Can we use a graphic of some kind to illustrate the 5 stages above?
The key terms and conditions of a venture/seed capital investment once agreed are set out on a document known as a term sheet / heads of terms. Term sheets are crucial documents for start-up companies to review and negotiate where possible. Term sheets for seed funding in particular are standardised documents containing a number of boilerplate provisions irrespective of the company involved. Venture capital investments may facilitate more negotiations.
A term sheet is not a binding contract to invest but sets out the broad parameters of a proposed investment. The detailed terms of the investment will be governed by the share subscription agreement, the shareholders agreement and the company’s constitution. Generally, the only legally binding terms in the term sheet are:
This provision sets out the capital being offered to the company and the percentage ownership that the investor will acquire.
The term sheet may provide that the total investment will not be provided upfront but will instead be advanced in periodic instalments. Later instalments may be conditional on the business meeting certain milestones. As these targets are typically imperfect indicators of performance it is important that start-ups play an active role in their negotiation. Start-ups should try to negotiate instalments that are at the start-ups option or automatic upon hitting the agreed milestones, rather than being at the investor’s option.
Anti-dilution clauses are used to protect investors in the event that a company issues new shares or new shares at a lower price. For example, if the company doubles the number of issued shares, the percentage the investor holds will decrease unless it is given the opportunity to subscribe for new shares or allotted additional shares as if it had originally subscribed at the lower price.
Term sheets normally provide that legal and other expenses of the investment will be borne by the company.
The investor may require the right to regular status updates on the company such as monthly financial reports.
The term sheet normally provides that the investor’s consent is required for key company decisions such as the issuance of new shares, raising new capital and selling the business. This restricts the founders’ autonomy by effectively giving the investor the power to veto certain decisions.
Pre-emption rights give investors a right to buy new shares in future financing rounds in order to prevent their ownership being diluted.
This right provides that if another shareholder intends to sell their shares to a third party they must first offer the shares to the remaining shareholders on the same terms and conditions as those offered by the third party. The non-selling shareholders will have the right to participate in the sale on a pro rata basis in accordance with their shareholding.
Drag-along rights allow majority shareholders to “drag-along” minority shareholders to a sale of the company. For example, if shareholders owning more that 50% of the shares in the company want to sell their shares then, as long as the board and a majority of the investors approve, all other shareholders must also sell their shares. This limits the power of minority shareholders who could refuse to sell their shares in an acquisition offer and block a deal approved by the majority.
Investors may seek a managerial role within the company on the board of directors. Investors are usually appointed as non-executive directors or as observers to the board. As the board is responsible for the day-to-day management of the company, appointment to the board gives investors an important say in the control of the company.
Most investors will say that they invest in people and not ideas. They want to ensure that the founders cannot secure the investment and then leave the company. To prevent this term sheets often provide that founder’s shares are subject to reverse vesting in order to tie the founder to the company. For example, a founder’s shares may be earned monthly over a three year period. If a founder leaves the company after 12 months, the company will have the right to buy back two-thirds of that founder’s shares.
Term sheets usually contain a number of assurances that the business is what the founders say it is. These give investors a right to financial claims against the company and/or its founders if the business or assets of the company have been misrepresented. Exposure under the warranty claims are generally limited to the amount invested or in early stage investments a multiple of the salary of the founder(s). The warranties give rise to a disclosure process whereby the company can disclose instances where the reality does not accord with the terms of the warranty sought.
The term sheet may contain a non-compete clause which will prohibit the founders from starting a competitive business or from joining a competitor for a certain period of time after they leave the company.
The exclusivity clause will generally prohibit the company from pitching to other investors for a certain period of time after the term sheet has been signed.
Although the term sheet is non-binding and its standard terms may be available on the investor’s website, the existence of the proposed agreement is strictly confidential.
Term sheets will generally set a tight deadline for acceptance.
Before the investment is completed the investor will undertake due diligence on the company and its founders including anti-money laundering checks. At a minimum the investor will require to be satisfied that the business has been incorporated, the employees have signed employment contracts and the company exclusively owns the intellectual property for the business it is building.
The due diligence is often undertaken contemporaneously with the negotiation of the Transaction Documents.
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