Receiving a term sheet is an exciting moment. On one hand, after a long process, you start to reap the rewards of your work. On the other hand, there is the fear of making a mistake that might return to haunt the business. In many ways, this is the most critical part of the whole process.
Term sheet analysis often remains the more challenging part for entrepreneurs, even when they are on their second or third business.
Most institutional investors normally take a fair, transparent and non predatory approach. They are conscious that alignment between them and founders is fundamental to the success of the business.
Nevertheless, ahead of term sheet negotiations, it is helpful for founders to have a grasp of key term sheet provisions. One mistake at this stage, can have a significantly negative impact on your business.
Term sheets for funding are one to five pages documents that outline the major terms and conditions on a deal. While they are not contractually binding and carry no legal leverage, they form the foundation for the binding legal investment documentation.
They can vary depending on the stage and magnitude of the investment. Seed round term sheets will be lighter and shorter than series a term sheets, series b term sheets or anything beyond.
Term sheets are given by the lead investor. This is the one which initiates the process and contributes a significant part of the funding. The followers, coalesce around the terms as agreed with the lead investor and "fill" the round.
As such, when negotiating a term sheet, you will interact primarily with the lead investor. A thoughtful negotiation, will not only help you achieve better terms, but also build credibility with investors. The best term sheets will not always offer the highest valuation - you should assess a term sheet as a whole.
An Ithaca specialist can help you discern negotiable items. They will advise whether conditions offered are out of market terms and therefore open for negotiation.
So what are some important items to consider?
Company valuation and allocation
Valuation is the value attributed by investors to your company. The value of your business in turn determines the price per share. There are two types of business valuation: pre-money and post-money valuation.
Post-money valuation = Pre-money valuation + money raised
Capital raised is the sum of all the investments by individual investors in the round. This is also known as allocation, i.e. the final investment amount deployed by each investor in the round.
Together with post-money valuation, this impacts dilution, the formula being:
Capital raised / post-money valuation = dilution
As a rule of thumb - dilution tends to range somewhere around 20% - 25% in a round.
non-predatory
Pre-emption / pro-rata rights
Whenever a new funding round takes place, new shares are issued. This means that existing shareholders are diluted, which reduces the shareholding percentage.
Pre-emption rights protect investors from dilution. They enable investors to maintain their current shareholding, by letting them buy additional shares, ahead of a new investor. The term sheet will specify if the new investor will have pre-emption rights.
Liquidation preference
This is one of particular importance in your term sheet. Liquidation preferences define the hierarchy of returns in the event of a liquidation preferences - so how returns are distributed amongst investors. The idea behind liquidation preferences is to give investors security and relative value. They de-risk the transaction by guaranteeing a certain return on their investment.
Liquidation preferences can guarantee to investors either their original amounts (1x) or multiples of it (2x, 3x, etc.). If an investor deploys £15m, they will receive £15m for a 1x preference, £30m for a 2x preference, etc.
There are three types of liquidation preferences:
- Non participating: the investor receives an amount equal to their investment, or a multiple of it. Thereafter, the remaining proceeds are distributed on a pro-rata basis amongst the other shareholders. The investor does not participate in this distribution. This type of liquidation tends to be founder-friendly
- Full participating: the investor receives an amount equal to their investment, or a multiple of it. Thereafter, the remaining proceeds are distributed on a pro-rata basis amongst the other shareholders. The investor participates in this distribution. This type of liquidation tends to be investor-friendly
- Capped participating: the investor receives an amount equal to their investment, or a multiple of it. Thereafter, the remaining proceeds are distributed on a pro-rata basis amongst the other shareholders. The investor participates in this distribution, only up to a certain cap. Once the cap is reached, the remaining returns are distributed on a pro-rata basis exclusively amongst common shareholders
In general a 1x non participating liquidation preferences is a good offer in an early financing round.
Liquidation preferences can have a huge impact on the returns of a business for founders. They become increasingly complicated as more investors have liquidation preferences over previous investors.
You should have a clear idea of how your returns might be impacted in different liquidation scenarios. A returns analysis simulating hypothetical distribution scenarios at different exit values is a great exercise.
Anti-dilution provisions
Anti-dilution provisions protect investors from future down rounds, so future rounds at a lower valuation. Down rounds tend to lower existing shareholders' ownership percentages significantly.
To protect themselves against this, investors can include an anti-dilution provision in the term sheet. These provisions help readjust the investor's ownership stake, by forcing the company to issue them new shares.
There are two types of anti-dilution provisions: weighted average anti dilution provisions and full ratchet anti dilution provisions. The former is more favourable to entrepreneurs and the latter to investors.
Board composition
Venture capital investors will often ask for one or more board seats. To optimise board composition, you will need to balance shareholder representation with having a lean board. Too many directors can slow down decisions and processes.
As you complete additional follow-on investments, the more board seats you give away, the more your level of control will diminish as a result. Angels will not necessarily request a board seat. VCs investors and funds deploying larger cheques will typically demand one or more board seats.
In some instances, you might be able to negotiate observer seats. These can contribute to the discussion in a board of directors meeting, but have no voting powers.
Drag along and tag along
Drag-along and tag-along rights come into play in case of liquidity events. They regulate shareholder behaviour in case the company is sold.
- Drag along rights: when at least a minimum threshold of shareholders want to proceed with a company sale, remaining shareholders must agree. These rights are deployed to ensure that majority shareholders can force through a sale of the company. In fact, buyers will want to buy a company as a whole and not be held hostage by a minority.
- Tag along rights: when a shareholder sells shares at a certain price, other shareholders can sell their shares pro-rata at that price.
Employee option pools (ESOPs)
Employee stock option pools (ESOPs) are used to incentivise and reward employee performance. They are a way of allocating shares to employees, aligning their interests with the success of the business.
ESOPs will be topped up at new rounds of financing. Depending on when the ESOP is created, it can dilute existing shareholders only, or both existing shareholders and the new investors.
Protective provisions
Protective provisions give the investor the power to deliberate on matters that are specified in the Term Sheet. These matters require approval by the investor in order to be implemented, even if they are not the majority shareholder.
These matters can be economic or operational and in general are related to key company decisions. However, if these provisions are too onerous, they can slow down growth and become problematic.
Dividends
Preferred shares can carry a dividend right associated to them. Dividends are payments paid out to investors from the company's earnings. Required or deferred dividends are uncommon in start up term sheets, given that the cash tends to be reinvested in growth.
Dividends are fixed if they are paid periodically in cash or stock. They are discretionary if they are paid when the business decides to. They are cumulative if they accrue over a period of time and are paid upon a liquidation event.
Information rights
Regular information sharing and reporting for investors. It is important that these are not too onerous - monthly updates, quarterly reporting and annual budgets and audit are normal. Any excessive auditing and reporting requirements can become onerous for your team.
Exclusivity and legal fees
A time period during which you cannot solicit new investors and need to suspend conversations with existing investors. The length of this period is up for negotiations. A protracted exclusivity period could harm the process and your chances of success.
Some investors might require you to pay, or contribute to the payment, of the legal costs. This can also be capped at a certain amount.
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