Things Startups Should Keep In Mind While Signing Term Sheet

Alok Patnia
Alok Patnia founded Taxmantra.com, an expert in tax advisory & compliance. He is a Chartered Accountant having prior exposure with Ernst & Young & KPMG.

After many months of chasing VCs, you finally got an investor who is interested in your startup.Sounds Great! Now what? First of all, you will be asked to sign a term sheet. As you may know, the term sheet is a document outlining the material terms and conditions of a business agreement between a startup and a potential investor. But before signing an agreement, there are many things to look at. There are many important clauses which should be carefully understood before you sign a term sheet. This article would stress on Things Startups should keep in mind while signing term sheet.

Related: Decoding The Term Sheet For Entrepreneurs

The ESOP carve out Clause

In the ‘ESOP’ clause or employee stock option plan, the term sheet states that the promoters/founders would carve out certain percentage of the share of the Company PRIOR to the funding. The important word to note is PRIOR. It means that promoters/founders would have to dilute that certain percentage of their own stocks for future employees.

The carve out of ESOP’s PRIOR to the funding is unfair on two counts:

1. Since the hiring of new talents would benefit the company as a whole, it should come from the share of every owner of the company and hence it should be POST and not PRIOR to the funding.

2. In case of non-allotment of the complete ESOP pool, the Investors would share the residual shares as well! Hence this was an indirect way to get more shares of the promoters under the umbrella of an ESOP plan. In this scenario, entrepreneur should retain the right to subscribe to the invested ESOPs so that the value remains with the entrepreneur.

Try and negotiate ESOPs dilution after funding and limit the commitment to smaller ESOP plan to begin with, since no one knows at the start of a business what really the ESOPs pool requirement will be.

Founders must ensure that the investor also dilutes his share for a bigger and better team that is hired later.

Also startups must have a hiring plan for a period of about 18 months with a smaller ESOP plan.

Drag along rights

This clause gives the majority shareholders(generally the investor)  of the company the right to drag the minority shareholders (generally the promoters and founders) with them in case the majority shareholders have decided to sell their stake to a third party.

If the investor has drag along right and he wants to sell his stake to a third party then he can drag the promoters/founders of the company with him to sell their stakes on the same terms and conditions that he is getting from the buyer irrespective of whether the promoters are in favor of the sale or not.

With Drag along rights the investor wants to make sure that the minority shareholder is not able to create issues in the selling process.

Drag-along clause gets kicks in when the company is on the threshold of acquisition, sale or merger. In most of the cases, this clause gets triggered when investor has found a buyer who is interested in buying 100% stake in the company and is not interested in buying the investor stake alone. In such case, drag along right becomes important for the investor as they can force the promoters to sell their stakes as well.

This clause would work in the entrepreneur’s interest only when the Drag Along is accepted with multiple times (say 10x-25x) return to the entrepreneur.

The essence of the right is basically to protect the investor against the risk of his investment becoming worthless. By having this right, at the end of say, 5 years, if the investor is unable to see the business growing and expanding, he is entitled to have the business sold off to a purchaser at whatever value the business is worth at that time. At this time, the investor will exercise the drag along right, and compel you to sell the business to that rival. You, having signed the agreement with the investor, will not be in a position to refuse and will have to agree with the terms of the offer.

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Tag Along right

This right becomes important for minority shareholders (founders) so that they can sell their stake along with the majority shareholders and they will not have to be forced to work with the new partner without their willingness.

Anti dilution

This is a standard clause in a term sheet and entrepreneur should try to minimize its impact in creative ways rather than arguing upon to remove this clause entirely.

The clause says that that when a company receives a second round of funding at a price per share that is lesser than the price the shares fetched in the first round of funding, the first round investors by exercise of the anti-dilution clause are protected from the resultant stock dilution. For example if the preferred investor bought in at Rs 10 per share and at a second round later stock is issued at Rs 5 per share, the preferred investor’s conversion price will convert to Rs 5 per   share.  This means each preferred share now converts into 2 common shares. Essentially, the additional shares the investor gets are at the cost of the founders.

Investors usually invest in a company with the hope that successive valuations will be higher and the return they can promise in turn to their investors will successively be an increase. However, market conditions may result in significant valuation swings in different market cycles and the anti-dilution is a material provision that investors seek for protection and is usually considered an automatic right.

Do not try to negotiate this clause away, but, take it as a given and negotiate in a manner to impose restrictions when the applicability of the clause wears off.

Liquidation preference

It is one of the essential components of preferred stock and is considered to be very important deal term in a VC investment. There are several varieties of liquidation preferences. In all cases, the gist of this term is that investors will get their money back first, before common shareholders get their money back. Liquidation event typically includes IPO, company buy-back, promoter or promoter led buy-back, trade sale, merger, acquisition, strategic sale (which may lead to change of more than 51% control), dissolution or winding up and the like. 

1. Multiple clause

It means the preferred stockholders are entitled to a multiple of their original investment (double or triple the amount) before the common stockholders get anything.Hence, no matter what the outcome, the VC would enjoy a 100% return on his investment and founders would be left with what remained if anything at all.

2. The Preferred and Participating Clause

It may say that in case of a sale, first the investor would take home let’s say 2x of his investment. Then, on the remainder, he would take his legitimate %.

Lets us understand this with the help of an example:

The founders company raised Rs 100 from a VC at a 30% dilution. Also let’s assume that after 5 years, the business would sell at Rs 800. Logically, VC would take home 30% of Rs 800 or Rs 240? But, this is not the correct number. Under the preferred and participating this is what would happen:

As per the ‘Preferred’ clause, VC would first take home 2*100 (2x liquidation preference) = Rs 200.

As per the ‘Participating’ clause, out of the money remained – Rs 600, VC would take home 30% or Rs 180.

Hence the total money that the VC would take home would be 200+180 = 380 instead of 240!

In other words, the Equity of VC just became 47.5% rather than the original 30% only because of this Draconian Clause.

Remember, whatever you agree to with your initial investors will carry forward to future rounds. That’s why it is best to avoid participating preferred.

Also Read: 5 Signs That You Have To Hire A Finance Director/CFO

To conclude

Remember these key points when negotiating and reviewing term sheets. There are, of course, many other provisions in the typical term sheet that merit very careful consideration. It is generally best to engage a professional to review and explain details before signing a term sheet. Try to negotiate the terms and do your best to knock out unusual conditions.