Making Sense of Term Sheets

To successfully negotiate a term sheet, you need to know what the relevant terms mean and the potential pitfalls to avoid.

Here are our top 10 tips to bear in mind when you are presented with an investor term sheet:

Valuation

Understand the difference between pre-money and post-money valuations.

Let’s say you need to raise 250k and believe that the company should be valued at £1.5m:

If £1.5m is a pre-money valuation, the calculation is £250,000/£1,750,000 x 100 = 14.29% equity to be offered;

Whereas if £1.5m is a post-money valuation, the calculation is £250,000/£1,500,000 x 100 = 16.67% equity to be offered.

Diluted v Fully Diluted

Has the valuation of the company been agreed on the basis of the issued share capital or the fully diluted share capital?

The latter will include any share options or warrants etc which have been granted by the company.

An investor will usually want to agree a valuation on the basis of the fully diluted share capital so that they are not immediately diluted by any existing option pool or warrants which may be in place.

Be clear about the basis of the valuation before you commit to a specific share price.

Conditions Precedent

The stuff you need to do before an investor will subscribe for shares in your company. Take the conditions seriously – an investor will not be obliged to do the deal if you don’t comply.

Make sure the conditions are sufficiently specific so it is clear whether you have achieved them or not. Also, don’t sign up to terms you can’t deliver (or can’t reasonably deliver before the investment takes place).

Investors who expect to claim EIS tax relief on an investment will often ask a company to obtain an EIS Advanced Assurance from HMRC so be prepared to provide this, and it can take some time to obtain.

Investor Rights and Board Representation

Investors may ask for a number of consent rights i.e. actions the company can only take if it firstly obtains the consent of the investors. These are often split into two categories:

Investor consent matters which must be approved by investors holding a certain % of shares in the company. These are usually limited to the most important matters such as disapplication of pre-emption rights and amendments to the company’s Articles of Association etc.

Investor director matters – normally more operational matters, such as approving the business plan and key hires.

The key is to strike a sensible balance with these consent matters. Consent rights should act as an appropriate “checks and balances” system and give investors some protection as minority shareholders. They are not intended to prevent the company from getting on with its day to day business so review consent matters (and any attached thresholds) carefully.

As you raise larger rounds of investment, you may need to accept more extensive consent rights.

Investors may also ask for the right to appoint a director to the Board. Try to work collaboratively with investors to ensure that any appointee will bring relevant skills and experience and is a good fit with other personalities on the Board.

Warranties

Warranties are promises relating to the circumstances of a company on a variety of matters such as financial and trading position, IP ownership and compliance with laws. If any warranties are inaccurate, these inaccuracies should be disclosed to the investors in advance of completion so they can form a true picture of the company’s health. The main purpose of warranties is to encourage full and frank disclosure to the investors.

Warranties are usually granted by the company and by founders personally. Liability for breach of the warranties should be capped: for the company, the cap is usually linked to the amount of investment and for the founders, the cap is usually a multiple of annual salary.

In general, the extent of warranties being sought should reflect the amount of investment being made and the stage of the particular investee company.

Compulsory Transfer/”Leavers”

These provisions set out circumstances in which there may be a compulsory transfer of shares. They usually apply to founders and other employees when a “transfer event” takes place, which will usually include cessation of employment. For that reason, compulsory transfer provisions are often referred to as “leaver provisions” and the leaver is obliged to offer up some or all of their shares for sale.

Often a distinction is made between “good leavers” (e.g. who leave employment due to redundancy or as a result of death or serious ill health etc) and “bad leavers” (e.g. who are dismissed for gross misconduct or who breach obligations of confidentiality etc), the main difference being the sale price of shares.

Exclusivity

Most investors will ask for an exclusivity period so that once the term sheet has been signed, you don’t speak to any other investors for an agreed period of time (usually until the deal is complete). This is an entirely fair ask from investors who want to know you are committed to doing a deal with them and it gives them comfort to move forward with the investment process i.e. due diligence, investment documentation etc. If you decide to do a deal with a different investor in breach of your Exclusivity Period, you will normally have to reimburse the first investor for any costs incurred up to that point.

From a company’s perspective, it is important to check that any exclusivity period automatically comes to an end if the investor decides not to proceed with the deal or is delaying unreasonably.

Costs

The term sheet may set out which party will pay the costs of the deal and if it doesn’t, you should ask the investors to clarify. Usually the company will cover the legal/diligence costs of the investors, but it is a good idea to agree a cap for these.

You should have clarity on the extent of costs being deducted from the investment funds - which will include deal costs (for the company and the investors) and any research or admin fee charged by the investors – so that you know the net amount to be paid to the company on completion. The extent of deductions will affect the total amount of investment you need to raise to deliver the business plan.

Non-binding

The majority of clauses in a term sheet will be non-binding, with the exception of provisions relating to exclusivity, confidentiality and costs. However, it is generally understood that there is a moral obligation not to re-negotiate the terms of the deal once the term sheet has been signed.

There may be provisions in term sheet which allow certain terms to be re-negotiated if circumstances materially change during the intervening period between the term sheet being signed and the deal being completed. But, it may be viewed as bad faith if you seek to re-negotiate provisions simply because you have had a change of heart.

Preferences and Anti-Dilution

I’ve mentioned these last, not because they are least important, but because they are generally not compatible with EIS relief, so don’t tend to arise in the context of any EIS investments. However, if you are dealing with a VC, international investor or other party who is not seeking EIS relief, you may be asked to grant these rights.

Both preferences and anti-dilution mechanisms can take a wide variety of forms and are worthy of a blog in their own right. For now, I’ll keep it simple:

Preferences: this usually means that the investor gets their money back first on any return of capital. Watch out, this may not be limited to the amount of their initial investment if they are looking for a multiple e.g a two times preference = two times their money back. This can have a significant impact on distribution of proceeds:

Example 1

Investor A invests £10m and asks for a 1.5 times preference. The company is sold for £50m. Investor gets £15m back and the remaining £35m is divided amongst the shareholders.

Example 2

Same as above, but the Investor has a 5 times preference. The company is sold, the investor takes all the proceeds, and the other shareholders leave with nothing.

• Double dipping: let’s go back to Example 1 where there is £35m left for distribution amongst the shareholders. That group of shareholders might include the investor. So, the investor gets their initial investment (or a multiple thereof) back first with their preference, then is able to participate in the remaining proceeds along with the other shareholders.

So, if you are agreeing to preferences, you need to be clear as to whether they will allow double dipping or not.

• Anti-dilution: this is where an investor has the right to be awarded additional shares if in the future the company issues shares at a price lower than the price paid by the investor. In such case, the investor may be awarded additional shares to make up for the dilution suffered by the investor as a result of the “down round”.

This is by no means an exhaustive list of investment terms, but does give an insight into the main provisions you may find in a term sheet.

It is very important you understand the implications of any provisions in a term sheet before you sign, because it may be difficult to negotiate changes at a later date.