As a founder or CEO, anytime you raise capital, whether it’s equity or debt, the investor you partner with will ask you to sign a term sheet with the details of the investment. And while term sheets are usually stated to be non-binding, investors expect you to honor them once signed. For that reason, it’s critically important to both understand and negotiate the provisions of the term sheet before you agree to them. Otherwise, you may find yourself in a deal with long-lasting and undesirable implications for your business
That’s particularly true if you’re considering raising money by giving up equity rather than taking on debt. In such cases you have to be careful because when you sell equity to an investor, you are in fact inviting a partner into your business. Getting the terms right is crucial.
Unfortunately, term sheets from equity investors aren’t always balanced or fair. In the best scenarios, they clearly describe the proposed transaction and contain reasonable provisions designed to help investors safeguard their capital. In the worst scenarios, they can endow investors with far reaching powers to interfere with your vision for the business and even fundamentally reshape it to their advantage. If you’re not careful, or simply lack experience negotiating term sheets, you could find yourself:
• Giving away more equity than you intended
• Restricted from raising additional capital in the future
• Losing control over your business or, worse yet, squeezed out of it completely
• Realizing lower-than-expected proceeds upon exit
To be clear, great mutually beneficial equity term sheets are executed all the time. The goal of this paper is simply to raise awareness about the major pitfalls that founders and CEOs can encounter as part of the process. Armed with a better understanding of what problems typically occur and how you can avoid them in the first place, you’ll be much better positioned to negotiate a fair and balanced term sheet that meets your needs and the needs of your investors.
Term sheet fundamentals
As a founder or CEO, you probably need financing to help fuel your business and take it to the next level. And while raising capital is a great way to help grow your business, you need to know exactly what you’re getting yourself into. Unfortunately, problems can arise under the following circumstances:
Not considering the impact of share preferences on common shareholders
Some founders and CEOs make the mistake of thinking that if they’ve sold 30 percent of their business to an investor, the investor will simply get 30 percent of the profits when the company is eventually sold. But if the investor has preferred shares, which is often the case, things become more complicated.
Preferred shares mean the investor gets its capital back ahead of common shareholders. This can be catastrophic for common shareholders if the company struggles and is sold for a lower-than-anticipated price. For example, if an investor bought a 30 percent stake in your company for $5 million via preferred shares and the company is later sold for $10 million, the priority return of capital means 50 percent of the purchase price
will flow to the investor rather than 30 percent.
And it’s not uncommon for the preference to be amplified via cumulative dividends (which function much like interest on the investment) or via double dip provisions (where the investor is repaid its capital first, and then continues to share equally alongside the common shareholders in the remaining balance of the purchase price). In the scenario described above, a double dip would mean the investor would be paid the first $5 million
for return of capital plus 30 percent of the remaining $5 million (or $1.5 million) for a total of $6.5 million (or 65 percent) of the total sale proceeds.
While scenarios like these are suitable for companies that achieve big exits, it can be very costly in less successful outcomes, particularly if the effect of the preferred shares is layered over multiple deals.
Examples of protective provisions include the right to approve:
- A majority of the board
- All future share issuances
- All borrowing by the company
- The hiring and firing of senior officers
- Full price anti-dilution protection (if the company subsequently issues shares at a lower price than paid by the investor, the investor’s shares are automatically repriced to that lower amount)
- Reverse vesting on founder shares (an arrangement under which the founders must give back some of their shares if they depart the company, voluntarily or otherwise, before the vesting period ends)
- Put clauses
Agreeing to standard term documents without knowing what they are
A reference to standard terms doesn’t mean that they’re fair or suitable for the company. Don’t assume that they’re boilerplate like the license for an app from the App Store. Ask questions and be sure that you understand exactly what they mean. Many of the protective provisions and share rights reviewed above are part of standard National Venture Capital Association (NVCA) approved terms. For example, standard CVCA terms give
the investor the right to require the redemption of its shares after a specified investment period, the right to compel the company to complete an initial public offering of its stock and first right to have its shares listed (registration rights), and a first right to purchase new issuances of shares ahead of founders, which are generally not provided by friends and family. Being aware of such terms in advance enables you to negotiate compromises.
Losing the balance of power on your board of directors
As noted above, investors may request the right to nominate a majority of the board of directors. This typically occurs with earlier-stage companies. Such companies are often founder-run and not used to their management team being accountable to a board of directors. As such, they may not fully appreciate the implications of board control. The board is legally responsible for overseeing the business. Regardless of the ownership interest of a shareholder, if the shareholder has the right to control the board of directors, it controls the company.
If you face this request from an investor, you need to consider what it’s telling you about them and how they view you. Are they planning to make sweeping changes to your business and want the authority to be able to do so? Should you encounter this situation, you can try to remedy it by nominating mutually agreed upon independent directors who would hold a balance of power between founder directors and investor directors. It’s important to note that an investor’s interest in board seats may evolve over time. As other investors come on, for example, or the company matures, it may feel less of a need to be represented on the board.
Alternatively, if the investor isn’t involved in future rounds or is divesting shares, it may be willing to take a step back and negotiate away its board seat.
Overly long due diligence periods
Term sheets are typically signed prior to the investor undertaking its detailed due diligence. For this reason, term sheets usually include exclusivity provisions by which the company agrees to refrain from negotiations with any other potential investors or purchasers for a period of time to allow the investor to complete its due diligence.
A reasonable period for due diligence is typically 30 to 45 days. Some investors may, however, request longer periods of 60, 90, or 120 days. Long periods do more than simply let the investor complete due diligence. They allow the investor to monitor the company’s performance for a period of time before deciding whether to commit, potentially limiting the company’s alternatives in the process.
After working exclusively with a single investor for 90 or more days, the company’s other fundraising leads may grow cold, and the company may run low on capital. This can give the investor leverage if it seeks to negotiate changes to the term sheet prior to closing. Remember, term sheets are typically non-binding for a reason and investors do renegotiate terms and even walk away from deals if the company’s performance takes a downturn during the due diligence period.
Your investor doesn’t provide the value-add they promised
All investors know that it’s a good thing to promise value-add, but not every investor has the skills and contacts to actually make it happen. If your investor has promised to bring in resources and contacts, and to help you raise more money, and then fails to deliver on that promise, it can be a real source of conflict. If you’re looking for this benefit from your investor, you should complete your own due diligence to validate the investor’s ability to provide the promised value-add before you sign a term sheet.
Preventing problems before they happen
The best way to prevent the problems outlined above is to ensure that you’re well informed.To do that, the following considerations are important:
Being fully aware of any differences in business culture between you and your investors
Not all money is good money. You’ve got to understand exactly who you’re partnering with and whether or not they’re a good match for your business. That’s why it’s so important that you spend time conducting due diligence on potential investors. In particular, talk to investors about their goals and priorities. Call up some of their portfolio companies and ask them about their experience working with the investor. And look into the track record of the individual partners and account managers of the investors. Who are they? What industries/ sectors have they worked in? What are their past successes and failures? In short, do everything that you can to understand exactly who it is that you’re going to be partnering with.
As part of this process, ask questions like:
• What are the investors’ goals and do they align with your own?
• What’s their style and is it compatible with yours?
• Are they in this for the long haul or looking for a quick return?
• How do they typically treat founding teams?
• Will they put restrictions on how you can use their capital?
• Who are their investors?
• Do they have deep pockets and will they be able to support you the next time you go to raise capital?
• What sectors do they focus on?
• Do they deliver the value-add they promise investees?
• Have their investees been successful?
• What kind of exits and valuations have they participated in?
Unless you truly understand what the investors you’re about to partner with are all about, you could easily find
yourself in a difficult position. Of course, you also have be aware of your own priorities. Determine exactly what
you’re looking for and what your business actually needs. Only with this awareness can you determine whether
or not a potential investor is going to be the right fit for you.
Understanding the differences in the types of securities
Different investors invest in different types of securities depending upon the stage of the company and the perceived risk of the investment. Very early stage companies may raise money using a Simple Agreement for Future Equity or SAFE. Angel investors will often invest in common shares. Venture capital firms doing later stage deals usually favor preferred shares, or, in higher-risk deals, convertible debentures. Preferred shares and convertible debentures, in particular, can be quite complex.
It’s important to understand the main differences between these securities. The table below outlines some of
these differences from the perspective of the company issuing the securities.
A common share is a simple ownership interest in a company. If 100 common shares are issued, each share represents an equal 1 percent ownership interest in the company.
– The investor is an owner of the business with the same economic rights as everyone else, making it easy to understand
– Common equity provides permanent capital with less complexity vs. preferred shares or convertible debentures
– Valuation can be a hurdle to close.
A preferred share is a preferred ownership interest in a company. It gives the holder the right to be repaid its invested capital upon a sale or dissolution of the company before any distributions are made to junior-ranking shares.
– Well known in the industry
– Can be customized to accommodate unique investor needs, including priority dividends, protective provisions, redemption rights, and price protection, etc.
– It’s equity and not debt, which creates a stronger balance sheet
– At lower exit valuations, they can result in a disproportionate share of proceeds going to the investor upon exit
– Depending on your jurisdiction, each class of shares (e.g., common, preferred) may vote separately on certain fundamental changes, which gives the holder added leverage.
– May include accrued dividends
A convertible debenture is a loan instrument that is typically secured by the assets of the company, and that may be converted into common or
preferred shares, usually at the option of the investor.
– May attract an investor who otherwise wouldn’t have been interested because it offers the investor the protection of being a secured creditor, if the company runs into difficulty, with the ability to convert into equity (preferred or common) at a predetermined price, if the company is successful
– Can defer valuation until a later date, which can simplify and expedite closing of a financing
– A portion of the investment will be classified as both debt and equity on the balance sheet, which requires more complex reporting on year-end financial statements
– The investment earns both debt and equity returns
– Typically has a term of 3 to 5 years and must be repaid if the investor does not convert
– Complex legal documentation
A SAFE, or Simple Agreement for Future Equity, is an agreement under which an investor advances funds now to purchase equity in a future financing round, where the class and price of the shares are to be determined by the future financing round.
– Straightforward legal agreement
– Avoids the need to value a company up front
– Not considered debt (no interest, no due date, no security)
– Ranks behind creditors upon dissolution
– Quick financing option
– May include a valuation cap or price discount from the next round
– Ranks ahead of common shareholders upon a sale or dissolution of the business
– Ease of issue can lead to unintended dilution if the company fails to properly track the impact of multiple layers of SAFEs on the founder’s position
Going into negotiations with an empty tank
Raising capital by selling equity takes time. Your chances of concluding a favorable deal with an equity investor is greater if you’re not running short of cash, so it’s important to start the process well before needing money. That’s why it’s a good idea to also consider other methods of filling your tank, such as venture debt. Not only can venture debt improve the company’s cash position, and therefore the negotiating position with equity investors, but it can also enable the company to require less money from investors and improve returns to shareholders. Investors seek opportunities that can return 5x to 10x their invested capital. Every $1 million of equity that is displaced by venture debt puts this multiple back in the pockets of shareholders.
Using an experienced lawyer
Investments are complicated commercial transactions. Since the term sheet is the document that sets out the blueprint for the investment, smart entrepreneurs involve their lawyers at this stage of the transaction. As in any complicated area of law, an experienced lawyer can help you wade through the issues to focus on the points that really matter to existing shareholders, and advise you which terms are commercially reasonable or market, and which are not. And while most entrepreneurs can read a term sheet to find what it includes, many, unless highly experienced, are not able to identify its strengths and weaknesses by evaluating what’s not included.
Ultimately, negotiating a successful term sheet comes down to education and awareness. If you know what to expect, you can save yourself a lot of trouble further down the road.
Negotiate your next term sheet with confidence
Depending on who you’re partnering with, negotiating a term sheet can be a complicated matter. It’s very important to know what you’re getting into and how it can potentially impact your business. Being aware of how the process works and where the potential pitfalls lie is critical. So too is finding an investor who makes the process easy for you and who isn’t motivated to negotiate terms that could ultimately put you at a disadvantage.
That’s one of the many reasons why venture debt is an attractive source of funding. In addition to being non dilutive, venture debt can provide an important source of capital to enable the company to continue to grow and to engage potential equity partners at the best time for the business and with the confidence necessary to secure the right financing on the right terms. That way you stay in control of your business longer while still securing the capital that you need.