Decoding the Term Sheet
Navigating the world of startup investments can feel like deciphering a complex code. At the heart of this labyrinth lies a crucial document that can make or break your entrepreneurial journey, the term sheet. This vital piece of paper is more than just legal jargon, it’s the blueprint for your startup’s future, dictating the terms of engagement with investors and setting the stage for your company’s growth and success.
Table of Content
- What is the term sheet
- Entry terms
- Exit terms
- Management terms
- Investor rights
What is Term Sheet ?
When an investor like a professional angel investor or venture capitalist
invests in a startup, they follow a process. The process generally involves
pitching followed by follow-up meetings. If the investor is convinced that
this startup is good for investing, then the investor signs a term sheet with
the startup founders.
The term sheet may be a binding or non-binding agreement that lists the
terms and conditions for making the investment. After signing the term
sheet, the investor does due diligence on the startup. Once due diligence is
complete the investor and the startup execute final binding legal documents.
The term sheet generally signifies that the investor is willing to invest at a
particular valuation. The complexity of the term sheet depends on the size of
the funding round and the type of investor. Angels usually have simpler term
sheets than VCs. Many investors have standard term sheets which they keep
as a base while negotiating.
The term sheet is also a legal document and thus I will recommend you take
the advice of a qualified lawyer or a Chartered Accountant who has
expertise in them before signing them. General lawyers and CA do not have
that expertise. Only selected professionals who specialize in startup matters
have this expertise.
I am listing some of the terms and conditions which are generally covered
under the Term Sheet. This is not legal advice, but my intention is to give
you some head start in understanding term sheets before you negotiate with
the investor and engage the professionals. Also, a big reason I am sharing
these terms with you is that without knowing these terms, funding looks very
glamorous. Media covers funding news in a way that it feels that funding is
not an obligation to investors but is like winning a prize.
Legal Detail
- Name and identification details of investors, startup and its founders.
- Date of the term sheet.
- Legal jurisdiction applicable in case of dispute.
Entry Terms
- Valuation — Pre-money valuation valuation of startup before taking
money from investor accepted by the investor. - Investment and milestones — The amount to be invested in the startup
by investors. The amount may be invested at one go or it may be as
per pre-specified milestones. Generally, the first tranche is given on
execution of final binding documents and completion of conditions
precedent. - Shareholding — Shareholding pattern of the company pre-investment
and after each milestone. This is also called the capital table of the company. - Type of Securities and Price Per Unit — Even though equity is given to
investors, due to legal and practical reasons direct share allotment is
not done. Generally, in India investors prefer either Compulsory
Convertible Debentures (CCD) or Compulsory Convertible
Preference Shares (CCPS). Y Combinator famous US startup
accelerator prefers using Simple Agreement For Future Equity
(SAFE). The price per unit is also mentioned in the term sheet.
Use of Funds — It is mentioned that the investment proceeds will be
used to achieve the pre-decided business plan and the milestones
decided between investors and the founders.
Exclusivity — This clause says that the founders or the startup cannot
raise capital from any other investor for the ‘period of exclusivity’
after signing the term sheet. The period of exclusivity is generally up
to 90 days and may vary according to the investor. I know of investors
who have this as 60 days also. - Conditions Precedent — These are generally conditions that need to be
fulfilled before any money will be transferred to the startup by the
investor. They mostly relate to the completion of due diligence and
legal processes. It may also involve the transfer of intellectual
property to the startup from the name of founders. - Conditions Subsequent — These are conditions that need to be fulfilled
as soon as money is received by the startup. Some examples of such
conditions are. - Appointment of auditors agreed by investors.
- Issue of securities.
- Legal process-related.
- Formulation of ESOP scheme.
Exit Terms
Liquidation Preferences, The liquidation preference clause tells who will get
the money first and in what quantum in case of a liquidation event for the
startup. A liquidation event is basically the closure, sale or merger of a
startup.
1x liquidation preference means the investor gets the original investment
amount back first before anything is given to the founders or other
shareholders. Generally, in the early stages 1x liquidation preference clause
is there. In the late stages of financing, it may be 1.5x or even 2x. It can be
any number decided by the company and the investors.
Types of liquidation preference
- Non-participating — The investor has the preference to choose
between taking the liquidation preference and getting money
before it is distributed between shareholders in the ratio of their
holding or take the money according to the normal shareholding
pattern but not both. - Participating — Here the investor has the best of both. The investor
takes liquidation preference and gets money invested according to
the liquidation preference ratio before it is distributed to
shareholders in the share holding ratio. The investor also takes
money again when it is distributed according to his or her holding
in the shareholding ratio. This is very rare in term sheets. - Transfer Rights — The investors can sell their shares at any time. The
founders will not be allowed to sell their shares during the lock-in
period. Moreover, after lock in finishes, the founders can only sell
their shares after the permission of the majority of investors. However,
this sale of shares will be bound by the tag-along rights of investors
and the Right Of First Refusal. - Exit Rights and Exit Strategy — The investors invest to multiply their
capital. The investors usually only get money back on the sale of their
shares to 3
rd parties. Thus, investors put a time period in the term sheet
whereby they put an obligation on the founders to find a buyer for
their shares or do an Initial Public Offering or buy back their
shares.
In case the founders are not able to do any of these then the investor would
have the right to sell the shares to any buyer they like and have the right to
drag along the founders and other shareholders to sell their shares.
Also in the event, even this is not possible or there is some breach of trust by
the founders of the investor would have the right to take money after getting a high interest or in worst case scenario the founders and other promoters will
have to give all their shares to investors at face value meaning that
practically they will be getting pennies for their entire shareholding.
This is a major clause and founders should take funding keeping in mind that
in the worst case scenario they will get practically nothing in the company.
Management Terms
- Founder Rights — Generally, founders need to sign a lock-in clause.
The founders will not be able to sell shares to anyone without investor
permission till a specified time, which is generally 4 years.
Sometimes the shares are also vested to founders as per a mechanism
listed in the term sheet. On day 1 they may start with 0 shares. A
popular method is to give 25% shares after first 12 months and 1/48th
shares every month thereafter for the next 36 months. - ESOP Pool — Investors understand that the core team of the company
and future employees of the company will be motivated and retained
by ESOPs. Thus, most term sheets will have a clause on ESOP pool
creation. This generally ranges from 7.5% to 10% on equity share
capital post-funding. The ESOP pool is from the equity of the founders
and investors specifically mention that their shareholding will not be
diluted for the ESOP pool. - Board — Generally, investors want the right to nominate at least 1 board
member. Moreover, many times investors want to appoint 1 board
observer also. These rights are thus written in a term sheet. - Voting Rights — The investor generally will write that the investor will
have voting rights on a fully diluted basis. Also, some investors will
also write that some specific things will need mandatory consent of
the investor director on the board.
Investor Rights
- Right of First Refusal — Whenever the founders sell their shares to
someone, they will have to give the option to the investor to buy the
shares first. This clause may be applicable to other non investor
shareholders also. - Tag Along Right — After the completion of lock-in, if the founders sell
equity shares to someone else then the investor can force them to sell
investor’s shares also at the same price. - Drag Along Right — If the founders cannot provide an exit to the investor
after a set number of years, the investor can sell the shares to any
buyer and drag along the founders to sell to that buyer at that rate. - Auditors — Investors generally want to have a say in appointing an
auditor. Some term sheets specifically mention auditor appointment
rights. - Rights in Future Rounds — Generally anti dilution rights are mentioned
in the term sheet. - Restricted Items — The terms may list items which will only be
allowed the subject to consent of the investor nominated director. The
founders and CEO are not allowed to decide on these matters on their
own.
Conclusion
In the dynamic world of startups, understanding the term sheet is paramount. This critical document outlines not just what a term sheet is but delves deep into the intricacies of entry terms, exit strategies, management provisions and investor rights. By mastering these elements, you equip yourself with the knowledge to negotiate effectively, safeguard your vision and foster a partnership that propels your startup to new heights. Remember, a well crafted term sheet is not just a contract, it’s the foundation of a thriving and sustainable business relationship.
