One of the most fundamental tools used by active angels is the term sheets. Yet, not every investor, especially new investors, do not fully understand the language and terminology used in these highly-important documents.
This brief is intended to clarify the following questions; What are term sheets, what do they represent, and why are they so critical for closing a deal?
Although it is a complex subject, we have a relatively simple framework that can help all angel investors develop a deep understanding of the significance and structure of term sheets, retain and apply that competency in real-life deals.
Non-Binding; Summary of Suggested Terms
Most ventures and angel investment come with a “term sheet” or, in some cases, a “memorandum of understanding” (MOU) that summarize the desired terms and conditions of the deal by the company or the investors. This becomes a negotiation framework that needs to be agreed and aligned on before solidifying a deal.
Unless a term sheet expressly states that it contains legally binding terms, early-stage investment term sheets are not legally binding agreements. However, term sheets can be thought of more like a set of notes outlining the principal elements of the deal as agreed by both parties, the giver and the receiving parties. They serve as a basis for soliciting interest from potential investors as well as used by legal counsel as the guidelines for drafting the final binding documents and agreements.
What type of topics the Term Sheet cover?
The issue is that they can be elaborate and complex. Term sheets can cover a variety of subjects. They can be written in very heavy business jargon or many legal terms, so they can be quite intimidating for less-experienced investors.
You will see every kind of provision from price, size of the round, composition of the board to liquidation preferences, drag-along rights, and anti-dilution protection, and many more, we have seen them all. The bottom line is that there are no rules as far as what can or can’t be included on the term sheet. It is up to both parties to decide on how complex or simple they want it to be.
The Five Key Areas of Concern for Investors
These documents do not need to be overwhelming and challenging. All term sheets can be grouped into five basic areas of concern. Within those areas, the specific provisions can be thought of as a set of tools representing the balancing of risk allocation between the concerns of the founders and the concerns of the investors in that basic area.
So, what are those five key areas?
- The Deal Economics – Investors want to ensure they are able to get a large enough equity position to make the investment worthwhile on a risk-reward basis. To make sure they get paid back first at the time of an exit, and to put a time-clock on the founders. To guarantee that the employee options don’t dilute them inappropriately.
- Investor Rights & Protection – Most investors structure the deal to ensure that no future financing deals include terms which will diminish the value of their investment or lead to other investors moving into a superior liquidity position, without paying appropriately for that right.
- Investment Management Governance & Control – Investors want to be informed on what’s going on in the company on an ongoing basis, having a say in critical decisions when the size of the investment merits it, and be protected against founder business behavior that could be damaging to the company.
- Liquidity – Investors want to make sure they maximize the chances to get their money back in all possible capital event scenarios (positive or negative), even if they have to force such a situation to occur.
- Exit Strategy – Experienced Investors would like to ensure that there are a clear pathway and a set of triggers for an exit. To know, that based on the event of certain financial indicators, the founders will be willing to exist in a form of investor buyout, partial sale or wholesale of the company within a particular range of time. They also want to know the company has identified a number of possible acquirers that are active in their business sector.
Fair, All Things Considered
Those terms and conditions may strike an outside observer as greedy or aggressive, yet, they are not really when you consider how equity investment deals work. Unlike lenders, and other forms of financing that come by nature with a legally-enforceable right to be repaid and often further secured by collateral or guarantees, early-stage investors purchase equity on no-recourse terms. If a company fails, its investment is gone. In cases of fraud or misdeed, equity investors have no right to be repaid. Although, investors are assuming 100% of the risk of failure of the venture, in proportion to the amount of money they put into it. The only way they get their money back is for two things to happen:
- The company performs and becomes more valuable, the valuation increases for an exit or
an opportunity arises in which investors can sell their stock/equity in the company to a qualified buyer for more than the original purchase price of their equity. (the expected multiples of 5X and more)
- In another way, equity investment can be thought of as a loan or a debt that the ultimate qualified buyer of the company is expected to repay at some point in the future, typically expected 3-5 years out.
Hard Lessons- Learned
Looking at it from this point of view, the many provisions of a term sheet begin to make more sense and seem reasonable. They provide protection for the company “Rollercoaster” ride that many investors are expecting somewhere down the road. Whether a term sheet is negotiated with a perfectly fair compromise is a function of the market and investing dynamics around a particular company or particular market sector at a particular point in time. All the same, the term sheet negotiation process is always a constructive way to address the structural-tension between the investors’ concerns and the founders’ concerns.
During negotiating terms, the founders have their own set of concerns and thinking about a different set of issues.
- Lose control of the company, either by selling too great a percentage of their company or by agreeing to overly powerful contractual control provisions.
Economically washed out by selling too much of their equity too early and too cheaply.
- Lose ownership of their shares/equity if they are fired or resign.
The company runs out of money and will shut down.
They prefer to not give personal guarantees or put up their home or other assets as collateral; and
- The fit with and value-add from their investors – smart or dumb money.
Investors interfering with the company operations or direction.
The Value In The Term Sheet Process
So when investor concerns collide with founder concerns, you can potentially develop a strong tension between the two sets of concerns and positions. The most important role in the formation process of a term sheet is to identify all the key issues and allocate the various risks and balances between the parties. If it is done successfully, you will come to a middle ground on the various issues to everyone’s level of satisfaction.