More often than not, most startups and businesses go through this phase of intensive idea pitch-ins and venture capital investor scrounging. Some take several months to successfully bag one or a few venture capital investors, while some take only a few. So after going through all the turmoil and hullabaloo of actually finding investors, numerous questions pop up.
Which one will be the best fit? What do the good investors do that the not-so-good ones don’t? Will this one even help to turn the startup or the business into a major player in the industry? And the questions keep coming.
The next step is to sit face to face with the investors and discuss the terms, and what you get handed in the process is an investment term sheet. The terms of the investment agreement are laid out on the term sheet.
What is an investment term sheet?
An investment term sheet is a non-binding agreement which sets forth the basic and finalized terms and conditions that have been set upon discussion. It is more like a formal blueprint document which later allows the company’s lawyer to draw up a detailed legal document.
In lay man’s terms, a term sheet ensures that the parties involved in a business transaction agree on almost all major aspects of the deal. This helps in avoiding the possibility of disagreement due to misunderstandings as well as the likelihood of unnecessary fights.
Term sheets are not usually legally binding contracts, almost like letters of intent. They are a great way to prevent a permanent drain of capital due to the expensive legal charges involved in drawing up a legal agreement.
Term sheets generally cover the most important aspects of a pact without going into every minor detail from every nook and corner. A binding or a legal contract mostly covers this type of detailing and contingency.
To be able to be prepared for an investment term sheet discussion with an investor, it is important to understand the basic elements of it.
Basic elements of an investment term sheet
1) Price and Valuation Negotiations
Valuation is a highly debated issue that goes on between a business owner and a venture capitalist. It’s not something that one can list and confirm on their own. Agreement of both parties is essential. In plain terms, the net worth of a company is the driving factor that fuels the investors to pay a high price for a piece of the action.
Valuation also depends on how much capital would it take for a company to be an absolute success. Therefore, to set up a high price, it is important for the company to have a strong management team, market potential, as well as a great financial return.
2) Dilution and Anti-Dilution Clauses
A proper understanding of the dilution and anti-dilution clauses is crucial as these clauses mention how the future investments will dilute the percentage of ownership of the business owner as well as the investor.
Generally, to be able to protect future shares from being sold at a lower value, venture capital firms most essentially need an anti-dilution clause in the investment term sheet. The anti-dilution clause is usually a very standard element of a term sheet. Therefore, it is only wise for the business owners to negotiate the terms stated under this clause rather than arguing upon eliminating this clause.
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3) The Option Pool Clause
An option pool clause deals with setting aside the amount of stock that a company can use for a number of purposes in the future. These purposes include stock as compensation for employees, stock to offer to the service providers, stock intended as an incentive for the employees, etc.
4) The Drag-Along Rights Clause
This clause allows the majority shareholder, which is usually the investor, the right to drag the minority shareholders, which is usually the business owner, along with them in case the former decides to sell their stakes off.
This also allows the majority shareholders to make it compulsory for the minority shareholders to sell their stakes on the same terms as that of the majority shareholders. The consent of the minority stakeholders is irrelevant as per this clause.
5) The Tag-Along Rights Clause
Clearly just opposite of the drag-along clause, this clause works in favour of the minority shareholders or the business owners. This clause allows the minority shareholders to sell their shares along with the majority shareholders or the investors. This clause ensures that the minority shareholders are not forced to work with someone against their will.
6) The Liquidation Preferences
When the company is sold or liquidated, the preferred stockholders as per the term sheet receive a certain amount of money before the distribution of an asset to the other stockholders. This clause is one such clause which can have a great impact on the business owners. This clause does not work in favour of the equity of ownership. There can be two kinds of preferences, multiple liquidation preferences, and a participation or non-participation preference.
7) The Voting Rights
A venture capital investor sitting on the board of directors is allowed with voting rights which are in favour of the company and on certain critical resolutions in the future. However, whether the venture capital investor will have one vote to cast or more totally depends on the terms laid down in the term sheet post-negotiation.
8) The Cost Of Counsel Clause
Most investors ask the business owners to compensate or pay for all or any legal cost that has been incurred while conducting due diligence and developing an investment proposal. This is one of the few non-negotiable clauses in a term sheet.
Besides all such clauses and terms, a term sheet also sets an outline of the total commitment that is expected from the investors. These commitments are mostly valid for 10 years. However, the term sheet is the debut point of the discussions that are about to happen between the investors and business owners.
The investors are mostly professionals who have years of experience in the field along with proper legal networks. Therefore, it is only wise for the business owners to come to the table fully equipped.
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