A term sheet essentially is a nonbinding agreement with the basic terms and conditions under which an investment will be made. But it can also be ridden with clauses that could come back to haunt an entrepreneur and his company and needs to be negotiated carefully.
For investors, term sheets help assign rights, carve out protections, and, if necessary, haggle over claims to future returns when a company is being sold or listing its shares on a stock exchange.
For entrepreneurs, it is important to consult with their peers and mentors before starting negotiations on a term sheet, listing clauses they would be willing to discuss and what they consider non-negotiable.
An entrepreneur would do well to have ready a so-called ‘best alternative to a negotiated agreement,’ or approaching an investor for Plan B or even a C. This becomes even more important for entrepreneurs during times like now, when wary investors seek to wrest as much control as they can before agreeing to put money into a startup.
Among the most important terms for entrepreneurs to consider are those relating to a company’s valuation and how much stake they would have to dilute. Clauses such as ‘liquidation preference’ could reduce the founders’ equity worth to much lower than what it appears to be.
Terms like these are widely misunderstood in the industry, and entrepreneurs should negotiate carefully. “Liquidation preference is fundamentally a downside protection instrument, which disincentivises entrepreneurs from selling a company at a sub-optimal price,” said Mukul Singhal, cofounder of venture capital firm Pravega Ventures, who has over a decade of experience in early-stage deal making.
“Some investors have started using it to juice up returns by negotiating a three-four times liquidation preference.” Liquidation preference, though, is meant to help investors recover their capital-in other words, a 1x return on investment before founders and employees start making money from a sale.
Another important term for founders is sweat equity. “As a founder, if you are able to sell a company in two years, but haven’t put in the clause of ‘accelerated vesting’ during a liquidity event (M&A or IPO), then you suffer even though you made a perfectly salable company,” said Aprameya Radhakrishna, cofounder of TaxiForSure that Ola acquired for $200 million in 2015.
While, typically, stock options are vested or allotted after completion of each year over 4-5 years, accelerated vesting allows employees to get the benefit of all options rather than having to wait as scheduled. Another point to consider is how many approval rights an investor can have in areas like new loans taken by a startup, fresh offering of shares or hiring an executive above a certain salary level.
“Supermajority rights are critical, which are things (an entrepreneur) cannot do without the approval of investors,” said Vipul Parikh, chief financial officer of online grocery BigBasket. Entrepreneurs should also watch for clauses such as ‘private matters’-a fine print typically inserted at the end of a term sheet.
It controls all top management hiring, any change in business strategy and the creation of any subsidiary. Even if a founder plans to take a home loan above a certain limit, the ‘private matters’ section will govern his decision.
Many investors also try to lock in promoters for periods of 45-90 days during which time they cannot negotiate terms with other investors.
While investors use this clause so founders do not shop term sheets with others to get a better offer, the standard period for this should not be more than 30 days.
“Fund raise, in my experience, has been a trust-building game. It pays to be honest, transparent and to not shop around in the early stages,” said Amarendra Sahu, chief executive of home rental startup NestAway. “In a way, good investors vet the moral compass of founders in addition to business acumen and passion.”
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Source – ET Retail