Key Terms and Conditions in a Term Sheet of Startup Funding
In the previous article, we have already learned that term sheets are the basis on which the entire relationship between the entrepreneur and the investor rests. Since there are several different aspects to running a business, there are several key terms and conditions which need to be worked out between the two parties. A collaborative approach on these key terms and conditions can spell success for the venture.
In this article, we will have a closer look at the terms and conditions which are commonly negotiated before an agreement is reached between two parties.
- Voting Rights: The term sheet explicitly mentions the quantum of shares that are being issued to different parties. It also clearly mentions the type of shares that are being issued. Some of these shares have voting rights along with the right to receive a dividend. However, other classes of shares may have the right to receive dividends but may not have the right to vote.
Voting is an important act that allows investors and entrepreneurs to influence the future of the company. Hence, the absence or presence of voting rights can be considered to be a make or break factor in many startup deals.
It is possible for the entrepreneur to provide voting rights to certain types of investors while refraining from providing the same to certain others. The thumb rule is that an investor only needs to be provided voting rights if they will be involved in the day-to-day operations of the firm.
- Veto Rights: Veto rights are special kinds of rights that are required by investors to stop certain kinds of decisions from being taken. These rights have been explained in detail in a separate article.
For now, it is important to understand that vet rights can be very important when several investors are involved in funding a startup. Hence, it is important for the term sheet to clearly specify which investors have veto rights and when these rights can be used.
- Liquidation Rights: The term sheet also provides a lot of information about the liquidation rights of each party. The liquidation rights are only relevant when the startup has failed and is being liquidated. In such cases, the term sheet will decide the order in which the various investors, as well as the entrepreneur and other stakeholders, will be paid. A higher liquidation right is important to investors since it reduces their risk in the investment.
- Board Rights: There are several entrepreneurs who want to take control of the firm in which they invest. It is for this reason that investors often explicitly mentioned in the term sheet that they want their representative to be a part of the board of directors. Now, the management of the startup company reports to the board of directors. If the investor controls the board, they can have a massive influence on the day-to-day operations of the firm.
Many entrepreneurs are wary of providing this influence to their investors since it could mean interference in day to day operations of the firm. The details about the access to the board of directors must be clearly mentioned in the agreement between the two parties.
- Information Rights: Startup companies are not like publically traded companies. This means that they do not publish their financial data periodically. Also, since a lot of these companies don’t have positive cash flow or profits, the traditional financial statements issued by these firms have limited applicability.
Investors often decide on the information that they would require from the company beforehand. The manner in which this information will be collected as the frequency with which the data will be published needs to be decided beforehand. It is imperative that these details be included in the term sheet in order to avoid conflicts later. Opacity can lead to a lack of trust which can be detrimental to the growth of any organization.
- Conversion Rights: A lot of the time investors want to have conversion rights. This is done to safeguard their capital, protect themselves from losses while trying to make the most amount of money. Investors often use convertible securities which allow them to convert their investments into debt if the company is doing badly and is likely to be liquidated. By doing so, these companies are able to get preference during the liquidation of the company.
At the same time, investors also have securities that allow them to convert debt to common stock. The details of these options as well as the time frame in which they can be exercised need to be clearly mentioned in the term sheet.
- Exit Rights: Last but not least the term sheet tries to create exit barriers. This means that both investors, as well as entrepreneurs, may not be able to sell their shares directly to third parties. Entrepreneurs often want to avoid certain types of investors and hence do not want the shares to be freely sold.
It is common for term sheets to mention the legal clause that the first right of purchase must be given to the stakeholders of the company viz. employees, entrepreneurs, etc. Only if these stakeholders do not want to buy the shares or do not have the financial wherewithal to buy them, can third parties be involved. It is also possible that the entrepreneur may have the power to stop certain investors from obtaining a stake in their business.
From the above points, it can be clearly seen that the term sheet is a very important document. It enumerates the rights and duties of the different parties in different situations and hence forms the basis on which all cooperative action is undertaken.
Authorship/Referencing - About the Author(s)
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