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 to take the advice of a qualified lawyer or a Chartered Accountant (CA) 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 headstart 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.
The following are the terms generally covered in a term sheet :
- Legal Details
- 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 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 cap-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 early-stage investor) prefer using SAFE (simple agreement for future equity).
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 tells 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 (IP) 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
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- 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.
Liquidation preference is of 2 types :
- Non-participating
The investor has the preference to choose between taking the liquidation preference and get 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 shareholding 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. Also 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 3rd 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 (IPO), 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 also 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 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 any one 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 12 months and 1/48th shares every month thereafter. I have seen some term sheets and generally some permutation of this formula is used in the term sheet.
- 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. Also 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 in the board.
- Investor Rights
The investors generally want the following 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 exit to the investor after a set number of years the investor can sell the shares to any buyer and also 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 subject to consent of the investor nominated director. The founders and CEO are not allowed to decide on these matters on their own.
Author: Saurabh Jain (Follow him on Twitter : @skjsaurabh)
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