Amidst the big rush for funding, most founders get carried away by the hullabaloo in the market rather than trying to understand the real implications. One such example is at the time of initial negotiation with the investors.
The term sheet is the first document that sets the terms of the deal and breaks the ice of negotiation between the promoters and the investors. However, most of the founders do not understand the meaning of the primary clauses in the term sheet, which might put them in a disadvantageous position.
In this article, I have detailed some clauses that require attention,
- Legal binding:
A term sheet does not have a legal binding. In other words, it does not guarantee money coming into your kitty. It is a simple contract that forms the basis of negotiation between both the parties (company and investor) and might prevent the company from looking at other prospective investors for a specified period.
- Liquidation preference:
Liquidation preference simply determines the amount of money returned to the investors against the original purchase price at the time of liquidation of the company. Liquidation does not only mean winding up or closing down of the company, but it also signifies mergers and acquisitions.
Most liquidation clauses state that the investor shall be repaid their investment capital before the promoters.
There are three types of liquidation preferences depending upon the kind of participation:
- Full participation: Apart from the fixed return, investors also get a share of the remaining proceeds on a pro-rata basis. This is a double benefit and preferred by the investors.
- Capped participation: Although the investors are entitled to participate in the surplus proceeds, their total return is capped and cannot be exceeded.
- Non-participation: Investors are not allowed to take part in the surplus proceeds of the company. This is most favourable for the company and founders.
This clause protects the initial investors from dilution of investment at the time of future rounds of funding. If the company issues additional shares to new investors for a consideration lower than that paid by the initial investor, it will pinch the latter’s pocket. As such, the initial investors might demand to get compensated by the issuance of additional shares to them so as to make their ownership equivalent to the new diluted purchase price.
- Pre-emptive rights:
Pre-emptive rights are given to the existing investors to give them the preference to participate in future funding rounds of the company. This gives the investor the right to maintain his or her ownership by buying a proportionate number of shares of any future issue of the shares. If the investors do not wish to subscribe, the balance shares can be freely available for subscription by other shareholders.
- Board control:
It is suggested that a good mix from the team of the investors and the promoters form the Board so that the interest of both the parties is safeguarded. A third person might also be introduced to give an unbiased and fair decision. A Board Observer might be appointed, if required by the investor.
- Tag Along and Drag Along:
The 'Tag Along' clause protects the interest of the minority shareholders. It implies that in case there is a sale of the majority of the shares of the company, the minority shareholders can insist that the purchaser also makes an offer to purchase a proportionate number of shares from them, at the same price and on the same terms as that of the majority shareholders.
The 'Drag Along' provision enables the majority investors to insist or drag along other shareholders, including founders, to give their consent to a sale of the company. In other words, this clause prevents the minority shareholders to withhold the sale of the company for any reason.
- Vesting period of founders:
If the founders exit, it might pose a risk to the investors as they have invested not only in the product but on the crucial team. Vesting means an ownership on shares of the company. This clause ensures that the key founders do not vest too much, too soon. The average vesting period is four years with a one-year cliff period. This means that after one year, you can begin accumulating equity ownership so that you can claim 25 per cent each year until you reach 100 per cent of your ownership interest after four years. The one year cliff means that if you leave before the end of your first full year, you will receive nothing.
Through this, exiting founders are entitled to liquidate only that portion of shares which has been vested by them over the years. The remaining shares owned by them are either transferred to the co-founders or investors or most commonly transferred to the ESOP pool.
The term sheet can be made as elaborate and as concise depending upon the terms of negotiation between the promoters and the investors. However, it is always best to understand the clauses from every perspective, as each has long-term implications.