So you’re running a tech company and you’re looking to raise a round to accelerate your growth. You’ve found your investors and you’re ready to negotiate the investment terms, but where do you start? Major contractual negotiations often kick-off with a term sheet, which outlines the key terms that will govern the contractual relationship between the parties. In this comprehensive guide, we demystify term sheets and provide you with insights and practical tips to help you navigate the negotiation process.
The Purpose of a Term Sheet
Generally speaking, a term sheet is not a legally binding document – it’s put in place as a precursor to a full suite of legally binding documentation. So what is the point if you are going to negotiate longer form agreements later anyway?
Term sheets are useful for a range of reasons, including:
- Clarity and Alignment: Term sheets bring clarity and alignment to a transaction as the parties involved are required to state and negotiate the key commercial drivers behind the proposed contractual arrangement.
- Efficiency: Negotiating a term sheet is typically quicker and less costly than negotiating a full length commercial contract or suite of investment documents. It allows parties to identify deal-breakers early in the process, saving time and money.
- Flexibility: Term sheets provide a degree of flexibility. While not legally binding, they serve as a framework for negotiations, allowing parties to refine their positions before committing to a binding agreement.
- Exclusivity: Term sheets often include exclusivity clauses. Whilst the enforceability of these clauses is debatable (depending on the specific drafting of the term sheet in question), they typically document a mutual understanding that the parties involved will negotiate exclusively for a set period. This reduces the commercial pressure to rush a transaction, enabling the parties to properly negotiate the deal. Note, however, that such a clause may not be necessary or appropriate if you are raising capital from a range of investors.
Key Terms in a Capital Raise Term Sheet
The key terms in a capital raise term sheet will vary depending on the type of transaction or arrangement the term sheet relates to. For most early stage startups, their first key contract will be with their investors, so let’s focus on some of the key provisions found in an investor term sheet.
The term that both founders and investors tend to care about the most is valuation. This determines the startup’s overall worth, and will be the key factor in determining the percentage of ownership the investors will acquire in exchange for their investment.
In the tech world, determining an appropriate valuation is part art and part science. Depending on the stage of the startup, the company might have no revenue, no customers and no intellectual property other than an idea, or it may have stable, fast-growing revenues with a clear customer base and a road-map for sustained growth. Determining the company’s value in either case is difficult, and ultimately comes down to what investors are willing to pay. The value may therefore be sometimes ‘set’ by your prospective investors. Other times, we see companies successfully set the valuation and find investors to coalesce around that price.
In determining an appropriate valuation, it’s important to consider:
- Market Approach: Are there start-ups similar to yours that have recently raised money? These act as a guide in determining an appropriate valuation for your business.
- Income Approach: What are your current cash flows and how fast is your revenue growing? Are you profitable? As a rule of thumb, the higher your revenues, your revenue growth and your profitability, the higher your valuation.
- Market Conditions: What’s the state of the broader funding market and economy? Valuations tend to correlate with broader market sentiment, so you may face much higher or lower valuations depending on when you raise.
- Valuable Assets: Do you own or exclusively licence any particularly valuable intellectual property? This may increase your valuation even if you’re pre-revenue or a very early stage start-up.
- Narrative: The story you tell about your start-up’s journey, the problem you’re solving and the team you have assembled influences an investor’s perception and emotional connection to your company, thereby impacting your valuation. Create a compelling story.
- Sector thematics: The industry’s growth potential, competitive landscape, regulatory environment, and rate of innovation can significantly influence your startup’s valuation. Startups in rapidly growing, less regulated, and technologically innovative sectors will usually attract higher valuations given their potential for high growth market domination.
When documenting the valuation in a term sheet, keep in mind:
- Pre-money vs. Post-money Valuation: Pre-money valuation is the startup’s estimated worth before receiving the investment, while a post-money valuation includes the company’s value plus the investment amount.
- Dilution Protection: WATCH OUT for anti-dilution provisions. These provisions protect your investors in the event that you issue new shares in your company at a lower price in future investment rounds. These provisions are great for your early investors, but come at the expense of the founders and other existing shareholders. It is therefore important to ensure the calculation mechanics are fair to all parties.
2. Investment Amount and Funding Structure
The investment amount and funding structure proposed by an investor are crucial for understanding the financial implications of the deal.
When it comes to the amount, it is important to raise enough capital to enable your start-up to grow and hit the milestones necessary to raise future funding (with some excess in case of unforeseen challenges). However, this should be balanced against the fact that you’re giving away shares to the investors, based on the current valuation. In the early stages your valuation is likely to be lower, so you’ll be giving away more shares per dollar invested. Staggering your raises to enable higher valuations in each round can sometimes be better than raising a lot of capital at a low valuation.
With regard to structure, if you’re entering a term sheet you are likely negotiating a new share issuance rather than a Simple Agreement for Future Equity (SAFE) or a convertible note. Some investors will seek to include a tranche funding mechanism within a share issuance capital raise. Tranche funding requires the start-up to achieve predefined milestones before the next tranche of funding is released. It is important to review the mechanics of these clauses carefully, especially as they relate to valuation. Generally speaking, you will want each new tranche issuance to reflect a higher valuation, to mitigate shareholder dilution and to reflect the progress being made between tranches.
3. Liquidation Preferences
Liquidation preferences determine the order in which proceeds are distributed between shareholders in case of an exit event, such as an acquisition or IPO. Tech startups should be cautious about the impact of liquidation preferences on ordinary shareholders, including the founders and employees. Key considerations include:
- Participation Rights: Some investors will seek to include participation rights in a term sheet. In this context, a participation right will entitle the investor to (1) a return of their initial investment (incl dividends) plus (2) their pro rata shareholding percentage multiplied by the total acquisition purchase price. This gives the preference shareholder a disproportionate return by ‘double dipping’ and may significantly reduce the pool of funds available for distribution to ordinary shareholders. If possible, you should negotiate non-participating preference shares, which only entitle investors to (1) a return of their initial investment plus (2) their pro rata shareholding percentage multiplied by the remaining proceeds after investor capital return. This is arguably a fairer arrangement and helps protect the rights of subordinated shareholders. Participation rights are always complex and heavily dependent on the wording used. You should always have them checked by a lawyer.
- Multiple vs. Single Liquidation Preferences: Almost all venture capital deals and even some angel deals will require liquidation preferences. A multiple liquidation preference entitles an investor to receive a multiple of their investment before any proceeds go to ordinary shareholders. For example, a 2x liquidation preference means the investor will be paid twice their initial investment before anyone else receives any proceeds from a liquidity event. A single liquidation preference only entitles the investor to the return of their original investment amount before the proceeds are shared with other shareholders. These clauses can therefore drastically reduce the proceeds available for distribution to remaining shareholders, including founders and employees. They should be reviewed with caution.
4. Board Composition and Control
The composition of the board of directors is a critical aspect of governance and company control. There is a balance to be struck between maintaining founder control and accommodating investor interests. When negotiating this clause in your term sheet, consider:
- Founder vs. Investor Seats: It is important to understand that, once the founders no longer hold a majority of board seats, they are at the mercy of the decisions of the investors. Whilst this does vary depending on the governance structure of the company, you should carefully consider whether you want to offer a board seat to a new investor. Boards can and have removed founders from their own company.
- Veto Rights: Be aware of any investor veto rights outlined in the term sheet. These can impact key decisions and the strategic direction of the company. Generally a single investor or investor appointed director should not have any veto rights. If they do, they should be extremely limited and specific to your circumstances.
5. Information Rights and Reporting
Information rights stipulate the level of transparency the startup must provide to its investors. It is critical to find the right balance between appeasing your investors’ desire for financial and operational information and in protecting your intellectual property and sensitive business information. Key considerations include:
- Information Types and Protecting IP: Generally information rights should only extend to financial reports, budgets, business plans and progress reports. Ensure that the term sheet adequately limits the scope of the information required to be disclosed, with exclusions from your reporting obligations for any proprietary information, intellectual property or sensitive business information. You should also include confidentiality obligations preventing the investor from disclosing not only the terms of the investment, but also any information provided to the investor.
- Financial Reporting: It is important to understand the frequency and depth of financial reporting required by investors. Generally financial information should be provided annually, or quarterly for more mature companies. Consider whether a level of aggregation can be applied to your reporting to mitigate the risk of your financial reports inadvertently disclosing sensitive information.
Negotiating a term sheet is a pivotal moment in the journey of a tech startup. Understanding the key terms is essential in securing a deal that aligns with your business goals and safeguards your interests. While this guide provides valuable insights, you should seek legal counsel to tailor your term sheet to your specific circumstances and to ensure you comply with applicable laws and regulations.
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