Ordinarily (but not always) a term sheet will be a non-binding document which sets out the intentions of company and prospective investor. So, if it’s not binding, why is it important? The term sheet is likely to be the first time you set out in detail how each party envisages the investment will be made and the responsibilities of the parties going forward. Whilst the document might state it isn’t legally binding it will set out in writing your intentions and it can be difficult to subsequently vary those written intentions.
With that in mind, here are a few points consider when starting negotiations.
What you put in and what you get out?
Valuation – the fundamental question before any negotiations can really start is are you happy with how much the investor thinks your company is worth before they invest and how much the investor thinks it will be worth after they have invested. Note that some shares may receive a better return for the investment.
Types of investment – whilst you might expect most investment into a company to be for the subscription of equity shares (in various forms) you may also see investors trying to put some of their investment in as debt. Debt can be secured against any assets the company may have and can offer some further protection to an investor if the company turns out to be unsuccessful.
Option Pools – investors like to know that their interest in the Company is fixed. That means that if they think you are going to need to issue further shares either to raise more capital or to incentivise key employees they will often require an option pool is established before they invest. The effect of this is that, you are diluted further, whilst their percentage shareholding remains fixed.
Anti-dilution – an investor will want to avoid a situation where any subsequent round of investment is at a lower price than the price they invested at. As a founder, whilst you might be content to allow an investor to participate in subsequent rounds of investment you need to consider whether anti-dilution provisions should include a requirement to invest further capital. Certain anti-dilution provisions (on a full ratchet basis) may simply require you to issue additional shares to the original investor to ensure that their percentage investment in the Company is not diluted.
Exit – any sensible investor will have (at least) one eye on the return on its investment. Part of this is looking at the end of the relationship. Investors may seek to have a share with priority or preference rights. Whilst everyone hopes that your company will become a huge success, a savvy investor will want to try to protect their investment if the company doesn’t do as well as expected. A route to gain some protection is to provide that the investors will receive in preference to the other ordinary shareholders an amount equal to investment. You may see an even more enhanced preference right, which would provide that the investor would receive their return on investment and then share in any remaining proceeds with all the shareholders.
Who does what and how?
Investor’s Decision Making Rights - Who controls the decisions of a company will depend on the type of investor you have and the amount of investment they are making. Some investors are happy to merely have a right to information. Some may require a right to appoint a director. Many investors will require some minority protections. These protections are intended to help protect the investment. However, any founder should be careful before agreeing these types of provisions to ensure that they are not drafted too widely preventing you from running the business.
An investor will often argue that they are investing in the individuals as much as the Company and will seek to ensure those individuals remain with the company to protect that investment. There are various mechanisms that may be used but the three most common are:
1. Vesting Shares – the effect of vesting shares is that you don’t really own them until certain events have occurred. These events can be linked to the passing of time (that is provided you have been engaged by the Company for a period of time you will receive the shares) or by the achievement of certain financial hurdles (once the net profit of the Company exceeds an agreed target you will receive the shares)
2. Leaver Provisions – even if you hold your shares from the outset of an investment an investor will often seek to include provisions which enable those shares to be bought back in certain circumstances. Are there circumstances where you should be forced to sell your shares? If yes, what price should you receive for those shares? An investor may argue that their consideration for equity in the Company is the subscription monies paid, whereas your consideration for your equity in the Company is your service to the Company. This really hinges on the valuation being applied to the Company, if this is a conservative valuation linked to historic earnings you could argue that you have already “earnt” your equity stake and should only ever be forced to sell your shares at their market value. However, many investors will seek to include the right to purchase the shares at a lower price in circumstances where you leave early or as a result of your misconduct.
3. Restrictive Covenants – investors will want comfort that you are not going to leave on day one and set up a competing business or work with a competitor. Simply stated like this it is difficult to argue with, but, ideally all restrictions will be linked to your employment and not your status as shareholder.