Understanding term sheets

A Term Sheet is a document that defines the terms of the transaction between the investor and the company. 

It outlines terms for the following broad categories:
  • Valuations
  • Control
  • Exit options
  • Downside protection

While most first-time entrepreneurs are more focused on the valuations, the terms and conditions that cover the valuations are as critical. E.g. a company raising USD 100,000 at a pre-money valuation of USD 400,000 may not necessarily have a better deal than a company raising USD 100,000 at a pre-money valuation of USD 300,000 if the terms of the second company are more favorable than the first.

While there are several terms that will require understanding, here we have outlined a few that are of importance to entrepreneurs. Disclaimer: Please consult your lawyer when dealing with a term sheet. If you need any information, write to us at info@thehatch.in and we will try to provide you answers.

Liquidation preference
Liquidation preference defines how monies received on liquidation are going to be split between different classes of shares. [Just like different categories of creditors will have different rights in terms of liquidation.]

The term sheet will specify what 'preference' the investor will get over 'common stock' owned by the entrepreneur/founders/existing share holders. E.g. the term sheet may suggest that, in the case of a liquidation, the investor will get 2x their investment before the balance, if any, is split between common share holders.

A liquidation preference may also allow the investor to instead convert their holding into the proportionate % of common shares and sell, if it is higher than the money they would get on selling at the price they would get if sold at the preference value.

In some cases, if the term clarifies, the existing investor may be allowed to convert to common stock and hold their holding. They would do this if they believe that the new buyers of the company will increase the value of their holdings.

Liquidation is not necessarily only if the company fails. It could be merger or a strategic sale or whatever. In these situation, what level of preference multiple is offered will decide what is left for the entrepreneur [and other common share holders] in case of liquidation.

In case where the investor is allowed the option of converting to common shares AND holding on to their shares, it may cause issues with the acquirer if they do not see value in the investor holding on or if there is a strategic interest clash.

As with every other term, the negotiating power of an entrepreneur with a proven track record [professional career record or previous successful entrepreneurship experiences] wil be higher than the negotiating power of a relatively newer entrepreneur. In bad times, the preference multiples asked could be ridiculous.

Drag Along
This term requires the minority share holders to sell their equity to an acquirer if a majority of the shareholders agree to a sale.

To illustrate with an example, if an entrepreneur owns 40% of the company with 2 VC firms holding the balance 60%, if they decide to sell their stake, this clause will force the entrepreneur to also offload his/her shares, even if he/she did not want to exit.

Implications are obvious. If the company does not do well and if the investors decide to bail out with whatever value they can realize, the entrepreneur would be forced to sell his/her stake even if they believe that there is merit in continuing with the venture.

Sometimes an investor may want to exit because the venture [or the domain] does not fit into their strategic thinking any more. In this case, if the investor wants to exit, even if the going is good, the entrepreneur may have to sell his/her stake.

Preference shares
Preference shares are shares that enjoy more privileges than common shares. These could be in availing dividends before common share  or preference share holders may also have greater rights to the company's assets and proceeds in the event of liquidation.

Here too, the implications on the entrepreneur are based on multiple factors including the multiple of liquidation preference, if it is included, etc.

In most cases, simple preference shares which give an investor rights over assets in case of liquidation and dividends before common share holders are not considered unfair by entrepreneurs as it represents only a fair demand that the investor is seeking to protect his/her capital and the entrepreneurs acceptance indicates a high level of confidence in the venture to allow an investor to protect his/her capital.

Well, this is a pretty straight forward one in which the investor who sits on your board seeks an insurance cover to as an indemnity cover should there be a legal case and the investor needs to protect himself/herself.

Depends on how much protection is sought and how much the insurance premium is, and how that amount is in relation to the amount that is raised.

I.e. the investor and entrepreneur need to evaluate if and if yes, how much, indemnity insurance makes sense. Especially if it is going to cost a lot and if the amount of capital raised is little.

Also, if the capital is raised for, say, concept testing where the exposure to liability is nil or limited, then it may not make sense to invest in insurance premium [again, if the capital raised is limited]

Anti- Dilution Protection
Anti dilution protects the investor's capital in case the entrepreneur decides to, for reasons of market conditions or strategic relevance or whatever, to accept capital from a new investor at a valuation that is lower than that at which the investor had invested.

In a situation where a subsequent round is raised at a lower valuation, anti dilution right allows the company to revalue the original valuation and thus issue additional shares to the investor.

This, in my view, is a fair clause and entrepreneurs should be confident enough and accept it. Fighting this clause would necessarily mean lack of confidence in estimating a higher value for the equity in subsequent rounds.

Right of First Refusal
ROFR allows investors the right but not the obligation to invest in the subsequent round of fund raising. With this clause, in the next round(s) of funding all things being the same i.e. as long as the existing investor too is offering the same value, the company will have to accept investment from the existing investor.

Vesting means that the stock will be available to the person after a pre-determined time or on reaching a pre-determined milestones.

Often used for stocks offered to employees e.g. ‘xx’ number of shares will vest on completing 24 months of employment.

Vesting is also common in the case of early-stage companies to protect the investors from one or all founders quitting the company after the funding. In the case of vesting for employees, the term sheet may specify a ‘cliff of a year’ followed by monthly vesting thereafter. This means that if the entrepreneur leaves within the first 12 months, he/she would get no equity. However, on completing 12 months, the entrepreneur would get a significant portion of his/her equity and the balance will vest monthly over a period of the next 2-3 years.

In the case of vesting though, there will be clauses which protect the entrepreneur in case of events like next round of funding, acquisition or even firing by the board.

While it seems unfair, it also provides protection to the entrepreneurs. For example, if one of the founders leaves or does not perform as expected and is asked to leave, then vesting ensures that he/she does not get the full benefit of the equity due and gets only as much is vested till leaving or being asked to leave.

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