A term sheet is a non-binding commitment (usually, though not always) made by – (a) an investor to invest into a company, and (b) the company to accept such investment. The term sheet sets the base around which the shareholder agreement is crafted. It is therefore important that you are careful about what you sign. This does not mean that the term sheet is a gospel. Some changes are okay. Not too many.
In this writing we have tried to simplify term sheets with practical explanations around key clauses. This writing only looks at early stage term sheets. As multiple investors come in over multiple rounds, more complex rights and obligations get negotiated.
What are the terms that (usually) go into a Term Sheet?
The term sheet sets out the pre-money valuation, i.e., the valuation of the company prior to the investment and the post-money valuation which is nothing but the pre-money valuation plus the amount of cash being infused. The investors’ contribution to the value is the amount invested, and therefore the investors’ shareholding percentage is the capital infused against the post-money valuation. The number of shares to be issued is derived from this calculation.
The term sheet provides for current and post investment shareholding, both on a fully diluted basis. Fully diluted basis refers to the total number of equity (also called common and ordinary) shares of a company that will be outstanding (or exist) after all possible sources of conversion, such as preference shares and convertible debentures and exercise of all instruments, such as convertible notes, stock options and warrants. Phantom Stock Units issued will also be considered as part of the capitalisation on a fully diluted basis.
The type of instrument against which funds are being raised in the new round. Broadly speaking, there are 3 kinds of instruments that the company issues to raise capital – (i) equity, (ii) preference shares and (iii) debentures. Preference shares and debentures may be redeemable or convertible, though we don’t often see the redemption feature.
• ESOP Pool
Stock options have a dilution impact on all shareholders. New investors do not want to suffer that dilution immediately upon investment. Therefore, they insist on creating (or enhancing) the stock option pool prior to the investment or on a pre-money basis. The requirement of the option pool varies from 5% to 15% and is dependent on the nature of the business and the requirement of stock options for an agreed period, which could vary from one to four years. The additional options are deemed to have been created on a pre-money basis, i.e., prior to the investment for determining investor shareholding.
• liquidation Preference
Investors expect a preference for return of their investment if the company goes into liquidation or is subject to a sale event. The most important terms under liquidation preference are rank and entitlement. The entitlement may be in the form of – (a) capital protection, i.e., investors receive the higher of their pro-rata share based on their shareholding or the amount invested, (b) a double dip where the investors first receive the amount they have invested and the surplus is then distributed amongst all shareholders (including the investors) based on the shareholding, (c) the investors receive the higher of the amount of capital invested with a return at an agreed rate or their pro-rata entitlement based on their shareholding. There is no hard and fast rule on what is actually negotiated though we see it most often in India. Rank, refers to inter se seniority amongst the investors. Rank becomes relevant only if the proceeds available for distribution are not sufficient to meet all liquidation preferences.
• Right to Participate in future financing
Each investor likes to retain the right to participate in financing rounds so that their % holding does not fall when the company raises money. They will participate on the same terms as are determined by the company’s Board and applicable to all participants in the round.
• Anti-dilution right
This is a protection against any issue of shares by the company at a price lower than the price originally paid by an investor on a per share basis. The anti-dilution protection comes in a few variants. The common ones are – (a) Broad based weighted average, (b) Narrow based weighted average and (c) Full ratchet.
While theoretically adjustments are possible whether the instruments issued are equity or convertible, owing to tax and foreign direct investment considerations, realistically, this will work only in respect of convertible instruments such as convertible preference shares, that too subject to limitations.
Broad based anti-dilution results in the price being adjusted downward based on the weighted average price of the original issuance and the new issuance. The weighted average is taken based on the entire capital.
Narrow based anti-dilution results in the price being adjusted downward based on the weighted average price of the original issuance and the new issuance. Only preference capital is considered for determining the weighted average.
In full ratchet, the conversion price is adjusted down to the new issuance price. Broad-based weighted average is most commonly used in India.
• Dividend rights
Right to receive a percentage of profits earned by the company. Dividend is payable only if the company is able to generate profits and is usually not cumulative. Typically, a nominal dividend of 0.001% is agreed upon as the rate of dividend. In addition, if dividend is paid to equity holders, dividend at the same rate is payable to the investors who hold convertible instruments.
• board structure
This section covers the strength of the Board and the manner in which the Directors are appointed. Investors usually seek a right to nominate one or more members to the Board. The remaining positions are taken by the founders and independents.
VCs (as opposed to later investors) like to see the founders themselves on the Board and sometimes insist that they cannot nominate others. Some VCs insist that founders who are not in employment, cannot be on the Board. The principle is that founders who are active and engaged should be on the Board and contribute. A founder leaving employment usually represents some dissonance either amongst the founders or between the leaving founder and the investors. It must be remembered that these provisions are part of the early stage financing deals, when value has not been created. Founders who have delivered value are usually in a better position to negotiate.
This section also usually covers provisions relating to conduct of board and shareholders meetings.
• voting rights
Investors secure for themselves voting rights consistent with their equity ownership. This is required in cases where investors use instruments other than equity shares.
• Investor Protection Matters
This is a list of matters that the company cannot carry out without investor approval. This list can be long or short depending on the investors. Ideally, approval should be required of some majority of the investors and not all the investors. A typical list of such matters is listed in the annexure to this writing. As can be seen, some are operational matters, and some are more strategic. It is important that the investor is engaged with the company on a regular basis. If not, getting approvals for these matters will not be easy – especially, operational matters. Typically, VCs have analysts tracking companies and keep checking-in with regular calls. It is easy for them to understand the thinking of the founders.
Financial investors make investments into companies with the object of selling their shares with a good return. Therefore, a fair number of exit rights are constructed into the term sheets. Exits could be in the form of strategic sale, sale of shares by the investors on an individual basis or a listing of shares. Some term sheets include buy-back provisions as well. Founders only have an obligation to make best efforts or commercially reasonable efforts to provide an exit as above. Founders cannot be said to be in breach if an exit does not materialise.
However, founders will be in breach, if they block an exit that presents itself which investors desire to avail of. If an exit does not materialize, investors have the ability to drag the founders and other shareholders in a sale. Drag is the ability of the investors to force founders and other shareholders into a sale that is negotiated by the investors. Drag will be available only if investors remain shareholders after the exit period or some substantial breach has been committed by the company or the founders.
Provisions relating to Ownership and Transfer
• Reverse Vesting
At an early stage, the value lies in the potential. The potential is realised only by the founders working with each other and the company. Early investors therefore seek that the founders should surrender some or all of their shares if their employment is terminated. This is one of the most negotiated clauses. Investors argue that this should be like stock options, meaning, termination for any reason should lead to the negotiated consequences. Founders seek a more nuanced approach. They want to protect themselves for scenarios where the termination is not due to their fault. These provisions see a wide variation. Surrender could be as a consequence of – (a) any termination, including death, termination by the company without cause, or (b) only if there is a termination for cause. Cause again has varied definitions. The shares surrendered usually go into a pool for future allocation.
The logic for the provision, as presented by investors is that if a founder leaves, he or she needs to be replaced and such a replacement will need to be offered options. This is an unfair dilution for other shareholders.
Growth and late stage deals do not usually have these provisions because by then founders have demonstrated their commitment and value has been created.
A word of balance though; continuing founders suffer as much from a founder leaving. This is one of the provisions that must be looked at entirely from the perspective of the company and it is more important to focus on checks and balances rather than the provision itself. Experience shows that continuing founders are most upset with a founder leaving.
Investors insist that some or all of the shares held by the founders cannot be transferred without approval of the investors. With each passing round, founders can request for a higher amount of liquidity. Later stage investors are often more comfortable providing liquidity to founders.