Venture Capital Term Sheets in Hong Kong: What Every Founder Needs to Know

Introduction: The Term Sheet Is Not Just a Formality

A venture capital term sheet is often the most important document a startup founder will ever sign — and yet it is frequently treated as a formality to be accepted quickly in the excitement of receiving investment. In reality, the term sheet sets the legal, economic, and governance framework for what will be a multi-year relationship with investors who will influence every major decision the company makes.

This guide walks through the key provisions of a typical Hong Kong venture capital term sheet, explains what they mean in practice, and highlights the terms that most directly affect the founder's economic outcome and control over their company.

The Investment: Pre-Money Valuation and Share Structure

Pre-Money and Post-Money Valuation

The pre-money valuation is the agreed value of the company immediately before the investment. The post-money valuation is the pre-money valuation plus the investment amount. The investor's ownership percentage is calculated as: investment amount ÷ post-money valuation.

Example: A company with a pre-money valuation of HK$40 million raises HK$10 million. Post-money valuation = HK$50 million. The investor owns 20% (HK$10M ÷ HK$50M). The founders own the remaining 80% (subject to any existing shareholders).

Valuation is primarily a negotiation between the parties based on the company's traction, market opportunity, team quality, and comparable deals. Be aware of the difference between the headline valuation and the effective valuation after accounting for liquidation preferences and anti-dilution provisions.

Preference Shares

Institutional VC investors almost invariably invest via preference shares (or convertible notes that convert into preference shares) rather than ordinary shares. Preference shares carry rights that protect the investor's downside while allowing participation in the upside. Key preference share rights include:

• Priority on liquidation (the liquidation preference)
• Anti-dilution protection (discussed below)
• Enhanced voting rights on specified reserved matters
• Conversion rights (into ordinary shares, typically at any time at the investor's election)
• Dividend rights (typically cumulative preferred dividends)

Liquidation Preference

The liquidation preference determines how sale proceeds are distributed among shareholders when the company is sold or wound up. It is one of the most economically significant terms for founders.

1x Non-Participating Preferred

The investor receives the higher of: (a) their investment back (1x their invested capital), or (b) their pro-rata share of the proceeds if they convert their preference shares to ordinary shares. This is the most founder-friendly structure: the investor only receives preferential treatment if the proceeds would otherwise give them less than they invested.

1x Participating Preferred

The investor receives their 1x preference first, and then participates pro-rata with ordinary shareholders in the remaining proceeds. This is more investor-friendly: even in a good exit, the investor extracts more value than their proportional ownership would suggest. In a very large exit, the economic impact diminishes, but in a moderate exit it can significantly dilute the founders' proceeds.

Multiple Liquidation Preference

The investor receives 2x, 3x, or more of their investment before ordinary shareholders receive anything. This is aggressive and is generally only seen in difficult market conditions or for companies perceived to be high-risk. Founders should push back hard on multiple liquidation preferences.

Practical tip: Model different exit scenarios — at 1x, 3x, and 10x invested capital — under each liquidation preference structure to understand the economic impact before agreeing to terms.

Anti-Dilution Protection

Anti-dilution provisions protect investors against the dilutive effect of future fundraising rounds at a lower valuation (a “down round”). They adjust the conversion price of the preference shares to compensate the investor for the loss in value.

Broad-based weighted average: The adjustment takes into account all dilutive issuances, producing a moderate adjustment. This is the market standard in well-negotiated term sheets.

Narrow-based weighted average: Only issued and outstanding shares are included in the calculation, producing a larger adjustment. More investor-friendly than broad-based.

Full ratchet: The conversion price is reset to the down round price, regardless of the number of shares issued. This is highly punitive to founders in a down round and should be resisted.

Practical tip: Carve-outs to anti-dilution provisions (e.g., for option pool expansions, conversions, and agreed issuances) are as important as the formula itself. A broad anti-dilution provision with narrow carve-outs is worse than a narrow provision with broad carve-outs.

Option Pool

A pre-money option pool is a reserve of shares set aside for future issuance to employees, directors, and advisers. Many investors require that the option pool be established before their investment, which dilutes only the founders (not the investors) at the current round.

The size of the option pool (typically 10–20% of the post-money share capital) is a negotiating point. Founders should push for the minimum pool size that reflects realistic near-term hiring needs, and should seek to include any existing unallocated options in the calculation of the pre-round pool (rather than having to create an entirely new pool).

Board Composition

Control of the board is as important as economic terms. Typical early-stage term sheets provide for a board of 3–5 directors: founders hold one or two seats; the lead investor holds one seat; and one or more independent directors are agreed by the parties.

Founders should scrutinise: (a) who selects the independent director(s) — ideally, by majority vote of the full board rather than exclusively by the investor; (b) the required quorum and voting requirements for board decisions; and (c) whether the investor's consent is required for actions outside ordinary course of business (reserved matters). Overly broad reserved matters requiring investor consent can paralyse the company's ability to operate.

Information Rights and Access

Investors typically require: monthly management accounts; quarterly updates; audited annual accounts; annual budgets and business plans; and prompt notification of material events. For the company, it is important to agree on the format, frequency, and distribution of financial reporting to avoid administrative burden.

Protective Provisions (Investor Veto Rights)

The term sheet will include a list of actions that require the consent of preference shareholders (or a super-majority of the board). Common items include: changes to the company's articles, issuance of new shares, sale of the company, mergers, incurring debt above a threshold, amending the business plan, and related-party transactions.

Founders should: (a) push for a narrow and specific list of veto rights; (b) ensure that day-to-day operating decisions are not caught; and (c) specify the percentage threshold required (e.g., approval of preference shareholders holding 75% of preference shares, rather than any preference shareholder).

Pro-Rata Rights

Pro-rata rights allow an investor to participate in future funding rounds proportional to their current ownership, maintaining their percentage stake. This is standard and generally acceptable to founders. Major investor pro-rata rights (which allow the investor to participate above their pro-rata share) are more restrictive and should be limited to the lead investor for the current round only.

Drag-Along and Tag-Along

As discussed in the shareholders' agreement guide, drag-along rights allow a supermajority of shareholders to compel minority shareholders to sell on the same terms in a trade sale. Tag-along rights allow minority shareholders to participate in a sale by the majority.

For founders, the key protections in the drag-along are: a minimum price floor (the drag price must not be less than the investor's liquidation preference, ensuring the founders receive a fair share if the drag is exercised); time limits on the transaction; and exclusion of related-party buyers.

Exclusivity and No-Shop

Term sheets routinely include a “no-shop” provision preventing the company from soliciting or entertaining competing offers for a specified period (typically 30–60 days) while the parties negotiate definitive agreements. This is reasonable and protects the investor's due diligence investment. Founders should ensure the no-shop period is as short as possible and includes a break fee if the investor walks away for reasons other than due diligence findings.

Key Takeaways for Founders

• Understand each term before signing — the excitement of a term sheet is the worst time to rush.
• Model economic outcomes under different scenarios: small exit (1–2x), medium exit (3–5x), large exit (10x+). The impact of liquidation preference and anti-dilution varies greatly across these scenarios.
• The right investor relationship matters as much as the economic terms. A fair investor with smart money is worth more than marginally better economics from a difficult partner.
• Get legal advice from a solicitor experienced in VC transactions — not just any commercial lawyer. VC documentation has specialised conventions that general practitioners may not be familiar with.
• Do not accept full ratchet anti-dilution or multiple liquidation preferences without a very compelling reason.

Conclusion

A well-negotiated term sheet is the foundation of a productive founder-investor relationship. The terms agreed today — economic rights, governance, and veto provisions — will govern every significant decision the company makes for years to come. Take the time to understand them fully, negotiate the material ones, and build a relationship with investors who share your vision for the business.

Alan Wong LLP advises founders, investors, and venture capital funds on term sheet negotiation, shareholders' agreements, and fund formation in Hong Kong. Contact our Investment Funds team to discuss your fundraising.