Written by: Magnus Ernegård, Executive Contributor
Executive Contributors at Brainz Magazine are handpicked and invited to contribute because of their knowledge and valuable insight within their area of expertise.
Making an excellent pitch for 15 minutes will most likely not make the investors directly write a check and provide 10 million for 20 % of your venture, as it might look like in dramatized entertainment shows like Dragons Den or the Swedish version Draknästet or the Danish Løven's Hule, which during the last weeks have been broadcasted on TV, we should all know that. It is a great TV show and is superior at creating a breeding ground for more people to become interested in entrepreneurship and start and run a venture. The entrepreneur's invention is getting exposed to the market, other potential investors might be interested, and the participants on the stage receive valuable advice from these famous Super Angels. It is undoubtedly an exciting reality show and real-life situation for the dragons and the fund seekers in the programme's boiled-down version. Still, many agreements, Due Diligence checks, and Term Sheets have to be established and settled before closing the deal.
But, if the Business Angels look interested in continuing the discussions after your pitch, the evaluations and negotiations start. The first step will likely be to agree on a Term Sheet, which is generally a non-binding agreement but presumably be one of THE most important documents you ever will sign as a Startup founder. However, some parameters are suitable if binding, such as confidentiality, exclusivity, validity, investment costs, and jurisdiction as dispute resolution. Considering there is a strong moral obligation to follow the parameters of the Term Sheet and if any party exhibits different behaviour in the investment process, it is highly likely they will get a pretty dubious reputation in the Startup funding market.
So, the Term Sheet signals that the Business Angel (or VC) want in, and by that, it's "just" a matter of working out the details. It contains the principal commercial, financial and legal terms of the investment. These terms are then included in detail in the investment documentation, like the shareholders' agreement and the investment agreement. Even if the content in the Term Sheet is likely to be seen as basics, we see from the Startup venture's perspective, and, advantageously, your Term Sheet is as detailed and comprehensive as possible. It could well be over 40 parameters in the Term Sheet, all of which you must understand the consequences of during your Startup journey.
The Term Sheet is usually presented and proposed by the investor to the Startup venture. The investor often has a negotiation advantage here and sometimes prefers that the Term Sheet parameters should be more general terms and short to adjust later in the contract negotiation. We think it is crucial to set up the Term Sheet parameters yourself as the founder and how you would like to have it before receiving the proposal from the investor. You could then consider, e.g., which top three clauses you will not negotiate about and which ones you would like to set a cap or a floor. You will then be able to provide faster feedback to the investor with a well-founded argumentation and structure. By selecting an experienced Startup-lawyer (more about that later in this article), they can focus you as the entrepreneur on what matters.
So, now suppose the Business Angels (or VCs) are interested in investing in your newly formed Startup. In that case, they will start to discuss the deal's outlines, including what percentages of equity they might get, the Pre-money valuation, Board structure and seats, employee option pool, and other protections and rights the investor would like to have.
In this short article, we primarily focus on giving a brief overview of some of the Term Sheet topics and not going through all of the possible parameters and clauses in the document. But the Term Sheet is very critical and stipulate factors that will follow you during the Startup journey, and what's in it often determines the final deal structure. Don't see the Term Sheet as a Letter of Intent but more as a blueprint for your Business Angel relationship, in which you, your attorney and the Business Angel(s) begin to write up the legal contracts. When the Term Sheets are precise, clear, and comprehensive, the lawyers "just" turn the terms into lawyer's language.
Sometimes, but of course not always, some investors take advantage of first-time founders raising their first round of capital to get better terms. But if the Startup with its attorney makes a thoroughgoing, longer and comprehensive Term Sheet and making the words more clearly upfront, it will most probably also save a good part of the Startup's legal fees. So, strive for the more extended and more founder-friendly Term Sheet!
The Term Sheet could be organised and split into two areas.
Financial parameters. Here, the deal's financial terms are outlined, including the
investment amount, the Pre-money valuation, the share price, stock option pools and any dividends.
One very central term and an important one for the future of your venture relates to Preferred Shares. If there are seasoned Angel investors (or VCs) you are dealing with, they will most likely request Preferred shares when investing in your Startup. As the founder and your team members participating in the option pool, the holders of Common shares are the ones you have. We will briefly look into a couple of types of "rights" the Preferred shares could include, which are essential to understand from the investor's and the Startup founder's perspective.
Preferred shares with Liquidation preference are perhaps the most negotiated Term Sheet clause next to the Pre-money valuation, which places the Preferred shareholder at the front of the line when dividing the capital and assets from an exit event. This could be a bankruptcy, gets acquired, merges with another company or in any other way has to close down. Under this preference right, there are a couple of flavours to understand.
Non-participating preferred, the investors receive preference over the common shareholders. But they do not get to participate with the Common shareholders in splitting up any leftovers after the preferred investors get their pay-outs.
Participation preference, the Angel investor (or the VC) get two benefits over the Common shareholders both the entire investment amount (or multiple if so defined, see below) and the investor's shares converts to Common shares and thereby gets a portion of the proceeds based on the pro-rata ownership in per cent.
Participation preference with a cap is a "middle ground" between the two above limits or a cap on the total exit amount.
Some more heavy-handed investors would like to push for a liquidation preference multiple, which might not be that common, but be aware. This clause means the preferred shareholder not only gets back their entire investment but will get two times (2X) or even three times (3X) the invested amount. This is before the Common shareholders like you as the Startup founder and your employees get any payment from the venture's exit if there is anything left.
Further, you as a Startup founder may decide to accept a higher liquidation preference in return for a higher valuation of your venture, but this is not always a sound choice. The liquidation preference is set according to the amount invested and is not affected by the company's valuation at the time of exit. Investors may end up walking away with their initial investment or more. You, as the entrepreneur and founder, should carefully examine the trade-offs you are willing to make. While valuation is a vital part of the Term Sheet and affects the business, it is not always worth exchanging other terms.
The anti-Dilution preference clause protects the preferred shareholders by preserving existing ownership percentages in a later financing round. This is mainly getting effects in a down-round when any additional new investor/-s comes on board, which we described in an earlier BRAINZ Magazine article. Your current investor doesn't want to dilute their ownership percentage of the venture and would like this protection. In addition, this clause can take three typical forms, like Full Ratchet, Weighted average and non-at-all, but this is a little over the top in this short article.
Corporate Governance and Investor protection parameters are the other area. Here, we define additional rights and protections given to the preferred share investors. It includes Board representation, voting rights on critical decisions and limiting the founders from taking on additional investments or selling the venture. Other areas like Drag Along Rights, Protective provision would be stipulated in this section.
Sometimes, when discussing the Term Sheet, some Business Angels and perhaps more likely VC could say: "This is non-negotiable", or things like "This is a standard deal term we have" or "This is how we always do deals". Then be aware if you would like to continue the negotiation with these investors, giving you an ultimatum. So, if you find your potential investor is either bully trying to win by force, you may better think twice. The same goes with the detailed-oriented technocrat who will negotiate and nag every point in the Term Sheet from scratch, not considering each side's give-and-take. You can, of course, give in on them or not. Still, the mere fact that an investor focuses on relatively unimportant terms is a sign of what that individual will be like to work with as a co-owner, Board member, committee member, or part of your Startup's inner circle?
Selecting an attorney with experience and knowledge of Startups
When you receive the Term Sheet, it could well be you see this kind of document for your first time (if you haven't already prepared one, how you would like the Term Sheet's clauses to look like). The investor/-s on the other side of the table have likely seen it hundred times, so having a Startup support provider and lawyer is crucial. In negotiating with the Angel Investors (or VCs) about the Term Sheet parameters, having an experienced Startup-focused lawyer who understands and has a documented tracklist of successful Term Sheet negotiation could be invaluable. In contrast, an inexperienced one could be a disaster. In addition, don't forget your selected lawyer reflects you and, thereby, your reputation on the Startup scene and eco-system. Also, don't forget this is your lawyer as the Startup founder, not anyone used or selected by the investor. That's said, seasoned and experienced attorneys in Startups in your country or city are often "a name" and well connected to the early-stage investors, accelerators and Startup support providers that are critical for your success. All parties, you, the investors and your attorney, should most likely cooperate for many years, so make sure to set up an excellent working climate, trustworthy relationship and communicate clearly from the beginning.
By that, it is perhaps not the big law firm you should choose? Maybe better the one with long experience and a sound expertise level of Startups, agile and your comfort with the attorney's
communication style, so get references and spend time with your prospective lawyers before selecting one? The bill can, of course, be high, and you should, of course, and as always, focus on the cost-side, but don't be obsessed with the hourly rate. With a competent and reputable lawyer who knows their way around Startups, and their network, it is likely it will be more efficient and well worth the expense in the long run.
Your lawyer carries out the negotiation most of the time, yet you have to be highly involved. So, coming to an agreement may be challenging, time-consuming, and very lengthy for you as a Startup founder. There might be occasions coming up when you will be dealing with several independent investors. But try then to convince the different investors to form a syndicate. Our firm recommendation is not to accept multiple investors with different content in the Term Sheet clauses, as this would either end up in a mess or taking far too much time and effort for you to handle during your Startup's lifetime.
In a syndicate, which contains multiple investors, one Angel investor (or VC) will likely be the lead investor for the deal and the one in charge of the negotiations from the investors' side. So, that individual is the one who initially agrees on the critical terms of the round with your Startup. The lead investor is usually an experienced Angel investor, who most likely is familiar with the Startup's industry and might also be the one who provides the highest capital injection. But it is also possible the Angel investors will ask for some experts in the industry who can support them to understand better the dynamics and risks in the sector concerned. It could also be the case that the Business Angels will invite them to meet with you and your team.
To sum it up.
Be aware negotiating for a higher Pre-money valuation, which many entrepreneurs are eager to do, may come at the price of a higher liquidation preference. Though a more extended Term Sheet is much more founder-friendly and good business practice, and founders should be doubtful if the investor comes up with a relatively short version of the Term Sheet.
If you don't have a law degree, we recommend looking for an attorney, preferably experienced in the Startup business. One other highly advisable alternative is to get in touch with seasoned and serial Startup founders to discuss and hear their views of the different parameters and clauses in the Term Sheet. Use your network and participate and engage yourself in the Startup community and eco-system events, summits and conferences.
You might have the high ambition of having reputable, renowned and prominent Super Business Angels (and VC firms) as investors and thereby get a kind of an approval stamp having your Startup in the inner circle. You have to balance being a Startup name attracting other financiers and perhaps new, highly energised team-members toward the fact you most likely must accept much more challenging demands, requirements and insistence of the Term Sheet parameters in your Startup. It might very well be worth it if your venture can attract the top-tiers Angels and VCs, but think carefully about and consider the long-term consequences for you, your team and your Startup.
Next month we will have a look at Due Diligence, a short version. Keep on Starting up!
Magnus Ernegård, Executive Contributor Brainz Magazine Magnus Ernegård has over 30 years of senior management experience from different industries in multinational industrial companies in various countries. Background in CEO positions, CFO, management consultant, production, business development, innovation, corporate governance, and entrepreneurship. Further, he has, over the years, gained Board and Chairman experiences from Boards within the Automotive, Logistics, IT Consulting, and Textile industries. Today, he is the owner and founder of the Startup support provider company BridgeToAngels based in Sweden and Denmark. Magnus has a proven track record in starting/developing businesses, company split, corporate exits, and organizational effectiveness. Magnus also serves as Advisory Council Member of Gerson Lehrman Group. He holds an MSc from the University of Lund, Sweden.
