What is a Term Sheet

Venture capital investors differ from other investors in terms of their exposure to risks that may be the highest when compared to other types of investment, as they invest in startup companies—often technology-based—with very high failure probabilities reaching up to 70%. This high risk exposure has been reflected not only in the inputs of the investment evaluation process but also in the legal and economic structuring of the investment, leading to the creation of structuring methods that are almost unique in terms of the investment method and the quality of rights obtained by the investor.

Typically, venture capital investors invest in two ways: the first is by directly purchasing equity stakes (Equity), while the second is through convertible notes (Convertible Note) within a specified period. In the case of direct equity, the process simply involves the startup issuing new shares (capital increase), and then the investor purchases them at an agreed-upon price. These shares are often preferred shares (Preferred Shares) with rights entirely different from those of common shareholders (Common Shares), who are typically the founders. As for convertible notes, the investor lends the company a specific amount, with the right to convert this amount into shares at a later date within a certain price range without determining the valuation. It is worth noting that there is a third method for financing technology startups known as Venture Debt, a type of financing that is virtually non-existent in our region despite its importance.

In this lengthy blog post, we will discuss the method of structuring equity deals by providing a simplified breakdown of the most important provisions of the Term Sheet signed by both parties. As mentioned in a previous article, this document establishes the structuring of the deal from its economic and regulatory aspects, and agreeing upon it means that both parties are fully prepared to draft binding agreements defining the relationship between them in the post-investment phase.

I prefer to divide the Term Sheet provisions into three sections:

• First: This is the section that addresses everything related to financial and economic aspects, meaning its provisions cover topics of valuation and everything that directly or indirectly affects it, the value of investments in the post-closing phase, in addition to the financial returns resulting from exit.
• Second: This section addresses the method of managing and governing the company, as well as the powers of the board of directors and investors.
•  Third: This is the section concerned with regulating the process of buying and selling shares among the owners themselves, or between the company and new owners—investors—on the other hand.

Section One: Financial and Economic Provisions

1- Valuation and Method of Calculating Shares

After defining the parties and providing an overview of the agreement, the first provision in the Term Sheet details the investment amount and valuation, and whether this investment is for purchasing new shares or existing shares from the owners. Since most venture capital investments are aimed at injecting liquidity into the company, issuing new shares is the method used. This provision distinguishes between the company's valuation before the investment and after the investment. For example, if the company is valued at 10 million riyals, this is called the Pre-Money Valuation. Then, after calculating the investment, assuming it is 5 million riyals, we arrive at the Post-Money Valuation, which will be 15 million riyals. This distinction stems from a financial concept that the valuation of any company is its value plus the cash it holds. However, in equity deals involving capital increases, distinguishing between the two valuations also helps in calculating shares.

The method of calculating shares is as follows. Assume the company has 10 million shares before the investment, and it is valued at 10 million riyals as mentioned. This means the value per share is one riyal. If an investor agrees to inject 5 million riyals into the company, the company will issue an additional five million shares in favor of this investor, thus increasing the number of shares from 10 million to 15 million shares, with the investor owning 33%.

It is very important to note that the method of calculating ownership percentages is based on the number of shares, not the amount invested. In complex deals (involving convertible notes), two investors may pay the same amount, but each receives a different ownership percentage.

2- Liquidation Preferences

This provision is considered one of the most important provisions in the Term Sheet. It determines what each partner—whether an investor or founder—will receive in the event of a company sale or liquidation, and crucially, who receives it first. This provision comes in different forms:

• In the event of a company sale or liquidation, the investor has the right to recover the invested capital, (then) after that, they have the right to receive a share equal to their ownership percentage in the company. For example, if an investor paid one million to purchase a 25% stake in the company, and then after five years the company was sold for five million riyals, the sale proceeds are distributed as follows: First, the investor takes the full amount they paid, which is one million riyals. Second, the remaining four million riyals are divided among the investors, with the investor receiving another one million riyals, representing their 25% share. Thus, the investor would have received two million riyals from the company's value of 5 million riyals.
• In the event of a company sale or liquidation, the investor has the right to recover the invested capital, (or) they have the right to receive a share equal to their ownership percentage in the company. For example, if an investor paid one million to purchase a 25% stake in the company, and then after five years the company was sold for five million riyals, the investor can choose between receiving their capital of one million riyals or receiving 1,250,000 riyals, which represents their ownership percentage in the company. However, they cannot receive both as in the first method.

There is another hybrid option, but it is complex and less common than the previous two options.

3- Vesting

In this provision, the investor ties the founders' ownership to their tenure with the company, through the gradual vesting of their shares over a specified period. Example: Assume a company owned by a single founder, with 80% ownership after the investor enters. The investor requires that all of the founder's shares be subject to vesting over four years, with 20% vesting each year. If the founder leaves after completing two years, they are entitled to only 40% of their shares. If they leave after three years, they are entitled to 60%. Sometimes this extends beyond the sale of the company, where a provision is included stating that vesting continues even after an investor acquires the entire company.

4- Employee Shares (Option Pool or ESOP)

The investor ensures the existence of unowned shares intended to be granted to talent recruited in the future. This talent is often not attracted to working in startups, especially technology ones, due to weak financial benefits and job security. Therefore, a provision is included in the Term Sheet stating that a certain percentage of shares will be set aside for future leadership hires. This percentage may range from 5% to 10% depending on the company's stage. Early-stage investors often seek to increase this percentage for three reasons: First, the company typically lacks talent and thus needs a large number of shares. Second, the share value is low because the company's value is low, thus requiring a larger number of shares to grant to talent to convince them to work for the company. Third, founders hold large stakes and can afford to lose a high percentage. The investor often ensures that this percentage exists before the company's valuation, so that their ownership is not diluted from day one.

5- Anti-Dilution

What terrifies an investor most is that the startup raises funds in a later round at a lower valuation than the round in which the investor invested. This means, from an accounting perspective, the investor records an unrealized loss in their books. For example, if an investor paid 5 million riyals at a valuation of 5 million, making the total company value 10 million riyals. Then, after a year, the company raised 2 million riyals but at a valuation of 8 million riyals. This effectively means the value of the investor's investment has decreased by approximately 20%. Therefore, the investor ensures there is a provision in the Term Sheet that mitigates the impact of down rounds. This provision typically comes in three forms:

– First: Everyone—the investor and the founder—bears any decrease in the company's value. In the previous example, the valuation would decrease by 20%, i.e., 2 million. Since the investor and founders each own 50% of the company, the value of their investments would theoretically decrease from 5 million to 4 million for each party, resulting in the following share distribution:

• 4 million for the founder (40%)
• 4 million for the investor (40%)
• 2 million for the new investor (20%)

– Second: Only the founder bears the decrease in value, while the value of the investor's shares remains the same. This is called full ratchet, and based on it, the share distribution is as follows:

• 3 million for the founder (30%)
• 5 million for the investor (50%)
• 2 million for the new investor (20%)

– Third: This is the most widespread and common form, called weighted average. In this form, the investor bears the decrease in value but at a lower percentage than the founder. It has a complex mathematical formula that is difficult to explain here, but generally, based on the previous example, the share distribution is as follows:

• 3.5 million for the founder (35%)
• 4.5 million for the investor (45%)
• 2 million for the new investor (20%)

As mentioned, the last option is the most common, while the first option is almost non-existent. The second option exists on a limited scale and in exceptional, very specific cases.

These five provisions are the most important ones that directly affect the economics of the investment and its returns, so investors pay close attention to them. In contrast, there are less common provisions that an investor may include, such as dividend distributions and valuation adjustments based on the company's future performance. These provisions are subject to various influences and depend directly on negotiations between the parties.

Section Two: Governance and Company Management Provisions

1- Board of Directors

Perhaps the most significant change when a company receives venture capital investment is its transition from being a company managed by individuals—here, the founders—to a company with a minimum level of governance and distribution of powers, ensuring decisions are made based on an institutional rather than individual structure. Therefore, institutional investors—not individuals—ensure the establishment of a board of directors with an investor representative to participate in making important decisions. The board's tasks are typically limited to decisions such as appointing or replacing the external auditor, approving the company's strategy, financial statements, and budget for the coming year, approving any amendment to the company's articles of association, which includes applications such as the entry of new investors or the exit of current investors, and other decisions.

The board usually makes decisions by simple majority (e.g., 3 out of 5 members voting, or 4 out of 7 members), but investors impose certain decisions that require the approval of the investor representative(s). Meaning, even if 4 members vote in favor and the investor representative votes against, the decision is not passed.

The required number varies depending on the company's stage. Early-stage startups do not require a large board of directors; three members may suffice, divided between the investor, the founders, and an independent third member. In later stages, the number of members is increased to 5 and then to 7 to increase representation of investors and independents, which helps raise the level of governance and even embed new skills and relationships the company needs.

2- Protective Provisions / Reserved Matters

There are decisions that the investor does not even allow the board of directors to make, as they affect their powers or rights. Therefore, decisions such as changing the number of investor representatives on the board or their powers, issuing new shares, increasing the number of shares allocated to employees, mergers, and acquisitions—all these decisions require the investor's approval after passing through the board. The aim is to add a higher and stronger level that enables the investor to prevent anything that could harm their investments.

3- Information Rights

The investor requires the company to provide them with updated information about the company's operations periodically, usually quarterly. The information includes, but is not limited to: the company's financial status quarterly and annually audited by an external auditor, any new contractual relationships or government transactions, and minutes of board meetings. The aim is to keep the investor continuously informed of the most prominent developments and to be able to act quickly if necessary.

Section Three: Share Sale and Purchase Provisions

1- Right of First Refusal

This provision regulates the process of selling shares owned by any partner. In short, the provision requires any partner wishing to sell their shares to another partner or an external investor to first offer these shares to all current company owners, who have the right to purchase them in proportions matching their ownership percentages in the company.

2- Tag Along

This provision addresses the same situation but in a different scenario specific to the venture capital investor's right. If the investor does not wish to purchase the available shares for sale, they have the right to also sell their shares to the external investor in proportion to their ownership percentage in the company. Moreover, the provision often includes the investor's right to sell all their shares if the transaction would result in a fundamental change in the company's ownership structure.

Example: A venture capital investor owns a stake of 20 shares (i.e., 20%), while the founder owns a stake of 80 shares (i.e., 80%). Assume an external investor offers to buy 10 shares from the founder (i.e., 10% of the company's value). In this case, the venture capital investor has the right to also sell a portion of their stake to the external investor, and the sale process should not be limited to the founder and the external buyer. That is, the (10%) is divided proportionally between the founder and the investor. The founder sells 8 shares because they own 80%, and the investor sells 2 shares because they own 20%.

What if the offer was to buy 60 shares from the founder's stake (i.e., 60% of the company)? In this case, there would be a fundamental change in the company's ownership, and thus the venture capital investor has the right to fully exit and sell their entire stake, selling 20 shares while the founder sells only 40 shares, and the division is not based on proportionality.

This provision primarily targets the stakes of founders or investors with large holdings whose exit would affect the company. Therefore, it sets a minimum threshold for the percentage of shares an investor must own before this right is activated, such as the shareholder owning at least 20%. Meaning, if a shareholder owning a 5% stake wants to sell their shares, the first provision (Right of First Refusal) would apply, but other shareholders would not have the right to sell their shares to the external buyer in the same proportion.

3- Pre-emption Right

This provision regulates the process of selling new shares issued by the company. If the company wants to raise new investments and issue additional shares, current investors have the right to participate in proportions matching their ownership percentages in the company.

4- Drag Along

This provision is one of the most controversial, as it grants a class of shareholders (new investors) the right to force the remaining shareholders to sell their shares if an exit opportunity arises that has been approved by the investors and the board of directors. That is, if the founder or another shareholder objects to the sale, they are legally compelled to sell their shares. The importance of this provision stems from the importance of the exit process for the investor. When an investor injects funds, they look forward to the day they sell their investments, whether to achieve satisfactory returns or even to recover their capital in the worst-case scenario. Therefore, the existence of a buyer for the company is an opportunity the investor does not want to miss. This provision has evolved and become less severe, now including a guarantee of a minimum return for investors. Meaning, the provision is not activated if the deal does not achieve profits of, for example, at least 100% of the cost paid by the shareholder objecting to the sale. The provision comes in various forms and methods that cannot be listed here as they differ based on the composition of the company's owners.