The anatomy of a term sheet and why startup founders shouldn’t lawyer up excessively for one
Fundraising is an important requirement for a tech company, more so for early-stage startups. And yet, when it comes to a term sheet, first-time startup founders can find it one of the most intimidating documents.
Speaking in a fireside chat at YourStory’s first Early Investor Summit, Siddarth Pai, Founding Partner, 3one4 Capital, said,
“The term sheet is a document that intimidates a lot of people. They have two responses — one they go the lawyer at the get-go and find the most expensive one or do a lot of market research and internet work. Now, what you read on the internet never translates into real life. And getting a lawyer from the get-go unnecessarily complicates the process.”
Explaining further, Siddarth said there were a few pointers that a founder needs to keep in mind when approaching an investor. He pointed out,
“No VC wants the privilege of running your business for you, so there is no actual reason to get intimidated by the term sheet.”
Avoid lawyering up from the beginning
According to Siddarth, the holy grail of a term sheet is that this is a principal-to-principal conversation. Any commercial terms are there for a reason and an entrepreneur is well within their rights to ask them for reasons.
He explained that a term sheet is a document between the two principals, the investor and the founder. “And it is important for founders to realise that initially the term sheet is not legally binding. Every term sheet starts off by saying this document is non-binding. The purpose of a term sheet is to understand what are the broad terms underpinning the investment,” he added.
Siddarth highlighted that lawyering up early often messes the relationship between a founder and a VC, because the negotiations take a long time to get resolved and subside. “Also, the problem with lawyering up is that it actually puts the VC in a fix on who is running the company,” he said.
The job of a lawyer is to help navigate complex legal terms and not discuss commercial negotiable terms. He added that if and when an investor gives a term sheet to a founder, it is with the belief the founder can build a business and scale it up over time.
The sacrosanct ‘no-shop’ exclusivity clause
If a founder receives a term sheet, it's a de-facto, honour-bound tradition that they don't ‘shop around’. In other words, founders who go looking for ‘better terms’ on the basis of one term sheet can face trouble.
According to Siddarth, such actions can leave an entrepreneur in a bad spot, “because, the moment you go to one investor saying you have got a certain term sheet with a certain valuation and details, more often than not, the investor you go to is going to call the guy who gave you the term sheet and ask about the negotiation”.
Pointing out that the VC community is a small, tight-knit one, he added that the moment a founder goes ‘shopping’ with their terms, it becomes common knowledge and makes investors wary.
The anatomy of a term sheet - the basics
Explaining the anatomy of a term sheet, Siddarth explained that the term sheet starts out with identifying the parties, the type of instrument one is going to invest in, the quantum of money, and dilution. Going by these elements, the term sheet can be broken down into different categories or sections.
The first category talks about the economic terms of the investment, in terms of valuation, returns, and liquidation preference. The liquidation preference guides how the money is actually going to be distributed in terms of an exit or a liquidation event. There are two aspects to this as well — participating referral and non-participating referral.
The ‘participating referral’ is a means of protection for the investor, which indicates where they will get back their money from. The remaining part is divided among everyone, the pro-rata for the shareholders. The non-participating referral liquidation preference is with the higher of the principal you put in or shareholding.
Siddarth pointed out, “The standard 1x liquidation for the first couple of rounds of funding, and the moment you reach Series A or Series B level, everything reverts to 2x of the principal and the participating share. What are the defined IRR?”
He explained that this is where the legality kicks in, because no startup founder can guarantee a return to their investors. He said,
“The fact that startups are a volatile asset class in itself, and the investor asking for a predefined IRR happens only in the Series B level. If an investor puts that in in the early stages, I would suggest, leave that term sheet.”
The next important part of a term sheet is control. “No investor invests in a company for the joy of running the company,” added Siddarth. The control always vests with the founder. Explaining further, Siddarth said,
“Ask an investor for the investor protection matters, and make sure these matters are based on certain actions that the company can’t take without their approval. But ‘affirmative matters’ don’t cede control. The way these work is, the founder is free to propose any item they can to the investors and board. These come in because an investor invests basis a particular thesis, and there are significant deviations from the plan that undermine the core principles for that investment; it is the job of the founder to keep the investor appraised of the same. The idea is to respect the thesis on which your company got investment.”
This category is where control again plays an integral part. All board members, irrespective of what is put down in the sheet, become liable for certain acts of the company. “There is a conversation among the investors and founders and then they decide the number of seats they get,” said Siddarth.
These rights talk about whether an investor will invest in different rounds of funding and how those tranches will play out. The right of first refusal also gives an option wherein the investor offers his rights to sell the shares to a third party. The first right goes to the existing investors and shareholders on what price the shares are being sold at, and the option of choice will be kept open.
There also is a ‘tag along’ when a founder or a key shareholder sells their share, and the investor can then choose to sell their share too. This depends on the number of founders and shareholders.
There is also a 'promoter vesting and shares’ category that talks about when and how a founder can exit in a certain period of time.
“The investor wants the founder to run the company and generally the exits of both the investor and founders work along the same time,” explained Siddarth. Generally, there is a vesting period, and, if a promoter wishes to exit before, there can be a conversation on the same.
“So, it is important to understand the terms, the playbook, and where the investors are coming from,” added Siddarth.
Warranties and indemnities
The representation of warranties comprises promises made by the founder stating that there are no indemnities, legalities, and or any liabilities that the company has. But, later, if it comes out that the founder had lied to an investor, the former is held liable. There are consequences to these loses.
Siddarth signed off by stating, “The term sheet is simple. While you have a lawyer to discuss, do not get the lawyer to negotiate. The investor too wants to close negotiations quickly.”
(Edited by Athirupa Geetha Manichandar)