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Understanding Funding and Finance through the CVCA – Part 2: Understanding the Term Sheet

MT❯Ventures welcomes you to the second installment of our series aimed at educating startups and founders on the Canadian Venture Capital & Private Equity Association (CVCA) model documents. As you may recall, the model documents encompass various legal agreements essential for equity financing transactions. Navigating the world of venture capital can be dauting for entrepreneurs, especially when it comes to the complex terms outlined in term sheet. This week, we endeavor to demystify the top ten definitive terms behind a CVCA Term Sheet. As a reminder, the Term Sheet is a preliminary agreement, negotiated and entered into by the startup and the lead investor to outline the key terms and conditions of potential investment. While the Term Sheet is not legally binding, it serves as a roadmap for negotiations and lays the groundwork for drafting the final definitive agreements.

Top Ten Definitive Terms in the CVCA Term Sheet:

1. Valuation and Investment Amount

At the outset of the Term Sheet, you will find the valuation and investment amounts. These are critical components of the investment and it is important that founders understand the difference between pre-money and post-money valuation.  Put simply, the pre-money valuation determines the value of your company before the investment, while the post-money valuation includes the investment amount. Understanding these figures is essential in order to calculate the percentage of equity the investor will receive and the percentage of equity founders may be left with.

2. Type of Security

The Term Sheet also specifies the type of security that is being offered to the investor –the securities may  be common shares, preferred shares or convertible debt. Generally in a CVCA standard equity financing, the type of security is a series of preferred shares. Each type of security comes with its own rights and privileges and it is important to understand the implications of each on your company’s capital structure.

3. Liquidation Preference

The liquidation preference term identifies which shareholders will be paid out first on the occurrence of a liquidation event. A liquidation event can be an acquisition, merger, initial public offering (IPO), or other action that allows founders and investors to cash out some or all of their shares. Preferred shareholders typically have a “liquidation preference” over common shareholders, meaning they will be paid out first. In some cases you will see a liquidation preference multiple, meaning that the investor will be paid out on a multiple of their investment before common shareholders are paid out.

4. Voting Rights

This section outlines the voting rights of the investors, which can include the right to vote on certain corporate matters and the ability to appoint board members.

5. Protective Provisions

Protective provisions are clauses that safeguard the interests of the investors. These provisions require the company to obtain investor approval before making significant decisions, such as altering the company's capital structure, selling the company, or making substantial investments. These provisions ensure that investors have a say in key corporate actions that could affect the value of their investment and protect them from actions that might dilute their ownership.

6. Anti-Dilution Provisions

Anti-dilution provisions protect investors from dilution in future events where the company may issue securities at a purchase price less than the purchase price of the securities paid for by the investors. This ensures that their ownership percentage remains relatively stable. While there may be different types of anti-dilution mechanisms (e.g., broad-based, narrow-based, full ratchet, etc.), the CVCA Term Sheet specifies a broad-based mechanism.

7. Conversion Rights

Preferred shares often come with the right to convert into common shares under certain conditions to allow investors to choose between recovering their investment through a liquidation preference or joining the founders in a share of the proceeds following a liquidity event. The Term Sheet will specify the conversion ratio and any triggers for conversion.

8. Right of First Refusal and Co-Sale

This clause gives existing investors the right to purchase shares if a common shareholder wants to sell, preventing unwanted third parties from acquiring a stake in the company. The co-sale agreement allows investors to sell their shares alongside a selling common shareholder. The CVCA Term Sheet also sets out certain exceptions to the right of first refusal and co-sale provisions, for example transfers to a holding company or for other estate-planning purposes.

9. Drag-Along and Tag-Along Rights

Drag-along rights allow majority shareholders to force minority shareholders to join in the sale of the company, ensuring that a potential buyer can acquire 100% of the company. Tag-along rights, on the other hand, allow minority shareholders to join a sale initiated by majority shareholders, protecting their ability to exit on similar terms.

10. Conditions to closing

This section outlines the specific requirements that must be met before the investment transaction can be finalized. In our opinion, this section is underrated! These conditions often include the completion of due diligence, approval by the board and shareholders, and compliance with legal and regulatory requirements. Meeting these conditions ensures that all parties are protected and that the investment is made on a sound basis.

We’ve only scratched the surface of the different key terms in the CVCA Term Sheet. Many of these terms will be further explored as we explain the definitive agreements

Of course, we always suggest that you work with your legal team in drafting your term sheet and the other definitive agreements. At MT❯Ventures, we are here to help! Whether it’s walking you through the basics of a CVCA equity financing or helping you through the complex legal drafting, our goal is to make financing as easy for you as possible. Stay tuned for Part 3 of our series Understanding Funding and Finance through the CVCA.

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