“Shall I compare thee investor to a summer’s day?”
“How very romanticised!” I hear you cry, but if you think about it, the relationship between a start-up and an investor is very much like a marriage, the Term sheet being the equivalent of a Prenuptial agreement. The Term sheet is a crucial document for the ambitious start-up. It is the document that outlines the terms by which an investor (angel or venture capital investor) makes a financial investment, a mini-proposal made by an investor before making a final decision.
It is important to emphasise therefore, that a Term sheet is not a legally binding document. This means that it is only used to document the general meeting of minds between the parties and not to serve as the legal basis for the investment. Certain elements of the Term sheet, such as the exclusivity clause, together with certain payment obligations are the exception, in that once the document is signed, those sections are immediately in force. Regardless of whether or not the investment is ultimately made, any breach of such clauses can subject the breaching party to legal action by the other.
Seed investment is often equated with small, but high risk investments. While many founders rely on their friends and family, others may delve into their personal finances to help facilitate the growth of their businesses. If you’re lucky enough to find a potential investment partner, you’ll need to record the key terms in a Term sheet, a number of which, are summarised below.
One of the key questions investors will consider is how much money will it take to make the company a success. The answer will be in the value of the company, which drives its price. The information used to determine valuation comes out of the due diligence process, that is, the process that establishes whether the company seeking investment is worth investing in. In the end, the value of the company is the price at which a willing buyer and seller can complete a transaction.
Ownership and valuation is typically calculated on a fully diluted basis, but what does this mean in practice? It means that all securities, that can result in additional ordinary shares, are counted in determining the total amount of shares outstanding for the purposes of determining valuation.
In the event that the company is sold or liquidated, the investor may expect a certain degree of priority over those holding ordinary shares within the company. Such an investor would receive what is called a ‘priority payment’ before any assets are distributed to ordinary shareholders, together with a share in any additional amounts as distributed.
If you’re a founder seeking investment, the investor may very well seek to implement reverse vesting as a way to incentivise you to stay. In essence, you’ll forfeit your shares and then re-earn them on a brand new vesting schedule, thereby releasing ownership of the company back to you over time. This not only protects the investor in the event that you leave, but also encourages you to stay and secure the company’s future success.
If an investor decides to invest in your company, they’ll want to have a say on how the company is managed to make sure it is really flourishing. If afforded management rights, the investor has the right to discuss with you the company’s affairs, finances and accounts. They may also wish to consult with you and advise management on all matters relating to the company’s operation. You can afford management rights to an investor using Rocket Lawyer’s Term sheet.
If you’ve entered into negotiations with an investor, they’ll expect monogamy (remember that marriage analogy?). Your investor wouldn’t want you running around behind their back just as you’re about to get hitched. The effect of the exclusivity clause (often called a ‘no shop clause’) is to prevent you from ‘shopping the deal’; that is, negotiating with other parties for a period of time once the Term sheet has been signed.
The negotiation of a satisfactory Term sheet is one of the most critical parts of the process of investment. If you’ve found the investor of your dreams, the Term sheet is the ideal moment to agree on a mutually beneficial agreement. By following some basic rules, start-ups can sign a Term sheet that lays the groundwork for a long and profitable relationship.
So what are you waiting for? Create a Term sheet today!