Startups and funding go hand-in-hand. First-time entrepreneurs are keen to bring angel investors and VC funds on board. That's when all the documentation and legalities come into the picture. Several entrepreneurs find it difficult to understand legal documents. One such document is the 'term sheet'. Vijay Sambamurthi, founder and managing partner at law firm Lexygen, explains the 'term sheet' in its entirety and what entrepreneurs must bear in mind before signing this document.
The term sheet codifies the discussions and includes things the parties have agreed to informally, not legally. Subsequent to the term sheet, there will be a due diligence process and the parties will eventually negotiate, agree on, and sign the definitive agreements. The signing of these definitive agreements is when a binding obligation to do the deal is formally created. So, a term sheet creates no contractual obligations on the investor to invest and on the company to issue shares to the investor.
Most terms in a term sheet are pretty standard and have evolved as “market practice” over many years of deal-making. It typically contains the details of who the investor is; name and identities of the investors and founders; the pre-money valuation of the company (as that is what determines how much equity stake the investor gets for certain amount of money); investment amount; whether the investors are going to get a board seat, and then a whole lot of special rights such as veto rights and affirmative rights.
Be careful with affirmative vote, liquidation preference clauses
Below are some the important clauses of a typical angel or VC term sheet that entrepreneurs should pay close attention to:
Affirmative vote means that unless the investors vote in favour of a particular matter, the company cannot approve such an action. While each VC or angel investor may have its own critical items when it comes to matters requiring the investor’s affirmative vote, the typical rights seen in most such deals include amendment of articles of the company, change in composition of the board of directors, share issuances at lower price than investors’ entry price, and change of statutory auditors. These are matters which can materially affect the rights of the investors.
Liquidation preference essentially means that in a scenario where either the company gets wound up or sold, the investors will get paid, before everyone else, a certain amount. What this amount should be is a matter of negotiation between the company and the investor, but most investors I know ask for a return of the investment amount along with any accrued and unpaid dividends. This can be seen as a “principal protection” right. In some cases the liquidation preference can get much more complex than a simple 1x return. Some VCs may even ask for 2x plus or 1x plus certain high internal rate of return (IRR). There are various ways one can structure this, but the basic concept behind a liquidation preference is that “the investors should get their money plus some return back, before the founders can get anything”.
These are often referred to in industry parlance as 'downside protection' clauses and are meant to protect the investors from the adverse consequences of downside events (like a sale of the company at a valuation lower than investors’ entry valuation, for example) to the investor. But there are times when investor protection becomes almost like a guaranteed IRR and that's where the debate starts on whether a liquidation preference is really fair. Entrepreneurs, therefore, need to be careful about such clauses.
Founders’ ownership: In early-stage angel, seed or VC deals, this is a very important issue to be addressed in the term sheet and definitive agreements. In a late-stage company, the ownership of the founders is pretty much cast in stone. But in early-stage startups, the founders' ownership is very dynamic as the VC is investing at a time when the risk is too high not only of the venture failing but also of the founders losing focus on the venture.
In order to keep the founders focused and committed, investors often put in restrictions on the founders' ownership. This works somewhat like a stock option plan where the founders start with a certain percentage stake and the remaining stake of the founders will be released to them over a specified period. Investors don't want a situation where they have funded a company, only to find one or more of the founders quitting or losing commitment soon thereafter, and continuing to sit on a 50 per cent ownership in the company! The idea is to hold the founders accountable.
At the same time, founders should be careful and be comfortable that the founder vesting schedule proposed by the investors is not too harsh on the founders. Investors, too, need to be fair with the founders while still having an effective mechanism to hold them accountable.
Restrictions on transferability are very common in VC term sheets. Usually, VCs will come in and tell founders not to sell their shares in the company until investors exit. However, founders may want to be able to sell a certain portion of their stock to be able to meet personal expenditure. So, in a term sheet, parties often agree that founders can sell up to a certain percentage of their holding, and there's a lock-in period agreed to of, say, three to four years for the remaining founder equity.
The exit clause is an important and interesting one. This clause requires the founders to commit to deliver an exit – either by an IPO or through an M&A deal – to the investors by a certain date. If that doesn’t happen, this clause would typically require the founders to buy back the shares held by the investors at a price that delivers a guaranteed IRR to the investors. Many entrepreneurs make the mistake of not giving enough importance to this clause either because they feel supremely confident that they would be able to deliver an exit or because “the whole thing is so far away in time anyway”!
As bullish and confident as entrepreneurs need to be to succeed, when it comes to signing up to obligations like this, they need to give it a lot of thought. I have seen term sheets where the founders had agreed to buy back the investor’s shares at a price that would deliver an IRR of 40 per cent, and frankly, I have been shocked at such clauses. One thing for founders to chew on while signing up to these clauses is this – when you commit to an IRR guarantee, remember that it is going to get progressively tougher to deliver that exit the further away in time that an exit event is – it is MUCH TOUGHER to deliver a 25 per cent IRR IPO five years from an investment than to do so three years from the date of the investment.
Types of early-stage financing deals
There are, broadly speaking, two kinds of deals in the early-stage ecosystem. One is a simple preferred/equity deal and the other is what is referred to as a “convertible note deal”. In a simple preferred/equity deal, the valuation (or at least the base case valuation) is locked in upfront and hence, the investor is coming in at a certain value and issued shares on day one. Even in a simple preferred/equity deal, the valuation could be subject to a reset based on certain milestones and contingencies, but there is a valuation agreed upon when the investor invests the money, and the investor is committed to staying invested in the company for a reasonable period.
In an early-stage (pre-Series A) deal, the convertible note structure is common not only in Silicon Valley but also increasingly in India. In such deals, the investor agrees to invest based on the potential in the venture, but is unsure about the valuation that can be ascribed to the startup. Therefore, the investor invests an agreed amount of money into the company and receives “convertible notes” of the company in return (and no shares of the company on day one). The convertible note would, under its terms, convert into equity shares of the company at a valuation that is at a discount to the next round of funding raised by the company. The usual discounts to the next round valuation that the convertible note holders would get could vary from 10 per cent to 20 per cent. Convertible deals are more common in angel and seed rounds, and not so common in Series A rounds.
What makes it all so complicated for entrepreneurs?
It is complicated because these founders are dealing with sophisticated investors. While entrepreneurs can find all this daunting, at the end of the day they will find the term sheet not just protects the rights of the investors but equally protects their own rights as well. Entrepreneurs deal with sophisticated investors who invest based on clear mandates and principles. Most importantly, the investors have a duty to manage other people's money – which is why they have to be more careful on how they deploy their money. So, investors come up with certain safeguards to protect themselves, and those principles get captured in a term sheet and eventually in the rest of the documents.
Entrepreneurs can often find all this daunting because they have not done this before. Some of them may not even think all this to be important enough in comparison to the more exciting task of building their businesses. However, entrepreneurs must appreciate that high-quality legal documentation is an absolute necessity to ensure that they protect their rights and control over the business that they are working so passionately to grow. Poor or one-sided financing documents can cause operational hardship and even financial leakages to founders even where they have built successful companies.
How to ensure water-tight term sheet
First and foremost, investors as well as founders should get top-notch legal advice. You wouldn’t hesitate to spend good money on getting the best doctors, so why would you not take the same approach when it comes to picking your legal advisors for something that is such an important part of your life – your startup! Most times, founders feel they can draft their own term sheet as there are “open source” type templates available online. May be they can and many of them even have pretty good drafting skills. However, it's not about the template but about getting top-notch advice. Good counsel doesn't only mean drafting a document that works, but it's about having good quality advice at the table for a founder at the time when he is structuring a deal with the investor. Simply put, founders need somebody on the legal side advising and mentoring them.
Suggestions for founders and investors
– It is, of course, important to guard yourself against signing up to unfair terms. Equally, try to understand what the standard market practice for such deals is, so that you don’t end up baulking at every other term in the term sheet that (wrongly) seems so unreasonable to you at first glance. Founders should understand that while some clauses may, prima facie, appear unfair, they are “standard market practice” for a good reason. Founders must make efforts to understand the intent behind each of these clauses, and seek advice from their legal counsel as to whether specific proposals in the term sheet offered by an investor are standard market practice or not.
– I find that Indian founders often get too obsessed about their notions of control and ownership of their startup, and this obsession impedes their ability to think optimally when they are raising funds. The point is they have to make a wise choice between excess dilution and under-dilution; they have to make optimal dilution. It is obviously better to own 10 per cent of a unicorn than to own 100 per cent of a $1 million company – and it is usually much easier to create unicorns by diluting more equity and more often.
– Pay special attention to the liquidation preference clause. There are lots of investors who are absolutely fair with entrepreneurs, but there are some who ask for highly unfair liquidation preference clauses. An onerous liquidation preference clause can pretty much wipe out all value for the founders in certain circumstances.
– Keep a pragmatic approach on funding. Keep your focus on closing the deal fast and don't overdo the posturing and negotiations – there’s your business straining at the leash to grow and you have to go back quick to taking care of it! So, don’t get dogmatic in your approach.
– Some times, because of their higher position on the food chain, investors can become tempted for “over-protection”. While I think it is fair to provide the investors with multiple layers of protection to address fair risks, it is not fair at all to seek unreasonable or unfair levels of economic and other rights in the garb of “downside protection”. It is my belief that successful investors win more by being fair and balanced in their dealings with founders than do by being too harsh. There should not be patent signs of unfairness in the term sheets that they offer.
– Again, I have realised from my experience advising scores of investors that the consistently successful ones don't just bulldoze the founders to get their way on deal terms, but make the effort to explain to them why those clauses are important and fair, and get the buy-in of the founders to those clauses.
Lastly, it is in your interests and the interests of your deal to ensure that the founders get their own legal counsel who is experienced in VC deals. This will save you and your legal counsel the trouble (and cost) of explaining each and every clause in the term sheet to the founders.
As told to Arti Singh.