Deciphering Term Sheets: The Big Cheese
by Hrishav Kumar
Posted on Mon, 31 August, 2020, 11:05 PM IST
Raising sufficient capital is the first and foremost thing the entrepreneurs look to do in order to come up trumps with their start-up or the business idea. Conspicuously, it is a quintessential practice amongst the entrepreneurs to juggle around various investors in order to drive them home. Once the investors are convinced of your idea and decide to invest in your venture, they will ask you to come with a term sheet.
A term sheet is a non-binding contract drafted by the lawyers in the form of a blueprint laying out the terms and contours of the investment. Thus, a term sheet is an essential event in the relationship between the start-up and the investors. Having said that, a term sheet often contains complex terms, confusing language, the mass of jargon, and figures which many a time becomes tough to decipher. Notably, the investors are experienced and savvy professionals who take up the language of the term sheets quite seriously. Thus, any sort of loose ends can prove to be catastrophic for your business. So, if you are an entrepreneur, the following are the details pertinent for a proper term sheet:
The value of a company changes a great deal once the investment starts coming. Valuation is the most important aspect of the term sheet and is determined by ‘pre-money valuation’ and ‘post-money valuation’. The pre-money valuation expressing the value of the company before the valuation takes into account various factors such as the strength of the team, intellectual property, market size, and competitive landscape. After the investment, the final value of the business is determined by the new investment in addition to the pre-money valuation. For instance, the pre-investment value of the company is Rs. 2,00,000 and the investor wants to invest Rs. 1,00,000, the post-money valuation would amount to Rs. 3,00,000 in this scenario with the investor now holding 33.3% of the share in the company. Next, you need to very cautiously decide how much stake you want to cede to the investor. Needless to say, a good valuation doesn’t mean high valuation, and you also need to take into account other investment terms. Pertinently, you need to keep a holistic view as high valuation in the first round would mean you will have to set the bar high for the future investments and failure in setting up a higher bar would give a poor impression and no investor would be willing to invest in the next round. Imperatively, contacting other investees who have previously accepted an investment from the same investor can is always helpful in coming up with a proper valuation.
At the time of the investment, the investors acquire preference shares in return for their investment. These are the shares different from the ordinary shares held by the founders or others. Liquidation preference is one of the most common types of preference share. It means the additional amount of money the holder of preference shares or the investors will get at the time of winding up of the company or at the time, the company is about to be sold. For instance, the company has ordinary shares of Rs. 15,00,000 and preferred shares of Rs. 10,00,000 with a two-fold liquidation preference and the company is sold at a price of Rs. 22,00,000. In such a scenario, the investors will get Rs. 20,00,000 and the founders will be left only with 2,00,000 notwithstanding the majority shares held by them. Thus, do not promise a liquidation preference you cannot fulfill later. Better be cautious than feel sorry!
Option Pool means the shares reserved to attract new employees or retain the existing employees. The purpose is to entice new hires by allowing them to have a share in the rewards. It is advisable to calculate the option pool post-money valuation so that investors can have a share in the dilution, however, the standard practice remains calculation pre-money valuation. For instance, the founder decides to reserve a 15% share for future options thus their new share will come down from 66.7% previously to 51.7% (51.7% for the founders, 33.3% for the investors, 15% for future hires). Thus, the founders carefully need to plan a hiring list while taking into account the retention plan for existing employees to ensure a profitable percentage. They can further negotiate with the investors to add to the pre-money valuation to ensure a beneficial share for all. Having said that, it is pertinent to note that an investor always wants a good support team.
In order to prevent the founders from leaving prematurely and to encourage them to continue with the company on a short or medium term, the investors make sure only a limited share of the founders is immediately diluted or they require the founder’s share is subjected to the founder vesting. Founder vesting means that the founder’s total share in the company will be agreed to but will have to be earned over time. For instance, the founder with a share of 50% and ownership of 10% per year decides to leave the company just after the second year. In such a case the vested portion of the founder is 20% and the unvested portion is 30%. Consequently, the unvested portion will be returned to the company and reserved in the opinion pool. Thus, the founder, in order to get full ownership of his share, is required to stick with the company for a certain period of time. This is done in order to save the company from falling because if a key founder decides to exit early, the investors will need a likewise key replacement. Thus, the returned share is utilized for attracting a key hire. If you’re an entrepreneur with a new business, you need to carefully scrutinize the shareholding clause in the term sheet in order to ensure you get most of your shares within a few years.
Term sheets also include clauses regarding the structure and formation of the board members. The investors generally like to appoint the directors to board and look to ensure their representatives acquire veto rights over key business decisions such as the signing of high-value contracts, raising capital, or changes in business goals. Pertinently it becomes imperative for the founders to carefully analyze and decide on the division of powers and assigning of the veto rights. Further, it is important to include drag-along and tag-along rights. In case the majority shareholders wish to sell their shares to third parties, the drag-along rights will empower them to force the minority shareholders to sell their shares on the same terms while the tag-along rights empower the minority shareholders to force the majority shareholders to include the minority shareholders’ shares on the same terms to that of the majority shareholders’ in case they decide to sell their shares to third parties. Thus, such shares help resolve disputes.
There are certain documents that accompany the term sheets that you need to be aware of as an entrepreneur:
This is a contract amongst the shareholders and the investors with respect to their stakes, rights, and position on the board of the firm.
Founders’ Employment Agreement
This is a contract amongst the founders wherein they decide the terms of their employment, whether or not they will be working exclusively for the company and not work for someone else without the prior consent of the company.
Restated Articles of Association
The Articles of Association defines the purpose and goals of the company and includes the modus operandi of achieving the goals. Thus, every time a new investment is made or capital is raised, this document is restated to redefine the powers and duties of the board of directors and the shareholders.
Needless to say, term sheets are crucial for a business especially a start-up. Thus, a lapse of judgment while drafting the term sheet can prove to be a major stumbling block and your start-up might come to end before a start. Last but not the least your start-up is like your baby and in order to ensure smooth run for your baby it is always advisable to contact a lawyer while drafting the term sheet and avoid the choppy waters that may lie ahead.
Please note that the contents of the article are for reference purposes only and should in no manner be construed as, and neither be relied upon for, legal advice in any particular circumstance or fact situation. Nevertheless, you may always raise all sort of general/specific query through our simple form and get an expert and reliable assistance on the matter within a short span of time. We at Caim Consulting are always glad to serve you with meaningful and relevant information on your business!