A term sheet is a short agreement that is used to define the main terms and conditions of a transaction. Used in the context of a fundraising, the term sheet is entered into between the founder and the investor and used to define the main terms of an investment.
The term sheet is generally considered to be a gentlemen’s agreement as most of its terms are non-binding. However, specific provisions of the contract, such as confidentiality, exclusivity (if applicable), costs, and jurisdiction, can be binding in nature.
The term sheet highlights the intent of the parties to proceed with the transaction.
As a result, term sheets are important documents for both investors and founders. A good term sheet saves time and money as it allows the process of negotiation to move forward and address legal issues, important commercial matters, and the timetable for negotiation, etc. A term sheet is divided into three sections: “economic terms,” “control terms,” and “others.”
The “economic terms” relate to the financial aspects of the deal. These are the valuation of the company, dividends, anti-dilution provisions, etc.
The “control terms” relate to anything pertaining to corporate governance. Matters relating to the board of directors, voting rights, protective provisions, etc. are covered in this section.
The “other terms” can include anything related to the proposed due diligence and the other activities that need to be completed before a binding document is signed.
The economic terms
The price and valuation of the company
The price of the deal usually referred to as price per share, can also be represented by defining the amount of financing. The valuation of a company, which is mentioned in the term sheet, is calculated either as a pre-money valuation or a post-money valuation.
- Pre-money valuation – this indicates the valuation before the investment is made.
- Post-money valuation – this is the sum of the pre-money valuation added to the proposed aggregate investment amount.
Equity value vs Enterprise value
Investors value companies according to several quantitative and qualitative factors, which include the following elements:
- the economic context
- competition with other funding sources
- the experience, quality and capacity of leadership of the founders
- the unfair advantage of the project, which will make competitors less impacting
- the scalability of the project
- the stage of development vs. the timing of the investment (early stage or not)
- an analysis of the financial and non-financial metrics – past performance, projections, revenue, earnings before interest, taxes, depreciation, amortization (EBITDA), cash burn, discounted cash flow, when available.
The enterprise or company value is computed after considering all the factors listed above.
The equity value, on the other hand, is the enterprise value corrected of its financial debts and available cash. The equity value is the enterprise value plus or minus the excess net debt or the excess net cash.
If a founder leaves the company before the end of the stock and option vesting period, the value of the company will generally be negatively impacted. Accordingly, such founder gets only a percentage of the stock. Often, founders will have different vesting provisions than the rest of the employees, especially if they started the company at least a year before the financing operations.
Depending on applicable laws, the vesting may take place in a gradual manner. Alternately, a process of reverse vesting may be implemented. If this system is followed, employees will receive all the shares that they are entitled to at the outset. Employees would have to transfer the unvested shares when the bad/good leaver event occurs.
The employee pool refers to the shares that are reserved for future issuance to employees. As the shares are set aside for future hiring needs, they do not belong to the founders, current employees, or investors. These shares are used to compensate and motivate the company’s workforce while saving cash and are especially important for startups since they allow for the attraction and retention of talent.
Having a large option pool makes it less likely that the company will run out of available share options to offer its employees. Consequently, the size of the pool is considered when the valuation of the company is being carried out. A larger pool effectively lowers the pre-money valuation.
Anti-dilution: preemptive right and ratchet
A basis anti-dilution right is to give a preemptive right to the investors. Accordingly, in case of capital increase (or issuance of convertible loans) decided by the majority shareholders, all the shareholders will be entitled to participate to such capital increase in proportion of their share of the capital.
A more sophisticated way is to grant the investors a ratchet. This anti-dilution provision is used to protect investors in case a company issues equity at a lower valuation than in previous financing rounds. There are two varieties: weighted average anti-dilution and ratchet-based anti-dilution.
- Full ratchet antidilution – if the company issues shares at a price lower than the price for the series with the full ratchet provision, the earlier round price is reduced to the price of the new issuance.
- weighted average anti-dilution – the number of shares issued at the reduced price is considered in the repricing of the previous round.
NCP= OCP x [(CSO + CSP) / (CSO + CSAP)]
NCP= new conversion price
OCP= old conversion price
CSO = common stock outstanding (number of outstanding shares before new issue)
CSP = common stock purchasable with consideration received by the company (total consideration received by the company for the new issue)
CSAP = common stock actually purchased in subsequent issuance number of new shares issued
Broad-based vs. Narrow-based provisions
A broad-based weighted average provision considers both the company’s CSO and the number of shares of common stock that could be obtained by converting all other options, rights, and securities.
A narrow-based provision will not include these other convertible securities and will limit the calculation to only currently outstanding securities.
The liquidation preference
A liquidation event is said to occur when shareholders receive proceeds against their equity in the company. It can be through a merger, an acquisition, or a change of control in the company, or a bankruptcy.
The liquidation preference impacts the sharing of the proceeds during a liquidity event, usually defined as a sale of the company or most of its assets. The liquidation preference granted to preferred shareholders can take several forms:
Participating stock – The preferred stockholder will receive his stock’s participation amount, then its pro-rata shares of the liquidation proceeds on an as-converted basis, where “as-converted” means as if the stock were converted into common stock based on its conversion ratio.
Capped participation – A cap on the participation limits the amount receivable by the preferred stockholder to a fixed amount and is usually determined as a multiple of the original investment. Once this limit is reached, the preferred stockholders will not be entitled to any further amount. Holders of common stock will then receive all proceeds until they have received the same amount per share as the preferred stockholders have received. When that happens, preferred stockholders are economically incentivized to convert their preferred stocks to common stocks.
Non-participating stock – During a liquidation event, non-participating stockholders receive an amount equal to their initial investment along with unpaid dividends. They are favored compared to holders of common stock (founders, management and employees), as the liquidation preference will become meaningless after a certain transaction value.
Right of first refusal and co-sale agreement
The ROFR/Co-sale agreement prevents the founders and the major common shareholders from selling shares without the company and the other investors being given the right to buy these shares. In the event of a sale of the shares by the majority shareholders, the minority shareholders are offered the option to force the transfer of their shares to the purchaser at the same terms and conditions offered to the majority shareholders. In order to make sure that majority shareholders cannot block any share transfer, the exercise of the co-sale shall be done in proportion of the share of the capital held by each party (proportional tag along right).
The drag-along agreement
Some investors can force all the others and the founders to sell the company, no matter the opinion of those being dragged along. It is especially useful if there are a lot of investors, in order to force them all to agree to a deal and save the company if need be.
A redemption right is another feature of preferred stock. It entitles investors to require the company to repurchase their shares after a predefined period. This allows investors to exit from an unattractive or weak portfolio. This stipulation, which is still a standard market practice in Chinese fundraising operations, shall be undertaken with caution.
These rights entitle an investor owning restricted stock to require a company to list its shares publicly so that the investor can sell them. If exercised, they can force private companies to become public. They are usually assigned when a private company issues shares to raise money. There are two types of registration rights:
- Piggyback rights – investors can have their shares included in a registration that is currently in the planning stages.
- Demand rights – these are the type of registration rights described previously
Investors must keep participating on a pro-rata basis in future financing rounds in order to not have their preferred stock converted into common stock in the company. It is relevant in a down round financing and can be very useful to the entrepreneur when the company is struggling and needs more funds.
The control terms
The board of directors
The board of directors of a company is a group of individuals appointed by the shareholders to oversee the activities of the company. They establish its mission, vision and values.
They are also the link between the management and the shareholders, and responsible for formulating the company’s strategy and its management structure. The members of the board can include investors and founders. Boards may also have a Board Observer, whose expertise can be useful for early-stage companies.
Protective provisions are veto rights that shareholders have over the management of a company or even its board of directors.
The objective of the veto rights is to protect the assets of the company and to prevent the management or the board from taking any decisions that are detrimental to its long-term interests. It does not entitle the shareholders to make a decision on the company’s behalf, but it does allow them to block a decision they disagree with.
The voting rights enable preferred stockholders to:
- participate in the voting sessions with the common stockholders
- be included in corporate decisions and
- limit action from the common shareholders without their agreement.
Dividends are decided and managed by the board of directors and approved by the shareholders. They constitute a reward of the financial risks taken by the shareholders.
Usually, the term-sheet will restrict the payment of dividends. Most startups conserve their funds and plough back all their profits into the company.
The other terms
Conditions precedent to financing
This is all the events that need to occur before a binding agreement is signed. It usually states that the funding is conditioned to the investors’ due diligence and its results, as well as the completion of all the necessary legal documents or presale restructuring. There are several clauses that entrepreneurs should monitor:
- No Shop Clauses – which can prevent founders from seeking another financing source
- The approval of the investor’s organization, if need be
- Employment Terms
- Investors Legal Fees
The entrepreneur is forced to provide the company’s financial statements and information to his investors, as well as usually the possibility to visit the company’s facilities and inspect its books and records.
The provision indicates the number of shares an investor needs to have to receive information right, in order to protect the company from sharing its confidential information to a great number of potential investors. It also ensures the confidentiality of information once it is received by investors.
Warrants associated with financing
A warrant shares several similarities with a stock option. It enables the investor to purchase a specific number of shares at a predefined price within a predetermined period.
Warrants may be linked to bridge loans. When an investor is planning to deploy funds, but is waiting for additional investors to participate, the company could issue convertible debt in the form of warrants. These could be converted into equity during the next financing round. Since the investor took on greater risk by investing before the others, the conversion of the warrants into equity shares could be made at a discount.
To know more, feel free to contact us:
Bruno Grangier: b.grangier@leaf-legal-com
Jean-Philippe Engel: firstname.lastname@example.org
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