The Term Sheet Check

An entrepreneur just told us, “I recently closed a convertible debt angel round. It was just lesser paper work and the valuation will get decided in the next Series-A round.” As a law firm, we responded asking, “Did you carefully weigh all your options?” “If it were an equity round, then the investor and entrepreneur are on the same team while raising Series-A; both sides want a higher valuation. In the case of convertible debt, the investor wants a lower valuation in the next round and the entrepreneur wants a higher valuation,” we reasoned.

Such conversations are, today, part and parcel of the startup world. The Indian entrepreneurship ecosystem is going through a boom cycle, complete with deep inspiration drawn from its counterpart in the valley. However, early-stage entrepreneurs would do well, to understand the finer nuances of clauses in the term sheet, rather than go with an option that is just easier. For some startups, the convertible debt approach may work; for others it could be the pure equity option that makes sense in the angel round.

At the end of the day, if both the entrepreneur and investor have clarity on what to expect in various potential outcomes, the relationship will work over the long run.

In this post, we unravel select key clauses in any term sheet, with the goal of educating the early-stage entrepreneur and help him or her simply understand what he/she is getting into. For starters, using a standardized term sheet, downloaded resource sites is not a good approach. Your business is different; your goals as an entrepreneur will be different and your investor can be your teammate or adversary, depending on how well you understand and negotiate the term sheet.

Read on, to find out more.

The key clauses

a) Valuation
As it is often repeated, several younger entrepreneurs end up thinking valuation is everything. With the risk of repeating ourselves, let me reiterate here that, while valuation is extremely important, it is crucial to view the term sheet in its completeness, including anti-dilution clauses, drag along/tag along clauses, board structure-related clauses, liquidation preferences, options pool and other protective provisions.

Having said that, the valuation is extremely critical. It simply refers to how much stake the promoter group and the investors’ hold, and whether it depends of the company’s performance going forward.

There is a lot of debate as to how valuations are arrived at for very early-stage ventures. Quite simply, it is the valuation that two parties on the table — entrepreneur group and investor group — agree to and it doesn’t have to make sense to the outside world. In that way, it is arrived at, by understanding the potential future value of the company and market conditions.

b) Liquidation Preference Clause
The second consideration is the liquidation preference clause. To put it simply, liquidation preference determines if the preferred stock investors have any preference, in the case of a non-IPO exit or change of control at the startup.
Let’s take an example here. Company A’s pre-money valuation is Rs. 20 crore and the investor invests Rs. 10 crore more, taking its post-money valuation to Rs. 30 crore. This means, the investor will have a 33% stake in the company. At the time of exit, if the company’s sale price is Rs. 21 crore, the investor holding 33.33% stands to make only Rs. 7 crore. However, if the investor holds a “preferred stock” with a 1.5x multiple, then he is guaranteed a return of Rs. 15 crore (1.5 times the Rs. 10 crore he invested) before any other distribution happens. In this case, the entrepreneur gets only Rs. 6 crore, even though he holds 66.67%.

Now, remember that a liquidation preference clause can be designed pro-promoter and pro-investor. It is important the entrepreneur understands, what he or she is getting into.

c) Anti-dilution clause
The anti-dilution clause is essentially added to protect an investor in case of a down round, when the valuation goes down.

This means, when a company raises its successive round of funding at a price per share lesser than what it was in the previous round, the earlier round investor can exercise the anti-dilution clause to be protected himself.
While the clause encourages the company to perform better and seek higher valuations in successive rounds, valuations may swing based on changing market conditions, hence making it an automatic right for investors. In such a circumstance, it is imperative for the entrepreneur to work around the clause in creative ways to minimize impact rather than doing away with it entirely.

d) Creating a board structure
An ideal board will have representation from both sides — investor and promoter group. In early-stage rounds, when a group of angel investors get together, typically, there will be one person representing the interests of the whole group.

The voting mechanism of the board is a crucial element to be included in the term sheet and entrepreneurs will do well to seek guidance from experienced hands to decide on this clause.
In some cases, the entrepreneur group may be a minority stakeholder; yet, the voting rites will ensure the promoter group controls the board.

Typically, an investor investing in a company will insist that his/her representative be present at all (board and shareholder) meetings to be privy to key discussions and protect the interest of shareholders. In such situations, Board Observers are appointed, but they do not have voting rights.We’ve also observed that a good board helps in steering a startup in the right direction, and it is good to build a board with independent directors, based on their expertise.

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e) Protective provisions
There is something called protective provisions that the investors will insist on. For example, major decisions like approval of annual budget, expenditure and diversification plans, marketing budgets above a certain value, sale of assets and altering capital structure of companies require prior approval of investors.
Needless to say, this will vary for every company and inexperienced entrepreneurs must seek guidance while finalizing on such clauses.
f) The options pool
In addition to equity for the promoter group and venture investors, entrepreneurs often set aside equity for key employees. This is mentioned in the term sheet and entrepreneurs must carefully evaluate the size of the option pool, since this directly affects the promoter’s holding.

g) Drag along and Tag along rights
While there are several other clauses added to the term sheet, two often discussed points of contention are Tag Along and Drag Along rights. These rights are typically used when the goals of the entrepreneur and investor differ for a multitude of reasons. For example, a venture fund may be at the end of its fund’s lifecycle and will want to exit a company, while the entrepreneur may want to hold on for longer.

Drag Along rights for an investor gives him the right to force the promoter group to exit, along with the investor group, if there is a buyer. Tag Along rights gives one investor the same benefits as other investors, especially at the time of exit. If one angel is selling, a Tag Along for another investor gives him the same rights as the former investor.
Of course, what we have included here is the theoretical explanation of several key clauses.

The conclusion
Remember that every clause in a term sheet is negotiable. The success of it depends on the market conditions in which a company is raising funds, the proposed business plan it has in hand, and the experience and credibility of entrepreneurs who are running the show.

Typically, if you are operating on a risky business model, the investor will insist on keeping in place more protective clauses. However, if you have an established business model and are already cashing in revenues, wherein you seek further external funding only to fuel growth, the clauses can be negotiated much more at ease.

Finally, as we come to the discussion about curtailing or minimising potential points of debate that may arise between an investor and an entrepreneur when signing a term sheet, just keep in mind these three guidelines:

· Go beyond the agreement and look at the spirit of the agreement.
· Transparency is essential.
· Lastly, ensure that all compliance are dealt with by professionals.

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