Fire Up Startup Insights series, kickstarted in collaboration with SucSEED Ventures, by our COO, Mr Ramesh Loganathan. The series is brought to you as a part of Startup Gyan Blog series by CIE-IIITH where we feature our mentors, investors and other stakeholders, talking on specific topics useful for Deeptech startups and the community at large.
In Conversation with Dhiraj, Lawyer and Partner at SucSEED Ventures:
Every start-up founder comes across a Term sheet when he/she pitches to raise funds from potential investors either at seed or angel or VC level. And with that comes the challenge, understanding Termsheet which contains numerous legal jargons and potentially confusing terms.
“My effort is to provide a clear and simple understanding of a Term Sheet and the key terms which a start-up founder should know” – Dhiraj Kumar Sinha
What is a Term Sheet?
A term sheet is the first step of the process under which an Investor invests in a start-up and the Founders. It sets out the broad parameters of the investment for negotiating the definitive agreement. Typically a Term Sheet is non-binding, as it is followed by due diligence of the start-up and unless the due diligence shows any red flag, the Term Sheet evolves into a definitive agreement commonly known as Shareholders’ Agreement or Investment Agreement.
The common and key terms used in a Termsheet:
Valuation: For a start-up, valuation generally is the agreed value of the start-up between the Investors and Founders and derived from metrics such as current sales and revenues, costs and profits, plans, projections and potentials of the business. It also depends upon the market trends like similar deals in same segment etc.
Pre-Money Valuation is the valuation at which Investors invest in a start-up and Post-money valuation is pre-money valuation plus the amount invested by the Investors.
ROFR: Right of First Refusal or ROFR as commonly known allows the Investors to accept (or refuse) investment in future rounds of fundraising by the Company before third parties have access to the deal. It also restricts the Founders to sell their shares in the start-up to third parties before offering it to the Investors.
Liquidation Preference: LP is the preference of the Investors to receive the amount invested by them in priority to the Founders in case the start-up is sold or acquired or wound up. This allows a possibility to the investors of getting at least some of their money back in case the start-up is failing.
The standard term for liquidation preference is 1x the investment, which means that investors get back up to the amount they invested before the founders should get anything.
Preference Shares Vs. Equity Shares: Typically the Investors prefers to invest in Preference Shares which gives them the preference over the equity shareholders (Founders) in case of dividend and liquidation proceeds. The most common instrument in Compulsorily Convertible Preference Shares which means the Preference Shares will be Compulsorily converted into equity shares later on.
Board of Directors: The Investors want to appoint their nominee to be a Director on the Board of the Company for effective monitoring, supervision and protection. Recently, the Investors are keener to have Investor Observers, who only attend and participate but does not vote in the meetings. Typically, Termsheet provides for the presence of the Investors’ nominee on the board meeting where critical matters are considered.
Reserve Matters: Reserve Matters or Affirmative Vote matters or Veto rights are the key strategic matters for which a start-up needs specific consent of the Investors and without which the founders can’t take such actions. Typically these matters include fundraise, amending charter documents, borrowing from outside, dividend, selling IP rights or assets of the Company, related party transactions in which founders are personally interested etc. Founders should negotiate Reserve Matters to create a balance between operational flexibility and protection for the investors.
Exit: Every Investor would bind the Founders to give it an exit after a certain period typically 3-5 years. Exit can be given either by finding another buyer/investor who purchases shares of investors or by a buy-back by the Company.
Tag Along: This allows the Investors to tag along with the Founders when Founders are selling the Company to a buyer.
Drag Along: This allows the Investors to drag the Founders to sell their equity in the Company in case they have found a buyer so that they can exit from the start-up. It can also work for both the Investors and Founders and vice versa.
Anti-Dilution: Anti-dilution applies when the next round of fundraising happens at the valuation lower than the previous valuation, typically happening in a falling economy or failing start-up. It helps the investors of the previous round (who invested at a higher valuation) to reach to the current round valuation (lower than the previous one) by receiving additional shares free of cost or at a nominal price.
ESOP Pool: ESOP Pool refers to an amount of equity reserved for future hires, and is a common tactic for attracting talent to a start-up. In my experience, an ESOP pool of 10% provides for sufficient room to incentivize and attract key employees.
Information Rights: Information Rights grant the right to receive periodical information like. performance metrics, financials etc. from the Company after the investment is made. Founders should exclude confidential information like technology, codes, algorithms etc. from such information rights to protect their interest.
In essence, founders must closely read the term sheet and determine if the structure works best for them and the company. A good term sheet aligns the interests of the investors and the founders because that’s better for everyone involved (and the company) in the long run.
Watch the complete interview for more quirks! Download your personal copy here – Understanding Term Sheet
Keep watching this space for more under Fire Up Series.
Stay safe and sound!