How to negotiate a term sheet

1 September 2017

~ Remember, « it is just a first step » ~

 

During the course of startup maturation, founders will, at some point, need to deal with new investors. Prior to any fundraising, one of the key steps you need to know about is the term-sheet, commonly called the “TS”.

The TS is one of the most important documents you will ever encounter as a founder. It is a cornerstone document that acts as a catalyst for capital injection transactions.

Literally a bullet-point list, this synthetic document lays down the conditions of the fund raising, and serves as a model for the legal documentation for the transaction. Only after both parties reach an agreement on the TS will a binding contract be established, according to the details as laid down in the TS.

 Because the TS forms the negotiation basis of the soon-to-be agreement, there is no strict standard. Some can be very light so all parties have room to maneuver during the negotiations, or re-negotiate if the background changes before the final documents are signed. Other parties will try to negotiate and settle an upfront agreement covering the largest scope possible to save time when drafting final documentation.

The TS is usually considered as a non-legally binding document. However, some general provisions ruling on confidentiality and exclusivity, such as “no shop provisions”, may be binding, and legal action is still possible on the basis of a wrongful termination of negotiations. Any wrongful termination could also carry a reputational risk, which is another reason to treat the TS as legally binding.

Your TS will include financing conditions: raised funds, valuation (pre-money), structuring, the main clause of the coming shareholder agreement (joint disposal, anti-dilution, pre-emptive rights, …), condition precedents, calendar etc.

There are three main considerations when negotiating your TS:

  • Financial matters;
  • Corporate governance;
  • Exit.

Financial matters

  • Valuation and share allocation

This is one of the most important points of negotiation. The price is expressed either pre-money (i.e. the value of the company before the investment), or post-money (i.e. the value of the company plus the new money received as an investment). The amount raised will determine the profile of the investor.

While negotiating, the question is often raised of whether the price per share is calculated based on the issued share capital (actual number of shares held), or the fully diluted share capital (actual number of shares held, plus all options and warrants already granted and a notional option pool available for future grants). Investors will, of course, prefer the latter approach as the price they pay per share decreases.

Finally, another point of negotiation will be adjusting the size of the option pool available for grants. However, it is in both founders’ and investors’ interests is to motivate key employees. The consequence is that the founder will see his own holdings diluted.

  • Class of shares

When subscribing, investors can be allocated different classes of shares: ordinary shares or preferred shares.

Ordinary shares have no differentiation in rights from the shares held by the founders and existing shareholders.

In the event that preferred shares should be allocated to incoming investors, the TS would include the characteristics of the attached rights, among which specifically includes the rights to capital and the rights to dividends.

The rights to capital: The class of shares allocated to investors often grants them a liquidation preference. They have a priority right regarding the return on capital (for instance in the event of a liquidation or a winding up), or on the sale of the company (exit). Thus, a multiple will be applied to their invested amount, and prioritized over the other class of shares. That multiple is commonly 1 to 2 times, but it can occasionally be higher.

Participating and non-participating shares: When the remaining proceeds will have to be split between the shareholders, it will be done so depending on whether the shares are participating (entitled), or not participating (not entitled).

The rights to dividends: Rights to preferential fixed dividends may be cumulative (increase as a debt until the company can legally release the dividends), or non-cumulative (released only when the company is legally allowed to do so).

Other share rights: An investor’s class of shares may also be granted with other rights, such as voting rights (enhancing the voting rights in certain circumstances), or redemption rights allowing the investor to get his money back. However, in practice, companies are often unlikely to proceed with share redemption due to underperformance, or failure to achieve an exit.

Founder vesting: Often required by early stage investors, this right allows the founder to earn their equity over time. That vesting can either occur, in whole or in part, on an anniversary date basis, or on the achievement of specified milestones. While it can be hard for you as the founder to accept a vesting while negotiating, it is understandable that a new investor requires it to ensure the founder is fully committed to his venture.

The investors’ class of shares is a key point of the TS. Whether you are a founder or an investor, we urge you to clearly outline the meaning of such granted rights, and even to model the impact on the capitalization table scenario according to the rights under discussion.

Corporate governance

  • Board of Directors

In exchange for their investment and to ensure they maintain control over the company they invest in, investors often require a right to appoint one or several director(s) to the company’s board.

Doing so enables the investors to guarantee they have a say in the management of the company and to monitor the way the business is led.

If, as a founder, you are ready to grant only one top investor a board seat, a judicious way to compromise with other investors would be to grant one with a board visitation right. This does not include a voting right, but is regarded as a consulting permission to keep an eye on the direction the business.

  • Information rights

Although the investor is granted with a seat at the board, a VC will generally require regular reporting from the company for ease of monitoring their fund structure. This is often called “customary information rights”.

Founders are often reluctant to give control to their investors, but two main things must be kept in mind to ensure the company’s good management: first, a handy-sized board, and second, balancing the power between investors and the company’s founder(s).

Exit

Ensuring the value of an investment is of key interest to the investor. Therefore, these are some of the main points which will be discussed in the TS.

  • Drag along tag along

The drag along allow the majority of shareholders who accepted an offer for their shares to force the minority shareholder to sell their shares on same terms.

Symmetrically, a co-sale allows a minority shareholder to require an offer of their shares on the same terms as the offer accepted by the majority.

In the event where the offer to the majority would result in a change of control of the company, such a symmetrical right is called a tag along. The importance of these mechanism is to prevent liquidity until the exit.

  • Good leaver / bad leaver

A TS contains reference to compulsory transfer provisions, often referred to as a “good leaver / bad leaver” clause.

Investors need to protect the exit valuation targeted. To do so, they need, amongst other things, to prevent key employees and the founder from leaving the company before an exit.

If the termination is wrongful, the leaver will be qualified as bad. Thus, these above-mentioned tools ensure they will not benefit from any future growth value from the shares, and that their equity will be made available to incentivize a replacement without diluting the other shareholders.

  • Anti dilution ratchet

This is a right granted to the investor offering protection in the event that a future fundraising is contracted at a valuation lower than the valuation at which he invested. Such an event is commonly named a down-turn.

Other tools to prevent liquidity before the investor’s exit include the right of first refusal (a preemptive right on shares to be sold by a leaving shareholder), and preemption rights (giving its holder priority rights to purchase newly issued shares in the event of a new round).

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As the length of fund raising transactions is continuously getting shorter, the TS needs to be standardized. While proceeding with your own fund raising you will encounter TS flagged by the seal of VC syndicate, incubators, accelerators, or other startup organizations.

A standard TS is obviously oriented to serve the interests of its author. However, legal mechanisms in such a contractual relation allow much more creativity than the standard you will usually encounter.

Before entering negotiations through a standard TS, remember that the TS is a tailor-made document, aiming to be the perfect fit between your own specific interests and those of your investors.

 

For further information, please contact:

Khalid Mazouz – k.mazouz@leaf-legal.com

Bruno Grangier – b.grangier@leaf-legal.com