If your company is ready for investment, congratulations! You've reached a milestone. Now you must ensure that both you and your investors have a documented understanding of the terms under which they will make a financial investment in your company. This post discusses what is typically included in a term sheet for an early stage equity financing. In particular, this post discusses a preferred stock equity financing term sheet. Term sheets will vary significantly depending on the preferences of the preferred investors and the negotiating power between the company and the investors. The items listed below generally describe what a company might expect to see in a preferred stock equity investment term sheet:

Price Per Share or Pre-Money Valuation.

The term sheet will often include either a price per share or a pre-money valuation on which the price per share will be based. In either event, the term sheet will almost always set forth the financial terms of the equity investment.

Maximum Offering Amount.

The maximum offering amount allows investors to calculate the maximum amount of the company that will be sold to investors in the offering and the minimum percentage of equity that the investor will own following the completion of that round (if the offering is fully subscribed).

Offering Period.

The offering period typically limits the time period in which shares may be sold. This is designed to make sure the offering doesn’t go on into perpetuity when the value of the company might have changed significantly.

Liquidation Preferences.

Generally, upon a liquidation of the company, the preferred shareholders will have the right to choose (i) whether to receive their original investment amount in the liquidation with the common shares receiving the remainder of the proceeds of the liquidation, or (ii) choose to convert to common stock at the conversion price (without receiving intial proceeds) and participate in the distributions on the same terms as the common stockholders on an as-converted basis. In some situations, the preferred shareholders may have the right to receive their initial investment and convert to common stock on the same terms as the common shareholders (i.e., participating preferred), but that is no longer the most common method.

Anti-Dilution Provisions.

The term sheet will also usually contain anti-dilution provisions, which protect the preferred investors from being diluted in a future "down round" or other equity offering by the company. Typically, the "weighted average" anti-dilution method is used, but a "full ratchet" method could also be used. The specifics of how the anti-dilution provisions actually work are beyond the scope of this post.

Board of Directors.

Preferred investors often ask for a provision that grants them one or more seats on the Board of Directors of the company. Often, the preferred investors and the common shareholders will each be permitted to appoint a certain number of directors and then vote together on any remaining directors.

Voting Rights.

The term sheet will often stipulate as to how the preferred shares will vote and whether they will be allowed to vote separately on any actions taken by the company. Subject to the protective provisions below, the preferred shares will usually vote together with the common shares on all matters subject to a vote of shareholders.

Right of First Refusal.

The preferred investors will almost always request (and usually obtain) a right of first refusal to purchase their pro-rata percentage of shares offered by the company in a future offering. This right allows the investors to protect themselves from anti-dilution. The term sheet may also include references to drag-along, tag-along and registration rights, but those terms are beyond the scope of this post.

Protective Provisions.

In addition to the anti-dilution rights and rights of first refusal described above, preferred investors will sometimes negotiate what amounts to a veto right on proposed actions of the company. The protective provisions generally set forth certain actions that the company may not take without the approval of the approval of a majority of the preferred shares or, in some cases the director appointed by the preferred holders.

Again, term sheets for preferred stock equity offerings may differ significantly based on the stage of the company and the preferences of the investors. However, the concepts noted above are some of the concepts startups should expect to see in a term sheet for an preferred stock equity financing.