Why a term sheet is necessary?
The term sheet is agreed upon between the startup and the investor before they enter into official agreement. Even though the term sheet is not legally binding (except for clauses relating to exclusivity, costs, and confidentiality), the terms in the term sheet are more or less identical to the terms in the final agreement.
Outline the key financial terms along with other terms:
- The size of investment
- The financing instrument that would be used:
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- SAFE: SAFE is an instrument that allows investor to invest their capital in a startup now in return for shares which will be provided in the future upon the materialisation of some triggering events
- Convertible Note (or Convertible Debt): The investors first loan money to the company, the loan amount is convertible into equity shares of the company. In effect, the convertible notes defer fixing a valuation on the enterprise until a subsequent financing round. Upon the completion of the future round of financing, the debt converts into equity shares at the purchase price determined at that time, subject to a discount (if any) to reward the investors for investing early.
- Convertible Preferred Shares: Holders of convertible preferred shares are entitled to a liquidation preference over common shares. At the same time, they might be convertible into residual value common shares.
- Common Shares: Commons shares used in the financing transactions are usually residual value shares of the same class issued to a company’s founders.
- Valuations of the company
- Preferred return of the investment: the amount that the company must return to the angel investor/venture capital fund before distributing any assets to other stakeholders
- The accruing earnings on the investment: accrued dividends on equity shares//accrued interest rate on convertible debts. Usually, the accrued amount is convertible to equity shares.
Some other terms to be agreed upon:
- Timeline and process from the date of signing the term sheet to the closing date
- Investor protection clause:
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- Anti-dilution provisions
- Control provisions
- Right to participate in future financings
- Right of first refusal
- Tag-along right
- Governance, management, and control:
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- Board structure
- Governance provisions
- Information rights
- Exits and liquidity Clauses
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- Drag-along provisions: If the investors want to sell the company, and they are backed by a certain amount of shareholders, minority shareholders cannot block the transaction, but must go along with the majority looking to sell
- Redemption right: Investors could demand repayment of the money they invested, with some additional agreed-upon return, usually a few years after their initial investment
- Liquidation preferences
Usually the terms of investment are conditional upon successful and complete due diligence about financial, commercial and technical aspects.
As compared with term sheet with VC, the investment structures and founder covenants are less constrained by standardised institutional practice.
Investor protection:
As compared with investing in a well-established company, investing in a company is much riskier from the perspective of an investor. As such, it is a norm that more clauses would be in place in the agreement to safeguard investors’ interest.
While a wide array of protection clauses might be granted to the investors, some major rights are listed as follows:
- Anti-dilution clause
- Right to approve material merger, acquisition, or liquidation of the company
- Right to participate in future financings
- Right of first refusal
- Tag-along right
Anti-dilution Clause:
When new shares are issued with a cheaper price than that paid by earlier investors in the same stock, equity of earlier investors might be diluted. Preferred shareholders especially, would be concerned that their equity ownership would be significantly diluted when later issues of the same stock hit the market at a cheaper price. For instance, if an investor owns 10,000 shares out of 100,000 outstanding shares, he initially owns 10% stake in the company. But if the company issues an additional 100,000 shares in the next round of financing, the investor’s stake in the company would be halved to 5% only.
Anti-dilution clause is incorporated to protect investors against their equity becoming diluted or devalued when the total number of outstanding shares increases by reason of later rounds of equity financing, or other situations when other holders of share options, e.g. employees exercise their options.
There are two categories of anti-dilution clause.
The first category is a full ratchet provision, whereby the preferred shares’ conversion price would be adjusted downward to the price level adopted in the later round of financing. For example, if the investor’s initial conversion price was $10 but the conversion price in the next round was only $5, then the investor’s conversion price would adjust to $5 accordingly.
The second category is a weighted average provision, and the formula for calculation is listed below:
C2 = C1 x (A + B) / (A + C), whereby
- C2 = New conversion price
- C1 = Initial conversion price
- A = number of outstanding shares before a new issue
- B = total consideration the company receives for the new issue
- C = number of newly issued shares
Control Provisions:
Having a stake in the company, investors may not desire to adopt a hands-off approach in relation to the company’s operation. At the very least, they might intend that the agreement shall incorporate clauses that enable them to exercise a certain degree of control. For example, they might assert a right by the board or the class of shareholders to approve liquidation or any change of control of the company. This entails that any merger would only proceed with the investor’s permission.
Other control provisions may require the investor’s approval of:
- material agreements or leases;
- annual budget;
- changes to the board or management team;
- payment of dividends or redemptions of shares;
- assumption of any debt obligations;
- changes to the articles of association or bylaws; and
- changes to the capitalization.
Such decisions would have material effects on the investor’s economic rights. As such, it is understandable that investors would like to have the aforementioned control provisions being incorporated into the term sheet and hence the later agreement.
Right to Participate in Future Financings:
To reward the investor for his early investment, it is common that founders or the company would grant investors the right to participate in future financings. If the company grows rapidly, investors might want to exercise such a right to invest more. While there might be times that the right is open-ended, i.e. there is no pre-determined limit on how much shares investors could further acquire, in other cases, the right for investors to invest further is subject to their pro-rata ownership in the company, so that they could maintain their pro rata ownership.
Nonetheless, by granting early investors the right to invest in future financing rounds, it runs the chance that such investors may sell their rights to outsiders. To plug such a loophole, transfer of pro rata rights might be restricted.
Right of First Refusal:
Right of first refusal is a right granted to protect investors against third parties. In case founders or other existing shareholders would like to sell its shares in the company, the investors are entitled to exercise its right of first refusal to acquire such shares before such shares could be sold to any other third party.
Tag-along Right:
When a major shareholder intends to sell his shares in the company, there is a possibility that the investor, as a minority shareholder, might be left behind in the company without an exit route.
Tag-along right (also known as “co-sale right”) could provide the investor with the necessary protection, especially when he does not have the financial resources to acquire a majority stake. When a major shareholder intends to sell his shares in the company, the investor may opt to exercise his tag-along right to oblige the majority shareholder to procure that the third-party purchaser shall extend his offer, so that the investor could also sell his shares to such a purchaser on broadly the same terms.
Governance, management, and control:
Board Structure and Governance Provisions:
Investors, especially for venture capitalists, may like to get involved in the governance and operation of the company. As such, in terms of board governance, the investor may require representations in the board (either an appointed board member or an “observer”), so that he could get involved in the making of certain critical operational decisions. It is also possible that investor may desire the incorporation of clauses that specify the reporting procedures or reserve a veto right for the investor or his delegate(s).
In terms of shareholder governance, clauses in relation to quorum of shareholders meetings and shareholder reserved matters may be incorporated. The company may need to meet the approval threshold before it could proceed on a list of actions. If investors are minority shareholders in the company, investors may request for the incorporation of a clause that requires approval of the share class that the investor belongs to.
Information Rights:
Given that the Hong Kong Companies Ordinance (Cap. 622) has only provided limited access for minority shareholders to access company information, the investor may request for additional information rights, such as right to request for copies of the company’s budgets and business plans, or the right to inspect records, etc., under which the company might be obliged to share with investors information on the company’s financial and business condition on a regular basis.
Exits and Liquidity Clauses:
Drag-along provisions:
If the majority shareholders want to sell the company, with the presence of drag-along provisions, the minority shareholders cannot block the transaction, but must go along with the majority looking to sell. The drag-along right enables the majority shareholder to compel the minority shareholders to sell their minority shares to a purchaser on broadly the same terms. The drag-along right is advantageous to the majority shareholders in the sense that the sale of shares would have higher marketability given that no minority interests would remain.
Redemption right:
A redemption right may grant investors a right to demand repayment of the money they invested, with some additional agreed-upon return, such as accrued and unpaid dividends, or at an agreed or fair market value upon meeting certain conditions after a specified period of time, e.g. a few years after the initial investment.
While it is rare that investors would like to exercise this right given that their primary intention to invest is to reap a big payoff and recouping their investments is not what they want, investors, especially for VC funds which have a short lifespan, might want to cut losses and invest in other projects or companies.
Liquidation Preferences:
In the event of liquidation or other liquidity events such as trade sale, liquidation preference clauses play a part in the determination of legal priority in distribution. These clauses define the share of investors in the proceeds of liquidation by assessing whether the impugned person has a prior right to receive amounts before other parties.
Whether the financing instrument is in the form of SAFE, convertible notes, or preference shares, the investor would usually be entitled to a higher priority than common shareholders. In other words, common shareholders would only be entitled to compensation after the investor has been paid the full amount of his investment entitled under the said preference clauses.