The term sheet serves as a road map for savvy founders in guiding the start-up's long term relationship with its potential investors.
A term sheet (also known as a “Letter of Intent”, “Memorandum of Understanding” or “Heads of Agreement”) is one of the first legal documents that a founder will need to navigate in the fundraising process. A term sheet is a relatively short document that sets out the key commercial terms on which investors agree to invest in the start-up.
Although a term sheet is signed, it is usually not a legally binding document (except certain clauses, typically concerning confidentiality and exclusivity, which are expressly stated as being binding in the term sheet). However, the importance of the term sheet lies in it functioning as the roadmap for the investment, with subsequent deviations to be carefully considered by the parties.
First-time founders may be daunted by the unfamiliar terminology and foreign concepts. However, it is important for them to have a general understanding of the broad concepts and points captured in the term sheet. Founders should not hesitate to engage and consult lawyers, even at this early stage, to aid them in making better-informed decisions when negotiating the term sheet, especially if they are dealing with more experienced investors.
Founders should also be mindful that Series A terms will form the starting point for subsequent financing rounds. Any misstep can be compounded in later rounds, which may require founders to sacrifice valuable negotiating leverage to correct such missteps. That said, for early stage founders, venture capital investors are a useful source of knowledge and advice as most venture capital investors are keen to play the role of educating their founders on investment terms and the fundraising process more generally.
B. ROLE OF THE TERM SHEET IN A VENTURE CAPITAL INVESTMENT
The term sheet represents the starting point when a start-up and its potential investors engage and negotiate on a possible investment. Usually, an investor delivers the first draft of the term sheet, containing the key economic terms and governance rights, to signal its interest in investing in the start-up. Depending on the circumstances and bargaining power, the term sheet may either be delivered in draft form and subject to further negotiation, or (more often) in signed form and served on a “take-it-or-leave-it” basis, sometimes with a deadline for acceptance. Whether (and to what extent) a term sheet can be negotiated largely depends on the specific circumstances and dynamics of the deal. But, as is the case with any contract, one should sign the term sheet only if and when there is a sufficient level of comfort.
The term sheet can be viewed as the skeleton of the transaction documents to be executed. It sets out the key terms and conditions that will be documented in greater detail in the transaction documents. The transaction documents typically required for a venture capital investment comprise a Subscription Agreement and a Shareholders’ Agreement, both of which can be found in the Venture Capital Investment Model Agreements (“VIMA”).
Legally, there is no requirement to enter into a term sheet before negotiating the transaction documents. However, it is a useful and practical exercise for the parties to spend sufficient time and effort on the term sheet, so as to reach an agreement on key issues. Doing so will help to avoid the need for protracted negotiations (and associated costs) when negotiating the transaction documents. Any concerns or disagreements should (to the extent possible) be raised at the term sheet stage. Any subsequent deviations from the term sheet will inevitably raise the potentially awkward question from the investor as to why the change in position from that agreed to in the term sheet.
C. DIFFERENCES IN THE LONG AND SHORT FORM TERM SHEET
The VIMA provides both a short- and long-form term sheet to cater to varying situations, such as when time is of the essence or where more details in the term sheet are required.
The short-form term sheet may be used if parties prefer to postpone the discussion on specifics terms, until the stage where the subscription agreement and the shareholders' agreement is being drafted. While the short-form term sheet may allow the investment to move ahead more quickly, it is suggested that parties use the short-form term sheet only if they are already fairly familiar with the funding and documentation process, because it refers to terms that are “standard”, “typical” or “customary for investments of this nature”. There are two takeaway points:
(a) first, the lawyers working on the transaction should be sufficiently experienced to know what the accepted market practice is; and
(b) second, the founder should understand (from his lawyers) what exactly he/she is potentially conceding by adopting accepted market practice.
In other words, the short-form term sheet is recommended for experienced founders and seasoned investors (such as venture capital investors).
In contrast, the long-form term sheet requires a discussion between the founder and the investors, on various key provisions which will be reflected in the transaction documents. This discussion will help to draw out each party’s position and facilitate the preparation of the transaction documents.
As a default position, it is recommended that all parties should use the long-form term sheet. Although the process is longer, the long-form term sheet educates investors (who may otherwise be unfamiliar with its concepts and provisions) and minimises the risk of facing the same (or more likely, more difficult) issues, at the stage when the transaction documents are negotiated.
D. KEY TERMS WHEN NEGOTIATING THE TERM SHEET
There are two groups of terms that are frequently negotiated in an early stage equity financing term sheet, namely:
(a) terms relating to the economics of the investment; and
(b) terms relating to control and governance rights.
The following summary is intended to serve as an introductory overview. For ease of reference, the long form VIMA term sheet is used as the basis for this discussion, which also proceeds on the related assumption that investors are subscribing for Series A preference shares.
A first-time founder will typically ask why investors require preference shares (as opposed to ordinary shares). Put simply, this is because preference shares are treated with preference over ordinary shares in certain critical situations (dividend distribution, liquidation or sale). These provisions will be examined in greater detail below.
The following are the key economic terms to consider:
(a) Pre-Money Valuation (paragraph 4) – the VIMA term sheet sets out the valuation of the start-up on a pre-money basis, that is, what the investors value the start-up as of today before the investment takes place. This is distinguished from "post-money" valuation, which is the sum of the pre-money valuation and the investment amount.
(b) Use of Proceeds (paragraph 8) – in most cases, the investment amount would generally be used for the start-up’s growth and expansion and to fund its day-to-day operations. However, if any portion of the investment amount is to be used for a specific purpose (for example, to open a new factory site or expand the business into specified foreign jurisdictions), this can be stated expressly or by reference to a business plan that has been agreed between the parties.
(c) Expenses (paragraph 16) – the term sheet commonly provides for the start-up to reimburse the investors’ expenses in relation to the investment, subject to an agreed cap. Typically, this reimbursement would be made to the lead investor (who is driving the investment and incurring the bulk of such costs). Matters for consideration would include the agreed cap and whether reimbursement is to be made only if the deal is completed.
(d) Dividends (paragraph 17) – typically, early-stage investors would not focus on dividends as a means of obtaining a return on the investment because the start-up is likely to use all free cash in growing the business, and profits are unlikely to be reported. As such, in most cases, one may see a qualifier that dividends are payable if and only declared by the board of directors of the start-up, rather than providing for any fixed dividends. That said, the term sheet may provide that, if dividends are in fact declared and payable, then preference shares would have “dividend preference”, meaning preference shareholders must be paid dividends first (either at a pre-agreed rate or as declared by the board), before dividends can be paid to ordinary shareholders.
(e) Liquidation Preference (paragraph 18) – liquidation preference provides preference shareholders (i.e. investors) a right to be paid ahead of ordinary shareholders when there is a liquidation or liquidity event. This protects an investor’s initial investment in a downside situation. The name is somewhat misleading, because it applies not only in the event of liquidation, but also upon other defined liquidity events (such as a sale of the start-up either via share sale or asset sale). There are two components here to consider. First, the “preference”, that is, the right to be repaid the actual amount invested (or, in certain cases, a multiple of the amount invested) ahead of other shareholders. Second, the “participation right”, that is, whether investors will continue to have the right to participate in the distribution of any excess amounts with ordinary shareholders, after the preference amount has been paid, giving investors two bites of the apple. Founders may wish to consider the expected exit scenarios and how the different liquidation preferences would affect these.
(f) Conversion (paragraph 20) – preference shares are typically subject to mandatory conversion (subject to anti-dilution rights, discussed below), such that the preference shares are automatically converted into ordinary shares upon the occurrence of certain stipulated events. One commonly stipulated event is the completion of a qualified initial public offering (“QIPO”). Mandatory conversion rights are intended to facilitate the occurrence of the stipulated events. For instance, a QIPO would generally be easier to undertake if the start-up has ordinary shares only.
(g) Anti-dilution Provisions (paragraph 21) – anti-dilution rights offer some protection to an investor in the event additional shares are issued at a price that is lower than the conversion price of the preference shares. Usually, the conversion price of the preference share is set at the original purchase price of the preference share, unless there are subsequent adjustments. While there are various anti-dilution mechanisms, broad-based weighted average adjustment is most commonly used in the market today.
(h) Employee Share Option Plan (“ESOP”) (paragraph 24) – the employee share option plan (“ESOP”) is designed to incentivise current and future employees by allocating shares to them in the start-up, as part of their overall compensation package. A typical ESOP pool for a start-up receiving Series A investment would consist of anywhere between 5% and 20% (but more commonly between 10% and 15%) of the fully diluted share capital. The specific size of the ESOP pool will depend on what the parties regard as sufficient to cover the start-up’s hiring needs, until the next funding round. It is also important to clarify whether the creation or any increase in the size of the ESOP pool will be deemed to be outstanding in the pre-money capitalisation of the start-up, for the purpose of calculating the value of the start-up (on a per-share basis). It is usual practice for the ESOP pool to be deemed outstanding (although exceptions apply depending on specific circumstances). This means that the fact of creating or expanding the ESOP pool (whether or not the pool is in fact adopted) will have the effect of diluting the existing shareholders, but not the incoming investors.
The following are the key economic terms to consider:
(a) Liability Basis (paragraph 11) – often, the term sheet will require the founder to personally stand behind the obligations of the start-up under the transaction documents. This means that if the start-up does not perform the actions agreed to under the transaction documents, or if any representation or warranty proves to be untrue, the founder’s personal assets will be at risk. While understandably discomforting to any founder, such a clause is not unusual for early-stage financing to ensure that the founder has “skin in the game”, particularly given the start-up lacks assets or a track record at that stage. The risk faced by a founder can be mitigated by negotiating limitations to the extent of his liability (for example, to the fair market value of the shares owned by the founder). Where there is more than one founder, the founders should decide whether liability should be on a “joint and several” basis (where a founder will be liable for a co-founder breach) or “several and not joint” basis.
(b) Voting Rights and Reserved Matters (paragraphs 19 and 26) – each preference share would have voting rights ascribed to it. While this would mean that the amount of control and influence the existing shareholders (including the founders) have over the start-up would be diluted, the founders would typically still retain a majority stake in the start-up, at least in earlier financing rounds. As such, investors would require the right to veto a list of matters which are of particular significance to them. This is commonly known as the list of “reserved matters”. One example of a reserved matter is the sale of substantially all of the underlying assets of the start-up. Such reserved matters and their associated approval thresholds should be carefully considered to ensure that they are appropriate. A balance should be struck between the need to protect the investors’ interests against the administrative burden that would be imposed on the start-up from having to constantly seek shareholders’ approval.
(c) Board of Directors (paragraph 25) – investors with significant stakes are typically given the right to appoint board members, giving them greater informational access as well as the ability to influence decisions made at the board level. Here, founders should bear in mind the dynamics of the board and the balance between founders, incoming investors, existing directors and later on, independent directors. There is also the need to ensure that the board does not become oversized – typically, an early stage start-up would have a board size of three or five members, while a later stage start-up may have a board size as large as seven or nine members. Generally speaking, it is preferable to have an odd-numbered board to avoid a deadlock, or the need to give a casting vote to the chairman of the board.
(d) Pre-Emption Rights over New Issuances (paragraph 27) – investors typically are given pre-emption rights. This refers to the right to subscribe for a portion (usually pro rata) of any new shares the start-up intends to issue (such as in a new fund raising round), subject to certain exceptions. This provides existing investors with an opportunity to maintain their existing shareholding percentage in the start-up. Founders should consider to whom the pre-emptive rights are offered – whether to all investors, or only to a specified segment (for example, those holding a minimum number, percentage, or class, of shares).
(e) Right of First Refusal and Tag-Along Right (paragraphs 28 and 29) – a right of first refusal (“ROFR”) allows the start-up and its shareholders to ensure that any shares offered for sale can be bought up by the existing shareholders. This ensures that the start-up’s shareholder base remains the same and prevents the shares from being sold to third parties. Conversely, a tag-along right allows investors to participate in any sale of shares by the founders and, occasionally, other shareholders. The tag-along right seeks to align the interests of an existing shareholder with those of other shareholders by allowing all shareholders to exit the start-up together. Particular regard should be given to who can exercise the ROFR and the tag-along right (typically the investors), and the trigger points for the exercise of such rights (which would be negotiated from case to case but would typically include the founders). In certain cases, however, investors are given the right to be able to freely transfer their shares without being subject to ROFR or tag-along rights of other shareholders; in other situations, transfers by investors may only be subject to a right of first offer by certain other shareholders (for example, other investors and/or founders). As such, there can be different variations and flavours of ROFR and tag-along rights depending on the specific circumstances of a given investment. Also, it should be noted that in early stage companies, the focus of ROFR and tag-along rights may be on transfers by founders or other ordinary shareholders, in which case, one would see such ROFR rights being given first to the start-up and/or other founders and only to the investors when such ROFR is not exercised.
(f) Drag-Along Right (paragraph 30) – the drag-along provision gives a specified group of shareholders the right to compel a sale of the entire start-up regardless of the intentions of the other shareholders. This right is useful when a potential acquirer wants to purchase 100% of the start-up, by ensuring that no minority shareholder can hold up the process. Negotiations will centre on the appropriate threshold to trigger such a right, as neither the founder nor the lead investor would want the other party to have the right to unilaterally compel the sale. In most situations, parties will reach a compromise where the drag-along right can only be triggered with the consent of both the lead investor and the founders.
(g) Restrictions on Founder Transfers and Restrictive Covenants on Founders (paragraphs 31 and 32) – it is not uncommon for investors to require founders to be subject to lock-up periods or restrictions on transfers of the shares owned by the founders. This arises from the fact that the founders are often key to the start-up’s success, and these restrictions ensure that the founders remain invested in the start-up, thereby aligning the interests of all parties involved. Early stage investors may also request departing founders to be subject to reverse vesting, which is a right to repurchase their shares over a certain vesting period. Non-compete restrictions are also standard, and serves to prevent the founders from setting up (or joining) a competing business after securing funding from the investors. Negotiations will often centre on the number of years these lock-up / reverse vesting / non-compete periods should extend to.
The term sheet serves as a road map for savvy founders in guiding the start-up's long term relationship with its potential investors. It is in all parties’ interests to reach a fair and amicable position to avoid any delay during the preparation of the definitive transaction documents and to avoid any lingering misunderstanding or distrust.
To optimise the outcome of the negotiated terms, it is important for a founder to ensure that he/she understands which terms are truly important, as well as to bring in his/her own lawyers early to tap into their experience in venture capital market dynamics.
Kyle LEE is the Joint Head of the WPGrow: Start-Up / Venture Capital Practice, a Partner in the Corporate/Mergers & Acquisitions Practice, and a Partner in the FinTech Practice at WongPartnership LLP. His main areas of practice encompass venture capital and start-up matters, local and international mergers and acquisitions, fintech, and general corporate and commercial transactions.
Jaewon Yoon currently serves as General Counsel of Jungle Ventures, a Singapore-based venture capital firm. He has been active in Singapore's venture capital and tech start-up space since moving to Singapore in 2015, after working at global law firms in New York, Hong Kong and San Francisco.
Disclaimer: This article is intended for your general information only. It is not intended to be nor should it be regarded as or relied upon as legal advice. You should consult a qualified legal professional before taking any action or omitting to take action in relation to matters discussed herein. This article does not create an attorney-client relationship and is not attorney advertising.
Published 29 May 2020