Term sheets: what binds you and what does not

Binding and non-binding parts

Most venture term sheets state that the economic and governance terms, such as valuation, liquidation preference, board seats and protective provisions, are not binding until definitive documents are signed. Certain provisions are usually expressly binding: confidentiality, exclusivity or no-shop, sometimes expenses, and governing law. Whether a clause binds depends on the wording, so read the paragraph that says which terms are binding.

Example: A founder signs a term sheet with a 45-day no-shop. Two weeks later, another investor offers better terms. The non-binding economics do not oblige the first investor to close, but the no-shop may prevent the company from soliciting or negotiating with the second investor until the period ends. Negotiate the length, what counts as solicitation, and whether it ends early if the lead walks away.

How the terms become legally effective

In a Delaware corporation, preferred stock rights are set out in the certificate of incorporation, or in a board resolution the certificate authorizes. Creating a new class of stock or increasing authorized shares usually requires amending the certificate. Under Delaware law, the board adopts a resolution declaring the amendment advisable, and a majority of the outstanding stock entitled to vote then approves it, with separate class votes where an amendment adversely affects a class.

Stockholders can often act by written consent instead of a meeting, unless the certificate of incorporation provides otherwise, if holders with the minimum votes needed sign. Delaware requires prompt notice to stockholders who did not consent. Plan these approvals early, because a co-founder or early investor whose vote is needed can delay closing.

What to check before signing

Model the economics on a fully diluted basis, including any required option pool increase and SAFE conversions. Check the liquidation preference, whether preferred stock participates after its preference, anti-dilution protection, board composition, protective provisions and any founder re-vesting. Small wording differences in these terms can mean large differences in outcomes on a sale.

The financing is also a securities offering, so plan the exemption and filings. Ask what diligence the investor will do, and get your documents in order: founder IP assignments, vesting agreements and 83(b) filings, option grants and board approvals, and contractor agreements. Gaps found late can delay a closing or change the terms.

Your next steps

1. Identify the binding paragraphs and negotiate the no-shop length and scope.
2. Map the board and stockholder approvals needed to amend the certificate of incorporation.
3. Clean up IP, vesting, option and securities records before diligence starts.