Critical things for entrepreneurs to watch out for in the investment term sheet
By Bhaskar Raj
No business can survive and thrive without having trust. Whether it is small businesses or multinational corporations, success starts from building trust among founders, partners, investors, venture capitalists, angel investors, clients, associates and ultimately customers.
As business progresses to a critical mass or declines to a failure chinks can appear in this trust, leading to disputes and parting of ways and ultimately liquidation of business. Partners may ask for their fair share, investors may demand their money back, VC funds may seek an exit, not necessarily on amicable terms. This is where the need for legal documentation in the form of an investment term sheet, a broader bullet-point document specifying the terms and conditions of a business agreement with investors in start-up companies. The term sheet outlines the conditions under which the investment will be made and business conducted. A typical term sheet for a venture capital transaction includes provisions such as valuation, investment and management structures and liquidation preferences.
Entrepreneurs should bear in mind that the term sheet is the starting point for negotiation with prospective investors and therefore all possible clauses should be incorporated by taking legal opinion to safeguard your interests as an entrepreneur who took the risk. Before putting it in black and white, entrepreneurs should engage in detailed negotiations with the investors covering all possible future issues.
“Though term sheets are non-binding, provisions should be clearly defined and incorporated bearing in mind the possibility of disputes over financial objectives, future capital needs, exit strategies and management control. Therefore the term sheet essentially should cover four elements – founder vesting (initial investment), valuation (price per share), liquidation preference and board structure and composition – for negotiating with the investor before executing the full documents around the investment,” said Mustafa Zafeer, founder and managing director of Musthafa & Almana Associates, a Dubai-based law and consultancy firm advising start-ups and VC funds.
Entrepreneurs usually ignore future higher valuation of their stakes in the term sheet, fearing reluctance or disapproval by the investors and settle for a lower price. That will prove disadvantageous in the future when the company grows in stature and size. A lower valuation will be a windfall for the investor at the time of exit, but the founder will be bearing the brunt by way of offloading more stakes at lower prices per share. Therefore make sure a higher price (valuation) for fewer shares than a lower price for more shares under liquidation preferences.
However, you can accept a lower price, but it should be in exchange for more flexible terms. You can also opt for ‘pre-money’ price by including Employee Stock Option for future employees or ‘post-money’ price. Pre-money will be more dilutive to the founders, whereas in the case of post-money the new investors will share the cost.
Care should be taken while agreeing for a certain valuation, higher or lower, as it can impact future capital mobilisations. Higher valuation may pose problem for raising capital before the company operations become viable as the prospective investors may offer to buy stock at lower prices. Earlier investors will seek protection by including ‘anti-diluting’ provisions.
Then comes the issue of control of the company once operations are streamlined and progress made. It is natural that the entrepreneur has to give away partial control to outside investors in exchange of capital. The term sheet should have clear provisions on ownership, control and composition of the board in such a way that the entrepreneur enjoys the power to take critical decisions concerning the running of the company.
Further, entrepreneurs should bear in mind that business failures can occur on account of unforeseen market forces, government policy changes, geopolitical developments, slowdown in economic growth or even recession, technology obsolescence, emergence of disruptive technology and market competition. A situation may arise that the company will have to go for liquidation on mounting losses and debt or losing market share. The term sheet should have provisions for this life after liquidation such as division of proceeds between stakeholders in the event of a sale or takeover by another company.
Liquidation preference provision in the term sheet assumes importance as it will have greater impact on entrepreneurs in the event of liquidation and entitlement of shares. If an entrepreneur opts for multiple liquidation preference, he/she will be entitled to get a multiple of their capital back prior to any other investors participating in sale proceeds. It is better to choose a lower liquidation preference.
“It should also be considered that the investor (venture capitalist, angel investor) is experienced and therefore include provisions in the term sheet to take care of his interest based on past experience with other start-ups, whereas the f may be a green horn, giving rise to the need for legal advice to make the document water tight to obviate unnecessary dispute,” said Mustafa.
All loopholes in the term sheet should be plugged before it is executed and the final agreement signed. Legal advice should be considered prior to a decision or agreement with the investors. After all, all parties need to balance the interests of the stakeholders. Let that be prepared by your own lawyer.