Term Sheet and Structure of VC Deal: SAFE, Convertible Notes, Preferred Stock

Term Sheet: What Is It and What Is It For?

Term Sheet (TS) is a non-binding (as a rule) document that records the key terms of the proposed investment. It is not a legally binding agreement (except for provisions regarding confidentiality and exclusivity).

Why is a TS needed:

Fixes the basic agreements before an expensive due diligence
Defines the negotiating positions of the parties
Serves as the basis for preparing legal documents (SHA, Subscription Agreement, Investment Agreement)

SAFE (Simple Agreement for Future Equity)

Invented by Y Combinator in 2013. The most popular instrument at pre-seed and seed stages in the USA, actively adopted in MENA/UAE.

Mechanics:

Investor provides money today
Does not receive shares immediately (no current valuation)
At the next equity round, SAFE is converted into preferred shares
Conversion occurs at a discount or at a reduced price relative to the next round’s valuation

Key parameters of SAFE:

Valuation Cap: Maximum valuation for conversion. If a SAFE has a cap of $5 million, and the next round takes place at a pre-money $10 million — the investor converts as if at $5 million (gets more shares).

Discount Rate: Discount to the share price in the next round (usually 15–25%).

MFN (Most Favored Nation): Provision without cap/discount: if more favorable SAFEs are issued — automatic conversion at the best terms.

Pro Rata Rights: The investor’s right to participate in subsequent rounds in proportion to their share (protection against dilution).

Example of SAFE conversion:

Investor invested $500,000 SAFE with a cap of $4 million
Series A round: pre-money valuation $8 million, share price $1.00
SAFE converts at $0.50 (cap $4 million / $8 million × $1.00)
Investor receives: $500,000 / $0.50 = 1,000,000 shares
Without cap: $500,000 / $1.00 = 500,000 shares
The cap gave the investor twice as many shares

Convertible Notes (CN)

An older instrument (preceding SAFE). A debt instrument with conversion into equity.

Differences from SAFE:

CN is debt (from a legal perspective): interest accrues, there is a maturity date
If the round does not occur, the investor can demand repayment of the debt (theoretically)
SAFE is not debt: no interest, no maturity

Parameters of CN:

Interest rate: usually 2–8% per annum (often added to the principal, not paid in cash)
Maturity: usually 18–24 months
Conversion discount: 15–25%
Valuation cap: similar to SAFE

Preferred Stock

In equity rounds (Series A and onwards), investors receive preferred shares (Preferred Stock / Preference Shares), not common stock.

Liquidation Preference

The key advantage of Preferred: in case of liquidation/sale of the company, Preferred holders receive money first.

Non-participating Preferred (Vanilla):

Upon exit, Preferred holder receives liquidation preference (usually 1x — return of investment) OR converts into Common and gets a proportional share
Chooses the more advantageous option

Participating Preferred (Double Dip):

Receives liquidation preference (1x) AND then participates in the distribution of the remainder as Common
Extremely disadvantageous for founders

Multiple Liquidation Preference:

2x, 3x: the investor receives 2-3 times reimbursement before distribution among common shareholders
Aggressive, became rare after 2022

Example:

VC invested $10 million for 25% (1x Non-participating Preferred)
Company sold for $20 million
VC chooses between: (a) liquidation preference $10 million or (b) 25% × $20 million = $5 million → chooses (a)
If sold for $50 million: VC chooses (b) = $12.5 million > $10 million

Anti-Dilution Protection

Protection against a down round (the next round at a lower valuation).

Broad-based weighted average: The most common standard. Adjusts the conversion rate proportionally to the scale of the down round.

Full ratchet: Tough for founders: conversion price is reset to the down round price. Occurs rarely.

Shareholder Agreement (SHA)

The key legal document regulating shareholders' rights.

Key provisions:

Drag-along: The majority (usually investors + founders) can oblige minority shareholders to sell shares on the same terms at exit. Needed to ensure a clean exit.

Tag-along: If the controlling shareholder sells shares, minorities can sell on the same terms. Protection for minorities.

Right of First Refusal (ROFR): Shareholders have the right to buy shares from a selling shareholder before he sells to third parties.

Preemptive Rights (Pro-rata): The right to participate in new rounds proportionally to one’s share.