Angel financing - Term sheets (part 2)


April 20, 2008

One of the first things a term sheet will outline is the investment mechanism for the deal. The two most common types are equity (via common or preferred shares) or convertible debt. Equity, as the name implies, is taking on investor's money in exchange for shares. Say for example your company currently has 1,000,000 shares outstanding. You and the investors settle on a valuation of $1 per share for a pre-money valuation of $1,000,000. The investors put in $250,000 and in exchange they are issued 250,000 shares. The post money valuation of the company is $1,250,000 and investors own 20% of the company.

Investors can either be issued common or preferred shares. Depending on how your current shareholder's agreement is written & company capitalization structure is, you will probably have all shareholders (founders) holding common shares. If investors are issued common shares, they have the same class of shares as the founders and hold the same rights. Since the investors are often the ones putting the most hard cash (as opposed to sweat equity) into the venture they will often want to protect themselves with additional rights.

This is accomplished by issuing investors a new class of shares so that their shares are of a separate type than the other shares outstanding. This allows different rights to be assigned to holders of these preferred shares. The types of conditions attached to preferred shares will vary per each situation/individuals involved. Some possible clauses attached to preferred shares to give investors greater protection are:

Liquidation preference - in the event of a company wind-up (at a loss), it can be stipulated that proceeds are first distributed to preferred shareholders and any surplus is then distributed pro-rata to all shareholders. This gives investors protection that they will be given first shot at any cash proceeds to recoup some of their investment.

Board seats - usually a set number of board seats are made available to founder's choice, a set number of board seats are made available to preferred shareholder's choice, and possibly a set number of board seats are stipulated to require mutual agreement. This gives investors protection that they will have a seat(s) on the board to have oversight of the company.

Voting structure - since investors usually enter into the first round of an investment with a minority position in terms of overall shares (20% in the example above), they will have limited control in terms of voting on shareholder's resolutions as in the early financing stages of a company founders will hold a majority of the shares. And unlike in a publicly traded company, it's not like they can easily sell their shares if they do not agree with the direction the company is taking.

Investors can get additional protection by having preferred shares vote separately or have greater voting weight than common shares. i.e. the shareholder's agreement can stipulate that in the event of a shareholder's motion the common shares & preferred shares vote as separate classes and to pass a motion a majority in each class must approve it.

There are many other terms that can be attached to preferred shares, if this is the deal structure the management team and investors have landed on, this will all need to be worked out during the term sheet negotiations.

The main issue with an equity investment is that it forces both sides to settle on a valuation, which as I discussed in an earlier article can be very hard to do in an early stage company. To get around this, another type of deal structure is convertible debt. Basically this treats the initial investment as debt that appears on the balance sheet. So in the example above, for the investor's $250,000 investment they are essentially loaning the company money and the company is taking on $250,000 debit. The mean feature about the debt is that it is convertible to equity. This usually is worded so that at a 'significant' future financing event, holders of the convertible debt can convert their debt to equity at the valuation agreed upon at the future financing event at a discount. This essentially defers the valuation question as it allows the company to take on investment, and not worry about determining a valuation until the future financing event at which time the company will be more mature, have a more predictable revenue stream, and be easier to value.

In return, investors get two upsides for making the early investment. First, the debt earns interest. The rate is negotiated between the investors and company but it is obviously going to be higher than a bank loan rate to account for the non-secured nature of the debt and risk around investing in an early stage company. Second, when investors convert to equity they convert at a discount. i.e. it will be worded that investors can acquire shares at X% of the share price set by the valuation of the significant financing event. This rewards the early stage investors for going in early and investing in the company & using their capital to help the company grow compared to the investors at the future financing event.

Some other common terms found in a term sheet are as follows.

Use of proceeds
When investors put their money into a company, the general expectation is they are providing capital to take the company forward and help grow the business by funding hiring of more developers, purchasing advertising, attending trade shows, etc. To get the company to its current state, founders may have invested a lot of their time in sweat equity, not drawn a salary, etc. However, just because there is an infusion of capital, it does not necessarily mean it should be used to re-pay past efforts. Remember, investors are investing in your company at a certain valuation at the point of investment. Rolled into this valuation is all of the work to date to get the company to its current point. To cover this, the term sheet will usually give some broad points on use of proceeds and may specifically state proceeds are not to be used to re-pay any debt the company may have. So if this is an important consideration for your situation, you will need to work out something with the investors and in return most likely give a reduced valuation.

Board of directors
A term sheet will usually stipulate the expectations on the board of directors for the company. Most notably the size of the board, how many seats management can have, how many seats investors can have, and stipulations on the number of external directors. The term sheet will most likely call for the formation of a compensation sub-committee of the board and specify who can be on it.

Management
The term sheet may call for employment contracts for key management positions to provide protection if an employee were to leave through non-compete and non-solicitation clauses. The term sheet may specify the allocation of a stock option plan for key employees and set out the vesting schedule.

Control
The term sheet will lay out actions that either require shareholder approval or board approval. Examples would be: changes to the shareholder's agreement, changes in the board structure, issuance of new shares, issuance of dividends, company wind-up, change in core business, sale of the company, assumption of debt, entering into any large contractual assumptions.

Targets
The term sheet may lay out a mechanism for investors to take control of the company if management does not meet targets. i.e. it could state if in X years, the company has not reached profitability, the company must either buy out the investor's shares or investors can take full control of the board. This gives investors protection that if the company has not taken off, they will either get their money back or can take control of the company to try get it on the right track.

Future financing / sale
The term sheet will specify that for any future financing requirements, investors get first right at investing. The term sheet will also have a drag-along provision where if a specified percentage of shareholders agree to sell to a buyer (assumed to be an acquirer of the company) then all other shareholders are forced to also sell their shares. The term sheet will have a piggyback provision that if a shareholder has found a buyer of their shares, other shareholders can also participate in the sale on a pro-rata basis.

Information access
The term sheet will state that investors are entitled to receive regular financial statements, budgets, etc.

Legal fees
The term sheet will generally state that the company is responsible for paying its own legal fees associated with the investment closing and the investor's legal fees associated with the investment closing. Because of this, you should factor legal costs into the amount of financing you are raising and probably want to set some maximum caps for both lawyers.

Exclusivity
The term sheet may require a period of exclusivity where while the deal is under work. Meaning during this period you agree not to be actively pursuing other financing options.

These are the main points of a typical term sheet. As you can see there are a lot of potential trade-offs that can be made. Investors may feel strongly about certain points and management may feel strongly about other points. Coming to a landing on the term sheet will be a matter of give and take.

In my next article I will discuss investor management. To view an organized index of all angel financing articles as well as see a roadmap of future articles, click here. If you have any comments or suggestions for future articles feel free to contact me: craig at mapleleafangels.com