The Terms Sheet is perhaps the most important document the entrepreneur can get right. All else fall – or hangs – from it. The Terms Sheet sets out the basic framework for the deal. It can be a excruciatingly boring document to develop and read – particularly as the language used tends to be like a foreign tongue. However, serious entrepreneurs must embrace it and get comfortable with it as their wealth is secured or squandered in this one document.
Once an Angel, an Angel syndicate or a Venture Capital firm indicates its intention to invest in a company, there are a number of important issues to be negotiated. Once agreed, this framework for the investment will be set out in a Terms Sheet which records the parties understanding of the key issues. Think of the terms Sheet as a Heads of Agreement. Key issues to be resolved at this stage include the form of investment, protections to be given to the investors, rights of the investors to appoint board representatives, control over major decisions, information rights, pre-emptive rights and exit strategies.
The Terms Sheet will govern the investment until such time as Due Diligence is completed by the investor and the parties negotiate the detailed legal Shareholders’ and Subscription Agreement. The major benefit of a Terms Sheet is that it focuses the energies of the parties on the major issues early in the process, saving both time and expense in drafting formal agreements later.
The real issue here is that the Terms Sheet is usually written by the investors side of the deal – their lawyers in particular – and they have done them multiple times and know what protections to put in that best suit the investor at the detriment of the entrepreneur.
It is usually a good idea for the entrepreneur to have pre-drafted a Terms Sheet with their advisor so that they know what they want – and don’t want – in the document before meeting with the investor. Tabling the Terms Sheet first is usually an interesting ploy to tilting the balance of power and it shows the investor you have done your homework and are not to be easily hood-winked.
An issue to bear in mind with the Terms Sheet is that the company is likely to need subsequent rounds of financing. Future investors are likely to want the same of similar rights as those granted to early round investors, and the company should weigh the impact of this in negotiating the early rounds.
Depending on how formal the investors are (i.e. less formal Angels versus Professional VC) the following issues are likely to arise in the negotiations of the Terms Sheet:
- Pre-money valuation – the value of all share in the company immediately prior the proposed investment.
- The Strike Price – the agreed price per share once the investment deal has been struck.
- Post-money Valuation – The pre-money value of the company plus the investment amount.
The form of the Investment Consideration: The consideration for the investment may take the form of ordinary shares, preference shares or convertible notes. Sophisticated investors will generally seek preference shares as they confer additional protection without leveraging the balance sheet.
Rights attached to Preference Shares include:
- Preferential rights to dividends
- Preferential right on a liquidation or winding up of the company
- Right to convert preference shares into ordinary shares at any time.
- Size of Investment and Tranches:
The investor may wish to make their investment in stages – known as tranches – with each tranche conditional upon the company achieving certain milestones. While mile-stone base funding is a fair approach, it is useful to link milestone-based payment to a pro rata of milestone achievement – if 75% of the milestones have been achieved in good faith, then 75% of the payment should be made. There is nothing worse than the entrepreneur working hard to reach the milestone and just falling short with the investor using this as a way to punish the entrepreneur with more punitive terms like withholding the – usually critical – funds unless certain actions are taken. It’s not an unusual ploy to force the founder off the board or even out of the company….and I say that from painful first-hand experience!
- Number of Directors: Investors will want to oversee and control the progress of their investment. In order to do this, they will seek to appoint a certain number of Directors to the Board and tailor the matters which must be considered by the Board.
- Protection against Dilution:
There are two types of anti-dilution protection:
- Restructures – protection against share dividends, share splits, reverse splits and similar recapitalisations occurs by adjusting the conversion price or preference shares to ensure that the number of ordinary shares issued on conversion represents the same percentage of ownership.
- Price Protection – if the company issues shares at a discount to the shares bought by an investor, the conversion ratio is adjusted to ensure the number of ordinary shares issued on conversion represents the same percentage of ownership.
- Redemption: Venture Capitalists may seek the right to force the company to realise the value of the investment at some point in the future by requiring the company to buy back or ‘redeem’ their shares if a liquidity event – usually either an IPO or trade sale, has not occurred by a certain date.
- Facilitation of Sale of all Issued Shares: Investors may also require a “Drag along” clause which compels all shareholders to sell their shares if more than a specified percentage of shareholders (usually 75%) accept a third party offer.
- Standstill for Founding Shareholders: Investors may also require that the founding shareholders agree to a standstill provision which prevent them from selling their shares in the company for a period of time.
- Executive Service Agreements: Key executives may be required to sign appropriate Executive Service Agreements usually linked to the company’s performance-based milestones.
- Information rights: Investors may want the right to receive certain information, such as monthly financial statements, annual audited financial statements and the annual business plan and budget approved by the Board.
- Intellectual property rights of the company: Investors may want assurances that the company has sole ‘legal and beneficial ownership’ of the intellectual property rights.
- Pre-emptive Rights: Investors may require a pre-emptive right to invest in future issues of shares before they are offered to a third party.
- Exit Strategy for Investors: Equity investors – in particular VCs – are driven by the need to realise the value of their investment and may seek to impose a provision enabling them to force a liquidity event – usually a trade sale, if such an event has not occurred with 3 or 4 years of the investment.
- Additional Management Members: Investors may require the company to recruit additional executives – typically a CEO or CFO – to the management team.
- Exclusivity Period: Investors may seek a period of exclusivity after signing the Terms Sheet, typically in the region of 30 to 60 days, where the investor has the right, but not the obligation to invest.