Understanding a Term Sheet: Part 2
In the Part 1 of this post we provided you with an overview.
Let us now talk about the terms found in a term sheet: Control vs. Economics. Control issues include Co-sale/tag along rights, Drag along rights, Pre-emptive rights, Board members and Information rights. The economic issues include Liquidation preference, Types of participation, Pre-money valuation, Redemption and Anti-dilution. These are just the examples but there are many pauses in a term sheet. Here is the detailed flavor of the control vs. economics issues:
Co-sale/tag along rights: They protects a minority shareholder. That is the key thing. The minority shareholder has the right to join majority shareholders in any sale of the company.
Drag along rights: They enable a majority shareholder to drag the minority shareholder along in the sale of a company. In this situation the minority shareholder gets the same price, terms and conditions as any other seller. What is the rationale for this? Well, some buyers will only buy the company if they want 100%. This can be a major bone of contention during term sheet negotiation.
Pre-emptive rights: They enable shareholders to maintain their percentage of shareholding by having the first opportunity to purchase new shares and/or purchase shares of other shareholders that are for sale.
Board members: This is another key control issue which you will see in the term sheet. Everything is adjustable, if you change one thing in a termsheet it is not done in isolation. So, choose the number of board members and the process of selecting them. This can also go into the term sheet as a control issue.
Information rights: This is fairly self-explanatory. The right to inspect the books and frequency of audits or a third party auditor. This can also be stated into term sheet.
Liquidation preferences is the biggest economic issue in the term sheet. A sophisticated investor like we say a private equity investor would opt for preference shares rather than common shares. The common shares are owned by founders, employees and investors. The preference shares will always get priority over common shares when it comes to distributions. So, when it comes to liquidation of a company the first call is for the preferred shareholders and then whatever is left over can be shared with common shareholders.
When we talk about preference shares and common shares the questions comes up is, do the preferred shareholders participate in the sharing process. In some cases the preferred shareholders get their money and they are done, there is no participation. I other cases even after getting their money back whatever is left over that participates in the sharing process.
Another economic issue that can be negotiated is the Pre-money valuation i.e. how much the company is determined to be worth prior to the investment being contemplated. This can be a major bone of contention during term sheet negotiation. This is quite unfortunate because the truth is this is just the one of the things that can be adjusted.
In other words, if you change the liquidation preference that has the impact on the valuation or if you change the type of security that has an impact on the valuation. To take valuation in isolation and not looking at other factors in the term sheet is very short sighted.
It should be just as flexible as all the other terms in the term sheet and then you have an issue called Redemption. Some of the preferred shares are redeemable if they have to be paid back by a certain date almost like a loan has to be paid.
The problem for entrepreneurs is this can actually trigger liquidation because if the money is not available to be returned to the shareholders on that day when it is due then the preferred shareholders could insist the company to be sold and look what they did. Off course this is also negotiated, you don’t have to agree to this when you are working on a term sheet but again it is adjustable because of the right price purchase.
Then we come to the issue Anti-dilution. An investor the current round of financing wants assurance that the next round will not take place at a lower price per share than currently on offer.
This deals with the situation where investor is worried that may be I am paying too much and in the next round maybe I can get the same share for a lower price.
So why invest now, I can invest in the future at a lower price. So, there are two types of anti-dilution provision: Full ratchet and weighted-average ratchet.
A full ratchet anti-dilution provision looks at the price per share during a down round, regardless of the number of shares issued. It then “ratchets” the conversion price down to that price, so the investor in the higher round gets more shares free of cost.
Whereas, a weighted-average anti-dilution provision reduces the conversion price in proportion to the actual number of shares currently outstanding and issued by the company. If the future down round is small, the ratchet effect is minimal.
The concepts in a term sheet are simple but the way they interact with each other is complex. It requires skills, creativity and practice. If you are new to this game, teaming up with a lawyer who does this every day can help.In summary, the term sheet is a key trigger of a relationship between the entrepreneur and the investor which could last for five to seven years.
It is very important that this relationship is built on the foundations of trust and common understanding and ensure that there is complete agreement.