You’ve cleared the daunting task of meeting VCs and answering their never-ending questions. They’ve agreed to invest in you and you think the worst is over! Not quite. The next task is to draft the term sheet.
A term sheet is a non-binding document which outlines the terms based on which an investor will infuse money into your startup.
A deal can fall through even at this stage. Here are a few things to keep in mind before signing the term sheet.
1. Are the VCs or Angels an expert in your field?
A good venture capital firm will employ people who have real-life experience in your field. Or better put, a good venture capitalist will invest in those companies they have knowledge about or employ people who can help in the marketing strategies to employ, recruit people, help in training your sales team, help with market research etc.
VCs claim to help with their team of expert staff. As an entrepreneur, you need to be cautious as well. This help comes based on your relationship with the VC.
2. Drag-Along rights
This clause allows the major shareholder to drag the minority shareholders to sell their share to a third party if the majority shareholder has decided to do so.
In this scenario, the shareholder goes ahead and sells his stake, irrespective of whether the founder is in favour of it or not. This clause comes into picture when the startup is on the brinks of a merger, acquisition or sale and the investor has found a buyer who is interested in buying 100% of the company.
This clause would only work in the entrepreneurs’ favour when the Drag-Along is accepted with higher time return to the entrepreneur.
3. Tag Along rights
This right protects entrepreneurs. It allows them to share their stake along with the major shareholders and they will not have to be forced to work with a new partner, without their willingness.
4. Anti Dilution
This is a clause that is found in every term sheet and instead of trying to remove it, entrepreneurs should look at ways to try to minimize its impact.
This clause says that if the company raises a second round of funding and the shares during the second round is lesser than during the first round, the shares of the first round investors are protected from dilution by the exercise of this clause.
For instance, the stock during first round investment is Rs. 10 but during the second round, it is issued at Rs. 5, the first round shareholders’ stock will convert to Rs. 5 but they will now own 2 common shares. The additional shares the investors get are at the cost of the founders.
This clause protects the investor since they invest with the hope that the valuations will be higher and the returns promised will successively increase. But, due to certain unforeseeable conditions, this clause will protect the investor.
5. Liquidation Preference
This is one of the crucial elements that will be in focus. It essentially means that the investors will get their money back first before the other common shareholders. Liquidation event typically includes IPO, company buy-back, promoter or promoter led buy-back, trade sale, merger, acquisition, strategic sale (which may lead to a change of more than 51% control), dissolution or winding up and the like.
There are 2 ways an investor can get his share back:
i. Multiple clauses
The original stockholders are entitled to a multiple of their original investment, which could be double or triple the amount, and the remaining is given to the common stockholders. This ensures that the VC gets over and above his investment.
ii. Preferred and Participating Clause
On the sale of the company, the investor would take, say 2x of his investment. And on the remainder, he would take his interest. This ensures that the investor is able to take 2x more due to the interest.
Since all these clauses are carried forward, it is better to decide on the methods in the initial stages.