What corporations need to know about VC term sheets

For corporations considering venture investing, the term sheet is where strategy meets structure. This guide walks corporate investors through the key terms, protections, and negotiation dynamics they need to understand before writing their first check — or their next one.

If you’ve followed along in our What Corporations Need to Know series, you’ve read why corporations might consider venture investing, the value of building an ecosystem, and the potential returns on investment – both strategic and financial. At TechNexus, we’re big advocates of corporations investing in early stage businesses, so we’re going to get into the nitty gritty - HOW to move forward with an investment and some of the most influential legal terms that any investor should understand before cutting a check. Today, we’ll cover what corporations need to know about venture capital term sheets.

Let’s play out a scenario, shall we? Let’s imagine that our post on venture investing sold you on the concept. Perhaps you’ve spent the last few weeks sourcing and talking to relevant startups, trying to find the right one to make your company’s first investment. You finally found it. The perfect company – strategically relevant, experienced team, killer product, large market, and you have the requisite sign-off from your C-Suite to invest. So now what?

The first step to actually facilitating a venture investment is a term sheet, a legal document issued by the lead investor meant to outline the key legal specifications of the round. If you are coming into the round as one investor among a syndicate, there is likely already a term sheet on the table, and your job is simply to review it and agree to it. If you’re the sole investor or the first to commit to a round, it may be up to you (and your legal counsel) to propose the terms. Either way, venture investors should have a good understanding of the key legal terms surrounding investment.

I like to break legal terms into two broad categories – terms that dictate control of the company and those that dictate the financial return of shareholders. Control terms determine who makes decisions in the daily operations of the business (typically management) and who makes decisions around future fundraising, exit transactions, and overall governance (a combination of management, shareholders, and the board). Financial terms outline ownership percentage of a company and the distribution of capital in the event of an exit or liquidation. We’ll walk through some of the key Control and Financial terms below.

Control Terms

• Board Structure: The term sheet will outline the board structure as well as the decisions that are purview of the board vs. management vs. shareholders. Boards may range from three to seven or more seats, depending on the stage of the company. For a three-person board of directors, the structure is typically one common shareholder (CEO), one preferred shareholder (lead investor), and one independent director. The board of directors has fiduciary responsibility to all shareholders and has the power to fire the CEO.
• Protective Provisions: Protective provisions are veto rights that investors have on specific actions taken by the company. Common protective provisions state that without preferred shareholder (or board) approval, the company can’t:
  • Change the terms of stock owned by preferred holders
  • Authorize the creation of more stock
  • Issue stock senior or equal to the preferred holders’
  • Buy back any common stock
  • Sell the company
  • Change the certificate of incorporation or bylaws
  • Change the size of the Board of Directors
  • Pay or declare a dividend
  • Borrow money

Financial Terms

• Valuation, price per share: Simply put, this is the price that investors will pay for each share of equity.
• Liquidation Preference: Liquidation preference will dictate which shareholders get paid out first in the event of an exit or liquidation. A 1x liquidation preference is most common (i.e., preferred shareholders are guaranteed their capital back before common shareholders get paid); in investor-friendly deals, 2-3x liquidation preferences can be negotiated.
• Pro Rata / Preemptive Rights: Pro Rata rights give the investor the right (but not the obligation) to invest in a company’s subsequent round in order to maintain its ownership. This right is very standard and important for investors to defend against dilution.
• Anti-Dilution: Anti-dilution terms protect investors from dilution from a future financing round that is at a lower price per share. It can be “broad-based weighted average” or “full ratchet”; broad-based is most common, and full ratchet is very investor friendly.

When it comes to corporate venture capital, there’s a third category of legal terms to keep in mind – what I’ll call strategic terms. If you are investing on behalf of a corporation, it’s likely that that corporation has not only a financial interest in the investment, but also a strategic one (see here for a refresh on strategic and financial returns). We’ll outline a few strategic terms you might consider below.

• Most Favored Nation: As in customer contracts, a most favored nation clause promises that the company will treat the investor as well as it treats any other investor that might request preferential treatment.
• Exclusivity: If a strategic investment coincides with a partnership, vendor agreement, or other relationship, a corporate investor may request exclusivity, either broadly, or from a specified list of competitors.
• Right of First Refusal: Corporate venture capital can sometimes be the first step to a strategic acquisition. If this is a consideration, a corporation may request a right of first refusal, giving it the option to purchase a company in the event the company receives an acquisition offer.

Legal terms may vary, and we always advise working with legal counsel that has specific venture capital deal experience. If you want to talk more about term sheets or if you’d like to learn more about the TechNexus approach, please reach out to Kaitlyn Doyle, VP at TechNexus.

By Kaitlyn Doyle at TechNexus Venture Collaborative