Term Sheets – Negotiation and Tips – Part 1

So, you have found someone (a VC) who wants to back you with the money you so desperately need. Just sign above the dotted line. Well, not so fast…

A term sheet is a non-binding document that lays out the important terms under which the VC or angel investor will make an investment in a company. A term sheet is used as a framework for discussion, negotiations and clarifications, before the final share holder agreement is drafted. (A share holder agreement or SHA is a binding document which legally formalizes the transaction.)

Since the term-sheet is the basis of the final SHA, it covers critical aspects like valuation of the company, control over decision making, exit options and how the investor’s capital would be protected against downside. Since a term sheet is usually drawn by an investor, it is usually loaded in favor of the investor and usually designed to protect the capital that the investor invests in the company, and to protect the investor from any action that may be detrimental to the investor’s financial interest in the company. It is therefore important that entrepreneurs understand the terms of a term sheet, do their homework well, decide on what terms they are comfortable with and what they are not comfortable with, and then, discuss the same with the investor. It is advisable to consult a lawyer who understands term sheets, and can advice you about what terms to be flexible on and what terms to accept. And most importantly, help you understand the consequences in case there are terms that are not in the best interest of the venture or the entrepreneur.

A term sheet, at a high level, can be broadly divided into two buckets – the commercial and the legal component.

www.investopedia.com is a good place for you to begin with for understanding the concepts and definitions.

Commercial Legal
Valuation Board Composition, Protective Provisions (Veto Rights)
Liquidation Preference – 1X, 1X+ participatory Investor Rights- ROFR, ROFO, Tag, Pre emptive Rights
ESOP Founder Vesting
Dividend Exit mechanism
Founder Vesting Information & Registration rights
Anti Dilution- full ratchet, broad based

The reason why we present it this way is that, while “commercials” can be negotiated quite a bit, the “legal” part of it cannot be negotiated to the same extent.  Founders need to pick their battle J

This post briefly touches upon valuation and liquidation preference.

Valuation.

Valuation can be broken down into pre-money and post-money valuation. The pre-money valuation is what the investor values your entity as of current date. The post money valuation is the sum of the pre-money valuation and the investment amount. To give you an example, if your company is valued at INR 3,00,00,000 and the investor is putting in INR 1,50,00,000, then the post money valuation is INR 4,50,00,000. The valuation helps the investor determine the stake he would like to take in your entity.

TIP: In early stage investment, valuation is more of an art, unlike later stage companies which would have revenues and a prior history to base valuation on.

While valuation is the most important aspect, the entrepreneur should evaluate the other benefits too – marquee investor, network, opening doors with large enterprises, recommending a smart employee, probably their ability to obtain brilliant exits. Take a look at their portfolio and probably speak with the company founders to get a better perspective of the “value add”.

The scale that the business can achieve and the founders ability to exhibit that in the plan, truly helps. Also, the founder should not forget in exhibiting their commitment to the scale.

Being educated of valuation numbers in other startups similar to yours or what the market is generally garnering helps.

Like in any other negotiation strategy, having more than one offer increases the negotiation strength, but in depressed markets having one offer itself is difficult. Watch, if you are being extremely desperate and also showing it.

The best strength, ofcourse, remains in building a rock-star product / startup.

Some of our experiences, if that is going to help you:

Buzz in cloud – 

Context: A data center with a very large tract of land allotted by the government, with prior experience of having built a data center, very senior management team, at a time when “cloud” is a buzz word.

Outcome: This should get great negotiation strength, right? Not necessarily, the desperation was so high to have money in the bank, that literally nothing was negotiated.

Media Moghul – 

Context: Senior management professional with immense execution capabilities in India’s richest company, was never an entrepreneur, about 48 years old, no team, just a ppt of the idea, no proof of concept yet. There’s nothing to negotiate? Not quite, the idea is so immensely scalable anywhere in the world, had the ability to stretch into multiple different business segments, founder charms enterprises to give him extremely expensive equipment with a growth-story.

Outcome: We close the deal with investment terms that one can dream of.

India education story – 

Context: Two founders who studied finance in NY, think of a product in technology (have no knowledge of tech), outsource the entire product build to a vendor with no contract or IP ownership terms discussed (well, there was an email broadly describing royalty payments and equity sharing etc.), extremely ambitious, projections of revenue and early traction very promising, very aggressive valuation expected by the founders.

Outcome: The term sheet was signed-up with the aggressive valuation with a clause that, if the numbers portrayed were not reached, then the valuation would be adjusted. The deal fell through during due-diligence, due to incorrect portrayal of number of earlier users, early revenues were not true, no IP owned, the tech vendor disappeared without giving out the source code.

Dividend

Dividend in simple words refers to a percentage which provides a share in the profits of the company. If the investment uses ‘preference shares’ as the instrument, then from legal perspective the instrument has to mention the rate of dividend. A typical dividend clause reads as cumulative or a non-cumulative clause.

 TIP: Investors look for big exits and not the small money in the form of dividends. From a founder perspective, keep the dividend rate low, can be as low as 0.001% and non-cumulative. (i.e. dividend is only paid for the year it is declared in, as opposed to an accumulation till the year it is declared).

Liquidation Preference

Liquidation preference in simple terms determines how the pie is shared in case of a liquidity event.(the money sharing clause when there is an exit). The clause also determines the sequence of pay-out.

 Liquidation event typically includes IPO, company buy-back, promoter or promoter led buy-back, trade sale, merger, acquisition, strategic sale (which may lead to change of more than 51% control), dissolution or winding up and the like.

The term sheet will specify the ‘preference’ the investor will get over other shareholders (founders/other early investors). The term sheet carries the multiples of returns the investor shall get, in the case of liquidation.

The clause also would also detail whether the investor just participates (i.e. to the extent of his shareholding percentage) or wants a 1x + participatory, also known as double-dip (i.e. the investor gets to take his investment amount first and then participate in the remaining proceeds).

Though majority of the deals in India are 1x + participatory, we have seen few deals with 1.5x + participatory.  It was in one deal we saw 2x+ participatory and interestingly it was from a social impact fund.

E.g. if the investor invests Rs.1 cr for 25% stake in your startup, and the term sheet stipulates a 2x return for the investor. Lets examine a Rs. 10 cr exit.

  • If just participatory right, the investor gets 25% of Rs. 10 cr = Rs. 2.5 cr.
  • If 1x+ participatory, the investor gets Rs.1 cr + Rs.2.25cr = Rs. 3.25 cr.

So, you negotiated hard for a 25% dilution during the valuation clause?

What’s the money that the founder makes if there is a small exit, say Rs. 5 cr.?

TIP: From a founder’s perspective, you may think of negotiating just participatory right.

If individual angel investor, he may evaluate but from institutional investor perspective, his math doesn’t add up for providing a return to their limited partners (the investor in the fund).

You may want to think of limiting the extent of participation in the remaining proceeds after the initial 1x. Uphill task, but we try.

If you have had some great experience, please share.

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Disclaimer:  This is not a legal opinion and should not be construed as one. Please speak with your attorney for any advice.

Ramya Sridhar is an attorney specializing in private equity and commercial contracts.

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