conversion: Preferred shareholders typically have the option to convert their shares into common shares at any time. This might be beneficial if the company's value has significantly increased, allowing the shareholder to benefit from the increased value of common shares, or if the shareholder wants to have voting rights typically associated with common shares.

Mandatory Conversion: In some circumstances, conversion can be mandatory. For instance, if the company gets acquired or goes public (IPO), the preferred shares may automatically convert into common shares. The specifics of when mandatory conversion occurs will be laid out in the investment agreement or the company's bylaws.

Conversion Rate: The rate at which preferred shares convert into common shares is usually set at the time of investment. The conversion rate may be subject to adjustments, such as in the event of stock splits or issuance of new shares.

Implications: Conversion rights can offer benefits to investors, allowing them flexibility and protection. They can retain their preferred status for dividends and liquidation preferences, but convert to common shares if it's more beneficial.

Legal Aspects: The specifics of conversion rights are usually outlined in the shareholders' agreement or in the terms of the preferred stock. As with all such provisions, legal advice should be sought to fully understand these rights.

Conversion rights are a complex but critical part of investment agreements, and understanding them fully is important for both entrepreneurs and investors.

Exit Rights/Strategy

Outlines any agreed-upon exit strategy or process.

Exit rights or strategies are crucial components of a term sheet or investment agreement, setting out the potential paths for an investor to realize a return on their investment. They are especially important for venture capitalists and other early-stage investors who need to plan for how they will eventually "exit" their investment.

Here's a detailed explanation:

Basic Principle: Exit rights outline the conditions or processes by which an investor can exit their investment, typically through a liquidity event such as a sale of the company (trade sale), an Initial Public Offering (IPO), or a merger or acquisition (M&A).

Trade Sale: This is often the most straightforward exit strategy, involving the sale of the company to another entity. The terms of the sale, including price and other conditions, are usually negotiated at the time of the sale.

Initial Public Offering (IPO): This involves the company going public and listing its shares on a stock exchange. This can provide significant returns for investors, but also requires the company to meet a range of listing requirements and regulatory obligations.

Merger or Acquisition (M&A): The company could be merged with another company or acquired. The terms of the merger or acquisition, including price and other conditions, are usually negotiated at the time of the transaction.

Buyback or Secondary Sale: The company or other shareholders could buy back the shares from the investor, or the investor could sell their shares to another private investor.

Liquidation: If the company fails, it may be liquidated, with its assets sold off and the proceeds distributed to the shareholders.

The exit strategy can significantly affect the potential return for the investor, so it's a crucial part of the investment agreement. It's usually subject to negotiation between the investor and the company, and as always, it's important to seek legal advice when dealing with these provisions.

Confidentiality and Exclusivity

Establishes confidentiality obligations and, possibly, an exclusivity period during which the company agrees not to seek other investors.

Closing Conditions and Dates

Specifies conditions that must be met before the deal can close, and the expected timeline.

Closing conditions and dates in a term sheet or investment agreement set out the specific requirements that must be met for the investment deal to be finalized. It's a critical part of an agreement that outlines when and under what conditions the transaction will close.

Here's a detailed explanation:

Basic Principle: Closing conditions refer to specific requirements or milestones that must be met before the investment is finalized. These conditions can vary based on the agreement but typically include items like successful due diligence, approval from regulatory bodies, or securing certain key contracts or partnerships.

Due Diligence: A common closing condition is the successful completion of due diligence, which involves a thorough examination of the company's business, including its financials, operations, legal standing, and more. If issues are discovered during due diligence, the investor may choose not to proceed with the deal.

Regulatory Approvals: Some deals may require approval from regulatory bodies before they can proceed. For example, large investments or acquisitions may need approval from antitrust authorities.

Other Conditions: Other potential conditions could include securing key contracts or partnerships, achieving certain financial or operational milestones, or the absence of any material adverse changes in the company's business.

Closing Date: The agreement will also specify a closing date, which is the date by which all conditions should be met and the investment transaction will be finalized. If the conditions are not met by this date, the parties may need to renegotiate or the deal may fall through.

Implications: The closing conditions and dates are key elements of an investment deal. Both the company and the investor need to understand and agree on these conditions to ensure a smooth closing process.

As with all aspects of investment agreements, the specifics of closing conditions and dates can be complex and should be thoroughly understood by both the company and the investor. Legal advice should be sought when dealing with these matters.

Representations and Warranties

Details any guarantees made by the company about its business.

Nature of Business: The company may warrant that it is a corporation duly organized, validly existing, and in good standing under the laws of its state of incorporation.

Authority and Consents: The company may represent that it has the authority to enter into the agreement and that it is not breaching any other agreement or law by doing so.

Financial Statements: The company might warrant that its financial statements accurately reflect the company's financial status and that it has no undisclosed liabilities.

Compliance with Laws: The company will typically represent that it is in compliance with all applicable laws and regulations.

Intellectual Property: The company might warrant that it owns or has a right to use all necessary intellectual property and that it is not infringing on the rights of any third party.

Material Contracts: The company might warrant that all material contracts are in full force and effect and there is no material default under any such contracts.

Litigation: The company may represent that it is not involved in any ongoing litigation or legal proceedings.

If a representation or warranty by the company turns out to be false, the investor may have the right to sue for breach of contract, or the investment could even be reversed. As a result, these representations and warranties are often negotiated in detail, and the company will often seek to limit their scope to avoid future legal issues.

As always, when dealing with legal documents like term sheets or investment agreements, it's important for both entrepreneurs and investors to fully understand these provisions and to seek legal advice.

Covenants

Specifies certain promises or agreements made by the company to the investor. This could include affirmative covenants (promises to do certain things, such as maintain certain financial ratios) and negative covenants (promises to refrain from doing certain things, such as taking on new debt without approval).

Covenants in an investment agreement are legally binding promises made by the company to the investor. They are meant to protect the investor's interest by requiring the company to fulfill certain conditions, or by restricting the company's actions in certain ways. Covenants can be of two main types: affirmative (or positive) covenants, and negative covenants.

Affirmative Covenants: These are promises to do certain things. They often relate to the operation and management of the business. Examples include:

• Financial Reporting: The company may be required to provide regular (often quarterly and annual) financial statements to the investor.

• Compliance with Laws: The company will typically promise to comply with all relevant laws and regulations.

• Maintenance of Assets: The company may agree to maintain its assets in good condition.

• Financial Ratios: The company may be required to maintain certain financial ratios, such as a certain level of liquidity or a maximum level of debt.

Negative Covenants: These are promises to refrain from doing certain things, without the investor's approval. Examples include:

• Debt: The company may be prohibited from taking on additional debt beyond a certain level.

• Dividends: The company may be restricted from paying dividends to shareholders.

• Asset Sales: The company might be prohibited from selling major assets without the investor's consent.

• Changes to Business: The company might be restricted from making significant changes to the nature of its business.

Covenants help ensure that the company is operated in a way that protects the investor's interests. However, they can also restrict the company's flexibility. A breach of a covenant can have serious consequences, often giving the investor the right to call for immediate repayment of their investment or to take control of the company. It's therefore important for both parties to carefully consider and negotiate covenants in an investment agreement, and for the company to carefully monitor its compliance with any covenants. As always, legal advice should be sought when dealing with such matters.

Drag-Along Rights

Specifies conditions where minority shareholders must go along with a sale if the majority shareholders approve it.

Drag-Along Rights, sometimes also referred to as "drag-along provisions", are contractual clauses included in shareholders' agreements in many businesses, especially startups. They protect majority shareholders and can be vital in facilitating the sale of a company.

Here's a detailed explanation:

Basic Principle: The drag-along right allows majority shareholders (usually those who own more than 50% of the company's equity) to "drag along" minority shareholders in the sale of a company. If the majority shareholders decide to sell their shares to a buyer, the minority shareholders are obliged to also sell their shares on the same terms. This ensures that a potential acquirer can obtain 100% ownership of the company, which is usually a key condition for such transactions.

Purpose of Drag-Along Rights: These provisions protect the interests of majority shareholders. Without drag-along rights, minority shareholders could potentially block a sale or merger of the company, or they could hold out for higher prices or better terms, thereby complicating the sale process.

Implications for Minority Shareholders: While drag-along rights can feel unfair to minority shareholders, they do ensure that the minority shareholders receive the same terms as the majority shareholders in a sale. Furthermore, they often facilitate the sale of a company, which may be the best outcome for all shareholders.

Legal Aspects: The exact terms and conditions of drag-along rights, such as the required majority to activate the drag-along, can vary and are usually specified in the shareholders' agreement. They are legally binding and, once agreed upon, cannot be opted out of without consent from the parties involved.

As always, when dealing with legal documents like shareholders' agreements or investment agreements, it's important for both entrepreneurs and investors to fully understand these provisions and to seek legal advice.

Tag-Along Rights

Specifies conditions where if a majority shareholder sells their stake, minority shareholders have the right to join the deal and sell their stake.

Tag-Along Rights, also known as "co-sale rights", are clauses in a shareholders' agreement that protect minority shareholders in the event that the majority shareholders decide to sell their stake. These rights essentially allow the minority shareholders to "tag along" on the sale.

Here's a detailed explanation:

Basic Principle: The tag-along right gives minority shareholders the ability to sell their shares under the same terms and conditions as the majority shareholders. If a majority shareholder sells their stake, they must give the minority shareholders the option to join the transaction and sell a proportional amount of their stake at the same price and on the same terms.

Purpose of Tag-Along Rights: These rights protect minority shareholders by ensuring they have the opportunity to exit their investment if the majority shareholders do. They prevent a situation where majority shareholders sell their stake, potentially to a buyer the minority shareholders do not approve of, while the minority shareholders are left holding shares that may have significantly changed in value or become less liquid.

Implications for Majority Shareholders: For majority shareholders, tag-along rights can make the sale process a bit more complex, as they have to offer the same terms to minority shareholders. However, it can also make their shares more attractive to potential buyers, as buyers have the opportunity to acquire a larger stake in the company.

Legal Aspects: The specifics of tag-along rights, such as the percentage of ownership that triggers the tag-along rights, are usually outlined in the shareholders' agreement. Once agreed upon, they are legally binding.

Just like with all other clauses in a shareholders' agreement or investment agreement, it's crucial for shareholders to understand tag-along rights and to seek legal advice when dealing with such matters.

Right of First Refusal (ROFR)

The company or certain shareholders have the right to buy shares before they are sold to a third party.

Right of First Refusal (ROFR) is a contractual right that gives its holder the option to enter a business transaction with the owner of something (in this case, shares in a company), before the owner is entitled to enter into that transaction with a third party.

Here's a detailed explanation:

ROFR in Practice: In a shareholders' agreement, a ROFR clause means that before an existing shareholder can sell their shares to a third party, they must first offer them to the company or other existing shareholders. The company or shareholders have the right to purchase these shares on the same terms as offered by the third party. If the company or shareholders choose not to exercise this right, only then can the shares be sold to the third party.

Purpose of ROFR: The purpose of this clause is to give the company and existing shareholders control over who can become a shareholder. This is particularly important in private companies, where the identity of shareholders can be crucial. It prevents unwanted third parties from becoming shareholders and protects the existing shareholders from dilution by outsiders.

Procedure: Typically, the shareholder who wishes to sell their shares must notify the company of their intention to sell, and the terms of the sale. The company then has a certain time period to decide whether or not to exercise its ROFR. If the company chooses not to buy the shares, the shares can then be offered to the third party at the same price and under the same terms.

Limitations and Exceptions: ROFR doesn't apply in all situations. For example, it often does not apply to shares that are transferred to family members, to trusts for estate planning purposes, or in the case of a shareholder's death.

ROFR clauses can be complex and their implications should be fully understood by all parties involved. As always, it's recommended to seek legal advice when dealing with such provisions.

Co-Sale Rights

Shareholders have the right to sell a proportionate amount of their shares if another shareholder is selling theirs.

Co-sale rights, also known as "tag-along" rights, are an important provision in investment agreements, designed to protect minority shareholders in the event of a sale of the company's shares by a majority or significant shareholder.

Here's a detailed explanation:

Basic Principle: Co-sale rights give the investor the right to participate on a proportionate basis in the sale of shares by other shareholders, typically the founders or other large stakeholders. If a shareholder is selling their shares, the investor has the right to "tag along" and sell a portion of their own shares under the same terms.

Protection for Minority Shareholders: Co-sale rights are particularly valuable for minority shareholders. If a majority shareholder decides to sell their stake, the minority shareholder can join the deal and sell their shares too, preventing a situation where they're left holding shares in a company controlled by a new, potentially unwanted, majority shareholder.

Sale Proportions: The specific proportions at which shareholders can sell their shares are usually defined in the investment agreement. Typically, it would be proportionate to their ownership stake, meaning if a shareholder owns 10% of the company, they would have the right to sell 10% of the total number of shares being sold.

Implications for Founders: While co-sale rights can protect investors, they can also limit the founders' ability to sell their shares without also providing an exit opportunity for other shareholders. This might not be ideal for the founders if they were hoping to sell a part of their stake without affecting the overall ownership structure of the company.

Legal Aspects: The specifics of co-sale rights, including any restrictions or limitations, are typically outlined in the shareholders' agreement. As with all such provisions, it's important to fully understand these rights, and legal advice should be sought.

Co-sale rights can have a significant impact on the dynamics of a company's ownership structure, and understanding them fully is important for both entrepreneurs and investors.

Management Rights

Details any specific rights granted to investors to participate in or observe the operations of the business.

Management rights refer to certain specific rights granted to investors, allowing them to participate in, or observe, the day-to-day operations of the company. These rights can vary widely based on the agreement between the company and the investor, and they are often provided to venture capital or private equity investors.

Here's a detailed explanation:

Basic Principle: Management rights may provide investors with the ability to participate in the decision-making process, access information about the company, or consult on the strategic direction of the company. These rights are typically provided in addition to any board representation that the investor may have.

Observation Rights: These rights often include the ability to observe the day-to-day operations of the company, access to regular financial or operational reports, or the ability to attend certain meetings.

Participation Rights: In some cases, investors might have more direct involvement in management decisions. They might have the right to approve or veto certain decisions, or they might be involved in developing the company's strategic direction.

Purpose of Management Rights: These rights are typically sought by investors who want to take a more active role in their investment. They can provide the investor with greater oversight and control over the company and allow them to help guide the company's success.

Implications for the Company: While management rights can bring valuable expertise and guidance for the company, they also mean the company's founders and executives are subject to greater oversight and potentially less autonomy in their decision-making.

Legal Aspects: Management rights are usually outlined in the investment agreement or the shareholders' agreement. The specifics can vary widely, and as always, it's important to seek legal advice when dealing with these provisions.

Management rights are an important aspect of investment agreements that both investors and entrepreneurs should understand fully. They can significantly impact the relationship between investors and the company, as well as the company's governance and decision-making processes.

Indemnification

The conditions under which one party must compensate another for harm or loss.

Conditions Precedent

The conditions that must be met for the transaction to go ahead.

Conditions precedent in a term sheet or an investment agreement refer to certain actions or events that must occur or be performed before the investment transaction can proceed. These are critical clauses that can determine whether or not the deal ultimately goes through.

Here's a detailed explanation:

Basic Principle: Conditions precedent are effectively "must-haves" for either the investor, the company, or both, before the investment transaction can proceed. They're actions or facts that must be true at a certain point in time (usually immediately before the closing of the investment).

Types of Conditions Precedent: These conditions can cover a wide range of issues. They may include the successful completion of due diligence by the investor, approval of the investment by the company's board of directors, obtaining necessary regulatory approvals, execution of certain key contracts, or the company achieving certain operational or financial milestones.

Satisfaction of Conditions Precedent: Before the transaction can proceed, all parties must generally confirm that all conditions precedent have been satisfied. If the conditions are not met, the party benefiting from the condition can typically choose to either waive the condition and proceed with the deal, or terminate the agreement.

Legal and Business Implications: Conditions precedent are legally binding. If a party fails to meet them, it may be a breach of the agreement, and the other party could potentially seek legal remedies. From a business perspective, conditions precedent provide a way for the parties to make sure certain key requirements are met before they're legally committed to the deal.

Documentation: Typically, the investment agreement will include a detailed list of the conditions precedent. This part of the agreement needs to be carefully reviewed and negotiated to make sure it is achievable and reasonable for both parties.

Waiver of Conditions Precedent: In some cases, the party that benefits from a condition precedent can choose to waive it. This could happen if the condition is not met, but the party still wants to proceed with the deal.

As with all elements of an investment agreement, it's important to fully understand the implications of conditions precedent. Both the investor and the company should seek legal advice when dealing with these matters.

Term and Termination

How long the agreement lasts, and the circumstances under which it can be ended.

Dispute Resolution

How any potential disputes will be resolved, often specifying a preference for arbitration or litigation.

Dispute resolution provisions in a term sheet or investment agreement set out the method by which any disagreements or disputes between the parties will be resolved. Given the complexity of these agreements and the potential for conflicts of interest, it's crucial to have a clear, agreed-upon process in place.

Here's a detailed explanation:

Basic Principle: Dispute resolution clauses establish the process and rules for handling disputes that might arise between the company and the investor. This includes disagreements over interpretations of the agreement, conflicts of interest, breaches of contract, and other issues.

Arbitration: Many agreements specify that disputes will be resolved through arbitration. This is a private process where a neutral third party (an arbitrator) decides the outcome. Arbitration can be binding (the decision is final and enforceable by law) or non-binding (the decision serves as a recommendation, but can be rejected by either party).

Mediation: Some agreements may favor mediation, which is a more informal process where a neutral third party helps the disputing parties negotiate a resolution. Unlike arbitration, the mediator does not make a decision; instead, the parties come to an agreement themselves.

Litigation: If a dispute cannot be resolved through arbitration or mediation, or if the agreement does not specify these methods, the dispute may go to litigation, which means taking the case to court. This can be a more time-consuming and expensive process, but may be necessary for complex or contentious disputes.

Jurisdiction and Governing Law: The agreement will also specify which jurisdiction's laws will govern the contract and where any legal proceedings will take place.

Implications: It's important for both the investor and the company to understand the dispute resolution process, as it affects their rights and options in case of a dispute. For example, arbitration often involves waiving the right to a trial by jury.

As with all elements of a term sheet or investment agreement, the specifics of the dispute resolution clause can be complex and should be thoroughly understood by all parties. Legal advice should be sought when dealing with these matters.

Governing Law

The jurisdiction and legal system that will apply to interpret the term sheet and resolve any disputes.

Assignment

Outlines whether and under what conditions the rights and obligations under the agreement may be transferred to another party.

The assignment clause in a term sheet or investment agreement determines whether and under what conditions the rights and obligations of the agreement can be transferred from one party to another.

Here's a detailed explanation:

Basic Principle: Assignment is the process of transferring the rights and duties under a contract from one party to another. In the context of an investment agreement, an assignment clause will specify whether the investor or the company can transfer their rights and obligations to another party, and under what conditions this can be done.

Restrictions on Assignment: Most investment agreements restrict the ability of parties to assign their rights and obligations without the other party's consent. This is to ensure that the parties maintain control over who they are dealing with. For instance, a company might not want an investor to be able to transfer their ownership stake to another party without the company's approval.

Conditions for Assignment: The agreement may allow for assignment under certain conditions. For example, the investor may be allowed to assign their rights and obligations to an affiliate or to a third party in the event of a merger or acquisition.

Effects of Assignment: If an assignment is permitted and takes place, the party receiving the assignment (the assignee) steps into the shoes of the original party (the assignor) and assumes the same rights and obligations under the agreement.

Legal Implications: An assignment clause is a legally binding provision, and any assignment that violates this clause could lead to legal consequences. As such, it's important to carefully review any restrictions or conditions on assignment.

Documentation: Any assignment should be properly documented, typically in the form of an assignment agreement, and the other party to the original agreement should be notified.

As with all aspects of an investment agreement, understanding the assignment clause is crucial. Both investors and companies should seek legal advice when dealing with these matters to ensure their interests are protected.

Expenses

Specifies which party will bear specific costs associated with the deal, such as legal fees, due diligence expenses, etc.

The expenses clause in a term sheet or investment agreement outlines how the costs associated with the investment transaction are to be divided between the parties.

Here's a detailed explanation:

Basic Principle: Investment transactions often involve considerable expenses, including legal fees, due diligence costs, regulatory filing fees, and other transaction costs. The expenses clause specifies who will bear these costs.

Allocation of Expenses: The allocation of expenses can vary depending on the nature of the deal and the negotiating power of the parties. In some cases, each party might bear their own costs. In other instances, the company might agree to pay some or all of the investor's expenses, particularly in larger transactions where the investor has more leverage.

Types of Expenses: The expenses that might be covered in this clause can include legal fees for drafting and negotiating the investment documents, accounting fees for financial due diligence, fees paid to investment banks or other intermediaries, costs for business due diligence (such as technical or market assessments), and regulatory fees for filings required to complete the transaction.

Payment Timing: The clause may also specify when these expenses need to be paid. Some expenses might be payable up front, while others might be due at the closing of the transaction or even afterwards.

Caps and Conditions: In some cases, there might be a cap on certain expenses that one party agrees to pay, or conditions under which certain expenses will be reimbursed. These details would also be specified in the expenses clause.

Legal Implications: As with other clauses in an investment agreement, the expenses clause is legally binding. Failure to comply with its terms could lead to a breach of contract claim.

Understanding the expenses clause is important for both the investor and the company, as it can have a significant impact on the net financial benefit of the transaction for both parties. Legal advice should be sought when negotiating this clause.

Information Rights

Describes the rights of investors to receive regular updates or specific financial or operational information about the company.

The information rights clause in a term sheet or investment agreement outlines the obligations of the company to provide certain information to the investor on a regular basis.

Here's a detailed explanation:

Basic Principle: Information rights are a key part of many investment agreements. They ensure that investors are kept informed about the company's operations, financial performance, and other key aspects of the business. These rights can be particularly important for minority investors who might not have representation on the company's board of directors or other direct ways to monitor the company's performance.

Types of Information: The types of information that a company may be required to provide can include financial statements (such as income statements, balance sheets, and cash flow statements), budgets, business plans, updates on key performance indicators, and notices of significant business developments (like a major new customer, a lawsuit, or a regulatory issue).

Frequency and Format of Reporting: The agreement will specify how often the company must provide this information (such as quarterly or annually) and the format in which it must be provided. For instance, financial statements might need to be audited by a reputable accounting firm.

Recipients: The agreement may also specify who is entitled to receive this information. It might be limited to certain major investors, or it might include all shareholders.

Confidentiality: Given the sensitivity of the information, the agreement will often include confidentiality obligations that restrict the investors from disclosing the information they receive to third parties.

Legal Implications: Compliance with the information rights clause is legally binding. If a company fails to provide the required information, it may be in breach of the agreement, and the investors could potentially seek legal remedies.

Information rights can play a crucial role in helping investors monitor their investment and make informed decisions. As with all provisions in an investment agreement, it's important for both investors and companies to understand these rights fully and seek legal advice as needed.

Key-Person Clauses

Specifies requirements about maintaining certain key individuals in the management team or workforce of the company.

Key-person clauses in a term sheet or investment agreement establish conditions related to the continued involvement of certain pivotal individuals within the company.

Here's a detailed explanation:

Basic Principle: The success of a startup or business often hinges on the abilities and contributions of one or more key individuals—like the founders or other top executives. Investors may want to ensure that these individuals remain involved in the company to safeguard their investment. The key-person clause helps to address this concern by setting out requirements or conditions related to the continued service of these key persons.

Key Persons Identified: The key-person clause will identify who the key persons are. This could be one or more founders, certain executives, or other important employees. In some cases, it might specify the roles (e.g., CEO) rather than the individuals.

Requirements or Conditions: The clause will specify what is required in relation to these key persons. For example, it might require that they remain full-time employees of the company, or that they maintain a certain level of involvement in the business.

Consequences of Departure: The clause may also set out what happens if a key person leaves the company or is otherwise unable to fulfill their role. For instance, it might give the investors the right to pull out of the deal, to convert their preferred shares into common shares, or to take other actions.

Legal Implications: Key-person clauses are legally binding. If a company fails to comply with the clause, it could potentially lead to legal repercussions, including breach of contract claims.

Negotiation Considerations: The specific provisions of a key-person clause are typically a point of negotiation between the company and the investor. The company may want flexibility to manage its team, while the investor may want assurances about the continued involvement of key individuals.

Both investors and companies need to understand the implications of key-person clauses. Legal advice should be sought when drafting and negotiating these provisions.

Non-Compete Agreement

Specifies restrictions on the company or certain key individuals from engaging in a similar business.

A non-compete agreement or clause in a term sheet or investment agreement sets forth restrictions on the company or certain key individuals from engaging in a similar business or competitive activities.

Here's a detailed explanation:

Basic Principle: The purpose of a non-compete agreement is to protect the investor's investment by ensuring that the company and its key individuals do not engage in activities that could directly compete with the business or undermine its value. It is especially common in industries where proprietary knowledge or customer relationships are vital assets.

Scope of the Non-Compete: The non-compete clause will define the scope of the restricted activities in terms of geography, duration, and the nature of the prohibited competition. For example, it might prohibit key individuals from starting or joining a business that competes directly with the company within a certain geographical area and for a certain period of time after leaving the company.

Parties to the Non-Compete: The non-compete agreement could apply to the company as a whole, preventing it from starting competitive lines of business, or to specific individuals such as founders or key employees.

Enforcement and Penalties: The agreement will specify the consequences for breaching the non-compete clause, which might include financial penalties, termination of the investment agreement, or potential legal action.

Legal Considerations: The enforceability of non-compete agreements varies widely by jurisdiction, with some regions having strict requirements for their scope and duration in order to prevent unfair restrictions on trade or employment. Therefore, the clause must be carefully constructed to be fair, reasonable, and compliant with local laws.

Balancing Interests: The company and the investor often have to balance competing interests when it comes to non-compete clauses. The investor wants to protect their investment, while the company and its key individuals want to ensure they aren't overly restricted in their future endeavors.

As with all provisions in an investment agreement, understanding and negotiating a non-compete clause requires careful thought and, ideally, the guidance of legal professionals.

Founder Vesting / Reverse Vesting

Specifies a schedule by which founder shares vest back to the company if a founder leaves the company.

ounder vesting, also known as reverse vesting, is a mechanism used in startup companies to ensure that founders are committed to the long-term success of the company. It's designed to protect the company and its investors, by ensuring that a founder can't leave the company early and walk away with a large ownership stake.

Here's a detailed explanation:

Vesting Schedule: Under a typical vesting schedule, founders "earn" their equity stakes over a certain period, often four years, with a one-year "cliff". If a founder leaves before the end of the cliff period, they forfeit all their shares back to the company. After the cliff, the shares vest incrementally (often monthly) until the end of the vesting period.

Reverse Vesting: Unlike the typical vesting schedule for employees, where the shares are granted and then vest to the employee, founders usually own their shares outright from the start. But in reverse vesting, the company has the right to buy back the unvested shares at the original (often nominal) purchase price if the founder leaves. Over time, as the shares vest, fewer shares can be bought back by the company.

Accelerated Vesting: Sometimes, a founder's vesting may be accelerated if certain events occur, such as if the company is sold. This can be "single trigger" (where one event, like the sale of the company, causes the acceleration), or "double trigger" (where two events must occur, such as the sale of the company followed by the termination of the founder).

Implications: Founder vesting is important to align the interests of the founders and the company. It ensures that the founders are motivated to stay and grow the company, rather than leaving early and potentially harming the company by taking a large equity stake with them.

Founder vesting terms can vary and are usually subject to negotiation between the founders, the company, and the investors. It's crucial to understand these terms and consult with legal counsel when dealing with such matters.

Lock-in Period

Specifies a period during which the investor cannot sell their shares.

Down Round Protection

Mechanisms to protect the investor from dilution in a future financing round where shares are issued at a lower valuation.

A "down round" is a financing event where a company issues additional shares at a valuation lower than the valuation at which previous shares were issued. This is generally seen as negative, as it implies the company's value has decreased. It can also dilute the ownership of existing shareholders, as new shares are issued at a lower price.

Down round protection is a clause in an investment agreement that protects an investor from the dilution that would ordinarily occur in a down round. There are several mechanisms for this, such as:

Anti-Dilution Provisions: These are the most common form of down round protection. There are two main types: 'full ratchet' and 'weighted average'. Full ratchet anti-dilution adjusts the price of the investor's shares to the new lower price if any new shares are issued at a lower price. Weighted average anti-dilution, the more common and less severe form, adjusts the price based on a weighted average of the price the investor paid and the price at which the new shares are issued.

Price Ratchet: A price ratchet gives existing shareholders the right to purchase shares at the new, lower price. This allows them to maintain their proportional ownership in the company without investing additional capital.

Preemptive Rights: These allow existing shareholders to buy enough of the new shares being issued in a down round to maintain their proportionate ownership in the company.

Convertible Notes: These are sometimes used as a form of down round protection. If a down round occurs, the note will convert into equity at the new, lower price, meaning the investor gets more shares for their investment.

These protections are designed to minimize the loss for an investor in a down round. However, they can be detrimental to the company and its other shareholders, as they can result in increased dilution. As always, it's important for both investors and entrepreneurs to understand these mechanisms and negotiate them carefully. Legal advice should always be sought when dealing with such matters.

Regulatory Compliance

The company's confirmation of compliance with relevant regulations and laws.

Subscription Agreement

The actual agreement to purchase shares, usually appended to the term sheet or executed simultaneously with the term sheet.

Expiry Date

The date until which the offer is valid, after which it may be withdrawn if not accepted.

Miscellaneous

This may include other provisions not specifically covered under other headers.