Start-ups operate in a high-risk environment, but tend not to pay enough attention to documents they sign. This is a dangerous approach, given the sums being poured into the sector. At the time of fund-raising, entrepreneurs feel obliged to sign any document an investor puts before them, assuming it to be standardised and, therefore, non-negotiable. This is not the case. You should be ready to negotiate any point in the agreement. After all, it’s you who has started the company and it’s they who’re looking to invest in it. They may even see value in your attitude.
Let’s examine the important clauses in a term sheet:
What is a Term Sheet?
A term sheet is a document outlining the terms on which an investor is willing to invest his money. This is a non-binding document, so it’s not enforceable in court. Its point is simply to lay the foundation for the shareholder or share purchase agreement. A term sheet, in effect, is to a shareholder agreement what an engagement is to a wedding. But do go through it thoroughly before you sign.
In particular, here are the clauses to pay attention to:
Your VCs are not just investing in the business; they’re investing in you. So they want to know that you won’t just bail on the company soon after they invest. Most often, founders have a vesting period of three or four years. If your VCs have entered a longer period, you could negotiate this downward, unless there is a specific reason for this. By the end of the vesting period, you’ll have fully vested, but it’s not as if your departure a year earlier would leave you with nothing. Most likely you’ll receive a quarter of your equity every year. If you leave in the first year, however, you will likely receive nothing.
Proportionate with the investment, the VC will get seats on the board of your company. To ensure that neither party (VC or founding team) is at a disadvantage, an observer may be appointed. Ensure that this person is able to maintain an unbiased view on your company. If the VC is opposed to this, be frank about your reasons for the change and push for the change.
Tag Along & Drag Along
The Tag Along clause implies that, in case of a sale of the majority of the company’s shares, the minority shareholders may insist that their shares be ‘tagged along’ (i.e. sold) in the same proportion, at the same price and on the same terms. The Drag Along clause allows majority shareholders to insist that minority shareholders give consent to sale of the company. Insist that both be included in the term sheet.
In case of the liquidation (or even an M&A) of the company, the investor will want to be repaid before the founding team can lay their hands on any money. If the support the VC is offering you is substantial, the VC may even want a share in the surplus proceeds. If not, you could ask that their participation be capped at a certain amount of the surplus or limited to their investment.
An early investor will want his investment to be protected from dilution when future rounds of funding come through. Usually this is done by issuing additional shares to the initial investor at every round.
Above article is contributed by Hrishikesh Datar – founder and CEO of vakilsearch.com, India’s largest facilitator of legal services online.
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