The Big Five Termsheet Clauses

In a challenging fundraising landscape, founders should focus on the “Big Five” term sheet clauses, which can significantly impact company control and economic outcomes. Learn how understanding liquidation preferences, anti-dilution rights, and more can shape venture capital relationships.

Jan 13, 2023

Marius Swart


Image copyright OranjeSafari.nl

Executive Summary

  • Term sheets lay out the proposed investment terms in a transaction with these terms having become standard.

  • However, given the current challenging fundraising environment, founders should pay special attention to certain clauses we internally refer to as the Big Five clauses (an ode to Pace’s Marius South African heritage ;)).

  • These Big Five clauses can have a significant impact on both the economics and control aspects of a company.

  • The Big Five clauses explained below are 1. Liquidation preference, 2. Anti-Dilution rights, 3. Pay-to-Play, 4. Protective Provisions, and 5. Drag-along rights.

Introduction

One of the ways a company can be financed is to raise money from venture capitalists. While only a very small percentage (less than 1%) of the companies that venture capitalists meet receive funding from them, the ones that do obtain an investment set forth the terms in a term sheet.

Term sheets have been around for decades and come in all shapes and sizes. Sometimes the document is a simple one-pager, but as the size of the business, and therefore the complexity, increases, we have seen term sheets exceed ten pages. Term sheets are legal documents but most are non-binding, meaning the VC can still decide not to invest. This does happen but most VCs are unlikely to extend a term sheet and not follow through on the deal.

As Brad Feld and Jason Mendelson communicated in their blockbuster VC book, called “Venture Deals”, there are only two key things that matter in an actual term sheet negotiation — economics and control.

Economic terms refer to the amount of capital to be invested and the structure of the investment. This includes the investment amount, the type of security offered in exchange for the investment, and the repayment terms. Control terms refer to the rights and responsibilities of both the investor and the startup, such as board composition, voting rights, and exit rights.

The term sheet will essentially be an indication of the founder’s future relationship with any investor. Examples of term sheets can be downloaded for free (see YC term sheet template) — it is, however, crucial to understand the implications of each clause so that founders can make an informed decision when negotiating the terms of the investment. With this article, we want to focus on what we internally refer to as Big Five clauses in the term sheets.

Why? After a record-breaking 2021, with very high valuations and a growth-all-cost mentality, the venture community was forced to slow down in 2022. This resulted in some of the most significant layoffs, insolvencies, and down rounds. With it, the discussion around Big Five clauses also increased and several founders were unaware of the implications of these clauses and so we wanted to shed more light on each of these.

These Big Five clauses are discussed as follows in more detail.Those that impact the economics of the deal:

1. Liquidation Preference:

This clause impacts how the proceeds are distributed if a company is liquidated. As the name suggests, this clause gives the venture capitalist a preference over founders and/or other shareholders when it comes to getting their money back. It is especially important in cases where the company is sold for less than the amount of capital invested.

There are two components: the actual preference and the participation. The real preference refers to the series of stock classes that receive a distribution ahead of other shareholders. The liquidation amount is stated as a multiple of the original investment. The industry standard during regular economic cycles has been 1x liquidation preference, which means the original amount invested. Lately, we have seen the multiple be as high as 3x the initial investment as investors try to protect to the downside, and several founders are forced to accept this to get a deal done.

The participation concept comes in three varieties. Full participation, capped participation, and no participation. For many years, 1x non-participating was acceptable, but recently this has been changing to full participation.

Image copyright EquityNet

No participation means the investor either gets the liquidation preference OR the stock converts into C/S, and the investor gets their as-converted basis allocation. Fully participating stock will receive its participation amount AND then share in the liquidation proceeds on an as-converted basis.

In our view, there are two things to remember as it deals with liquidation preferences:

  • The participation concept has a larger impact on low outcomes and less on higher results.

  • The next round will stack their preferences on the top of the previous round of investors. As such, in early-stage financing where Pace Ventures invests, we like to keep it simple and have a 1x non-participation clause. If participating, the clause goes away if the company achieves a meaningful return of at least 2x to the VC.

2. Pay to Play:

This is another term most relevant in downrounds and can be helpful to founders when the company is finding it hard to raise follow-on financing. The crux is that investors must keep participating pro-rata in future financings or risk having all or a portion of their preferred shares converted into common stock. In this scenario, investors will then lose the rights associated with preferred stock. When this happens, it impacts the deal’s economics by reducing the liquidation preference for non-participating investors.

The founder wants to avoid a pay-to-play scenario where the VC has the right to force a recap of the company (i.e., financing at a very low valuation) if other investors do not participate in the round. This means that the venture capitalist can dilute the other investors’ shares.

3. Anti-Dilution:

This clause gives the venture capitalist the right to purchase additional shares at a discounted rate if the company issues additional shares at a lower valuation. This can impact the founders’ control of the company, and there are two varieties: weighted average anti-dilution and ratchet-based anti-dilution.

The most used provision is the weighted average concept, which considers the magnitude of the lower price issuance and not just the lower valuation amount. Therefore, the number of shares issued at the reduced price is considered in repricing the round, but with full ratchet, all the previous round shares are repriced, not only the newly issued shares.

Those that impact the control aspects of the deal:

4. Drag-Along Rights:

This clause gives the venture capitalist the right to force or drag along the other shareholders, including founders, to sell their shares regardless of how the others feel about the deal. The best outcome for founders is asking for a drag-along clause only triggered when most common stockholders, not the preferred holders, consent. This way, founders will be dragged into a deal only if most common shareholders feel it is a good deal and not only the venture capitalist.

5. Protective Provisions:

These give venture capitalists effective veto rights on specific actions in the company, such as the sale of the company or the issuing of new shares. We have seen legal teams turn red in the face negotiating these provisions, but they have become standardized nowadays. The terms are included to protect the VC and cover the following main areas:

  • Changing the terms of the stock owned by the VC

  • Authorize the creation of more stock

  • Issue stock senior or equal to the VC

  • Buy back any common stock

  • Borrow money (usually a cap is included to allow for some flexibility)

  • Sell the company

  • Change the certificate of incorporation

  • Change the bylaws

  • Change the size of the board of directors

  • Pay or declare a dividend.

The critical thing founders should remember is that these clauses do not prohibit them from any of these activities. They simply require the consent of the investors.

Conclusion

Kindly note that none of the information in this article constitutes legal advice from us. We are NOT lawyers, and there is no substitute for an excellent legal team that knows venture capital.

However, we hope that this post is helpful to founders in avoiding uncomfortable discussions with their investors, especially in environments where down rounds and liquidations have been and will become more frequent.


Image copyright OranjeSafari.nl

Executive Summary

  • Term sheets lay out the proposed investment terms in a transaction with these terms having become standard.

  • However, given the current challenging fundraising environment, founders should pay special attention to certain clauses we internally refer to as the Big Five clauses (an ode to Pace’s Marius South African heritage ;)).

  • These Big Five clauses can have a significant impact on both the economics and control aspects of a company.

  • The Big Five clauses explained below are 1. Liquidation preference, 2. Anti-Dilution rights, 3. Pay-to-Play, 4. Protective Provisions, and 5. Drag-along rights.

Introduction

One of the ways a company can be financed is to raise money from venture capitalists. While only a very small percentage (less than 1%) of the companies that venture capitalists meet receive funding from them, the ones that do obtain an investment set forth the terms in a term sheet.

Term sheets have been around for decades and come in all shapes and sizes. Sometimes the document is a simple one-pager, but as the size of the business, and therefore the complexity, increases, we have seen term sheets exceed ten pages. Term sheets are legal documents but most are non-binding, meaning the VC can still decide not to invest. This does happen but most VCs are unlikely to extend a term sheet and not follow through on the deal.

As Brad Feld and Jason Mendelson communicated in their blockbuster VC book, called “Venture Deals”, there are only two key things that matter in an actual term sheet negotiation — economics and control.

Economic terms refer to the amount of capital to be invested and the structure of the investment. This includes the investment amount, the type of security offered in exchange for the investment, and the repayment terms. Control terms refer to the rights and responsibilities of both the investor and the startup, such as board composition, voting rights, and exit rights.

The term sheet will essentially be an indication of the founder’s future relationship with any investor. Examples of term sheets can be downloaded for free (see YC term sheet template) — it is, however, crucial to understand the implications of each clause so that founders can make an informed decision when negotiating the terms of the investment. With this article, we want to focus on what we internally refer to as Big Five clauses in the term sheets.

Why? After a record-breaking 2021, with very high valuations and a growth-all-cost mentality, the venture community was forced to slow down in 2022. This resulted in some of the most significant layoffs, insolvencies, and down rounds. With it, the discussion around Big Five clauses also increased and several founders were unaware of the implications of these clauses and so we wanted to shed more light on each of these.

These Big Five clauses are discussed as follows in more detail.Those that impact the economics of the deal:

1. Liquidation Preference:

This clause impacts how the proceeds are distributed if a company is liquidated. As the name suggests, this clause gives the venture capitalist a preference over founders and/or other shareholders when it comes to getting their money back. It is especially important in cases where the company is sold for less than the amount of capital invested.

There are two components: the actual preference and the participation. The real preference refers to the series of stock classes that receive a distribution ahead of other shareholders. The liquidation amount is stated as a multiple of the original investment. The industry standard during regular economic cycles has been 1x liquidation preference, which means the original amount invested. Lately, we have seen the multiple be as high as 3x the initial investment as investors try to protect to the downside, and several founders are forced to accept this to get a deal done.

The participation concept comes in three varieties. Full participation, capped participation, and no participation. For many years, 1x non-participating was acceptable, but recently this has been changing to full participation.

Image copyright EquityNet

No participation means the investor either gets the liquidation preference OR the stock converts into C/S, and the investor gets their as-converted basis allocation. Fully participating stock will receive its participation amount AND then share in the liquidation proceeds on an as-converted basis.

In our view, there are two things to remember as it deals with liquidation preferences:

  • The participation concept has a larger impact on low outcomes and less on higher results.

  • The next round will stack their preferences on the top of the previous round of investors. As such, in early-stage financing where Pace Ventures invests, we like to keep it simple and have a 1x non-participation clause. If participating, the clause goes away if the company achieves a meaningful return of at least 2x to the VC.

2. Pay to Play:

This is another term most relevant in downrounds and can be helpful to founders when the company is finding it hard to raise follow-on financing. The crux is that investors must keep participating pro-rata in future financings or risk having all or a portion of their preferred shares converted into common stock. In this scenario, investors will then lose the rights associated with preferred stock. When this happens, it impacts the deal’s economics by reducing the liquidation preference for non-participating investors.

The founder wants to avoid a pay-to-play scenario where the VC has the right to force a recap of the company (i.e., financing at a very low valuation) if other investors do not participate in the round. This means that the venture capitalist can dilute the other investors’ shares.

3. Anti-Dilution:

This clause gives the venture capitalist the right to purchase additional shares at a discounted rate if the company issues additional shares at a lower valuation. This can impact the founders’ control of the company, and there are two varieties: weighted average anti-dilution and ratchet-based anti-dilution.

The most used provision is the weighted average concept, which considers the magnitude of the lower price issuance and not just the lower valuation amount. Therefore, the number of shares issued at the reduced price is considered in repricing the round, but with full ratchet, all the previous round shares are repriced, not only the newly issued shares.

Those that impact the control aspects of the deal:

4. Drag-Along Rights:

This clause gives the venture capitalist the right to force or drag along the other shareholders, including founders, to sell their shares regardless of how the others feel about the deal. The best outcome for founders is asking for a drag-along clause only triggered when most common stockholders, not the preferred holders, consent. This way, founders will be dragged into a deal only if most common shareholders feel it is a good deal and not only the venture capitalist.

5. Protective Provisions:

These give venture capitalists effective veto rights on specific actions in the company, such as the sale of the company or the issuing of new shares. We have seen legal teams turn red in the face negotiating these provisions, but they have become standardized nowadays. The terms are included to protect the VC and cover the following main areas:

  • Changing the terms of the stock owned by the VC

  • Authorize the creation of more stock

  • Issue stock senior or equal to the VC

  • Buy back any common stock

  • Borrow money (usually a cap is included to allow for some flexibility)

  • Sell the company

  • Change the certificate of incorporation

  • Change the bylaws

  • Change the size of the board of directors

  • Pay or declare a dividend.

The critical thing founders should remember is that these clauses do not prohibit them from any of these activities. They simply require the consent of the investors.

Conclusion

Kindly note that none of the information in this article constitutes legal advice from us. We are NOT lawyers, and there is no substitute for an excellent legal team that knows venture capital.

However, we hope that this post is helpful to founders in avoiding uncomfortable discussions with their investors, especially in environments where down rounds and liquidations have been and will become more frequent.


Image copyright OranjeSafari.nl

Executive Summary

  • Term sheets lay out the proposed investment terms in a transaction with these terms having become standard.

  • However, given the current challenging fundraising environment, founders should pay special attention to certain clauses we internally refer to as the Big Five clauses (an ode to Pace’s Marius South African heritage ;)).

  • These Big Five clauses can have a significant impact on both the economics and control aspects of a company.

  • The Big Five clauses explained below are 1. Liquidation preference, 2. Anti-Dilution rights, 3. Pay-to-Play, 4. Protective Provisions, and 5. Drag-along rights.

Introduction

One of the ways a company can be financed is to raise money from venture capitalists. While only a very small percentage (less than 1%) of the companies that venture capitalists meet receive funding from them, the ones that do obtain an investment set forth the terms in a term sheet.

Term sheets have been around for decades and come in all shapes and sizes. Sometimes the document is a simple one-pager, but as the size of the business, and therefore the complexity, increases, we have seen term sheets exceed ten pages. Term sheets are legal documents but most are non-binding, meaning the VC can still decide not to invest. This does happen but most VCs are unlikely to extend a term sheet and not follow through on the deal.

As Brad Feld and Jason Mendelson communicated in their blockbuster VC book, called “Venture Deals”, there are only two key things that matter in an actual term sheet negotiation — economics and control.

Economic terms refer to the amount of capital to be invested and the structure of the investment. This includes the investment amount, the type of security offered in exchange for the investment, and the repayment terms. Control terms refer to the rights and responsibilities of both the investor and the startup, such as board composition, voting rights, and exit rights.

The term sheet will essentially be an indication of the founder’s future relationship with any investor. Examples of term sheets can be downloaded for free (see YC term sheet template) — it is, however, crucial to understand the implications of each clause so that founders can make an informed decision when negotiating the terms of the investment. With this article, we want to focus on what we internally refer to as Big Five clauses in the term sheets.

Why? After a record-breaking 2021, with very high valuations and a growth-all-cost mentality, the venture community was forced to slow down in 2022. This resulted in some of the most significant layoffs, insolvencies, and down rounds. With it, the discussion around Big Five clauses also increased and several founders were unaware of the implications of these clauses and so we wanted to shed more light on each of these.

These Big Five clauses are discussed as follows in more detail.Those that impact the economics of the deal:

1. Liquidation Preference:

This clause impacts how the proceeds are distributed if a company is liquidated. As the name suggests, this clause gives the venture capitalist a preference over founders and/or other shareholders when it comes to getting their money back. It is especially important in cases where the company is sold for less than the amount of capital invested.

There are two components: the actual preference and the participation. The real preference refers to the series of stock classes that receive a distribution ahead of other shareholders. The liquidation amount is stated as a multiple of the original investment. The industry standard during regular economic cycles has been 1x liquidation preference, which means the original amount invested. Lately, we have seen the multiple be as high as 3x the initial investment as investors try to protect to the downside, and several founders are forced to accept this to get a deal done.

The participation concept comes in three varieties. Full participation, capped participation, and no participation. For many years, 1x non-participating was acceptable, but recently this has been changing to full participation.

Image copyright EquityNet

No participation means the investor either gets the liquidation preference OR the stock converts into C/S, and the investor gets their as-converted basis allocation. Fully participating stock will receive its participation amount AND then share in the liquidation proceeds on an as-converted basis.

In our view, there are two things to remember as it deals with liquidation preferences:

  • The participation concept has a larger impact on low outcomes and less on higher results.

  • The next round will stack their preferences on the top of the previous round of investors. As such, in early-stage financing where Pace Ventures invests, we like to keep it simple and have a 1x non-participation clause. If participating, the clause goes away if the company achieves a meaningful return of at least 2x to the VC.

2. Pay to Play:

This is another term most relevant in downrounds and can be helpful to founders when the company is finding it hard to raise follow-on financing. The crux is that investors must keep participating pro-rata in future financings or risk having all or a portion of their preferred shares converted into common stock. In this scenario, investors will then lose the rights associated with preferred stock. When this happens, it impacts the deal’s economics by reducing the liquidation preference for non-participating investors.

The founder wants to avoid a pay-to-play scenario where the VC has the right to force a recap of the company (i.e., financing at a very low valuation) if other investors do not participate in the round. This means that the venture capitalist can dilute the other investors’ shares.

3. Anti-Dilution:

This clause gives the venture capitalist the right to purchase additional shares at a discounted rate if the company issues additional shares at a lower valuation. This can impact the founders’ control of the company, and there are two varieties: weighted average anti-dilution and ratchet-based anti-dilution.

The most used provision is the weighted average concept, which considers the magnitude of the lower price issuance and not just the lower valuation amount. Therefore, the number of shares issued at the reduced price is considered in repricing the round, but with full ratchet, all the previous round shares are repriced, not only the newly issued shares.

Those that impact the control aspects of the deal:

4. Drag-Along Rights:

This clause gives the venture capitalist the right to force or drag along the other shareholders, including founders, to sell their shares regardless of how the others feel about the deal. The best outcome for founders is asking for a drag-along clause only triggered when most common stockholders, not the preferred holders, consent. This way, founders will be dragged into a deal only if most common shareholders feel it is a good deal and not only the venture capitalist.

5. Protective Provisions:

These give venture capitalists effective veto rights on specific actions in the company, such as the sale of the company or the issuing of new shares. We have seen legal teams turn red in the face negotiating these provisions, but they have become standardized nowadays. The terms are included to protect the VC and cover the following main areas:

  • Changing the terms of the stock owned by the VC

  • Authorize the creation of more stock

  • Issue stock senior or equal to the VC

  • Buy back any common stock

  • Borrow money (usually a cap is included to allow for some flexibility)

  • Sell the company

  • Change the certificate of incorporation

  • Change the bylaws

  • Change the size of the board of directors

  • Pay or declare a dividend.

The critical thing founders should remember is that these clauses do not prohibit them from any of these activities. They simply require the consent of the investors.

Conclusion

Kindly note that none of the information in this article constitutes legal advice from us. We are NOT lawyers, and there is no substitute for an excellent legal team that knows venture capital.

However, we hope that this post is helpful to founders in avoiding uncomfortable discussions with their investors, especially in environments where down rounds and liquidations have been and will become more frequent.

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