One takeaway from our discussions with entrepreneurs and investors when we were researching our Tech Report is the importance of the Term Sheet.
Although, in most cases provisions in a term sheet will not be binding, this does not detract from its importance. The term sheet is likely to be the first time you set out in detail how each party envisages the investment will be made and the responsibilities of the parties going forward. Whilst the document might state it isn’t legally binding it will set out in writing your intentions and it can be difficult to subsequently vary those written intentions.
One clear message from our entrepreneurs and founders was the importance of understanding who was investing in your business and what their expectations are. The Term Sheet is the first place to make clear those expectations.
Whilst every deal is different, we set out below some of the common concerns that arise when negotiating and agreeing the terms of an investment.
Amount and Timing
Ensure that you aim to raise sufficient money for the current phase of your business plan, but bear in mind that later investment rounds are likely to be at more favourable valuations. Sometimes, investors, will seek to ‘tranche’ investment rounds, fixing a valuations at an initial point with funding released against certain milestones. Beware that a tranche approach does not fix the valuations too far into the future.
Structure of Investment
Consider whether it is appropriate to structure the investment as debt, equity or a mixture of the two. Angels investors will typically want to put as much of the investment into equity as possible to qualify for SEIS/EIS relief. Many VCs will seek to split their investment between equity and debt like instruments, such as loan notes and preference shares (shares that carry a fixed coupon and redemption premium).
Founders’ Deal
Investors will look closely at the founders’ engagement with the company and will expect to agreed remuneration terms which are appropriate for the size of the business and ensure that the investment is going to drive growth rather than pay founder’s salaries.
Equity Split
The key commercial term, how much equity will the investor require and how much will remain for the founders. Consider the whole funding journey.
Share Structure
Many VC investors require preferential rights for the shares that they subscribe for. These may include:
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A right to a preferential dividend after a period of time.
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A ‘liquidation preference’, entitling them to receive their money back ahead of other shareholders. This can either be non-participating (protecting only the down side) or participating (sometimes called a double dip) entitling the investor to both 1x money and their equity % of the remaining proceeds.
Typically, shares will carry one vote per share. However, some investors may seek enhanced voting rights in certain circumstances (such as step in).
Special rights are more common for VCs. Angel investors will typical invest for ordinary shares, to ensure EIS treatment.
Ratchets
Ratchets are a mechanism to readjust the equity holdings based on the exit valued achieved, allowing management to earn more equity if they deliver an exit value above a certain hurdle. Ratchets can be a useful way of addressing differences in valuation, give founders an ability to earn value back if they feel an investor is under valuing the business.
Warranties
As part of the terms of their investment, an investor is likely to seek warranties to confirm that the business, trading affairs, assets and labilities of the company are in good order. The warranties will cover the key assumptions that the investor is relying on. Typically, warranties are sought from both the investee company and its founders/management team.
In addition to warranties on the commercial, accounting, legal and tax position of the investee company, a typical investor will seek warranties on the future business plan of the company. While such warranty should not require the founders to guarantee future performance, they will require founders to confirm that the business plan has been prepared with responsible care, based on reasonable assumptions and accurate facts.
Limitations
It is typical for the investor’s warranties to be subject to a number of contractual limitations. For instance, general warranties tend to be subject to a time limit of 18 to 24 months, whereas tax warranties are usually subject to a limit of seven years. The maximum amount that the investor can recover will also typically be capped. While an investor will usually be entitled to claim against the company for the total value of their investment, the liability of individual founders is typically capped at between 1x and 3x their annual salary. The logic being that the founders should be at risk of sufficient pain to ensure that they have properly consider the warranties, but not subject to complete ruin in the event of a warranty claim.
The Board
The composition of the company’s board of directors will be tightly regulated under the terms of the investment. Equity investor will typically have the right to appoint one Investor Director and may also seek to appoint a Board Observer (with rights to attend and speak, but not vote, at board meetings). Certain investors may also require the right to appoint a non-executive chairman of the company.
The terms of a typical investment will prevent further directors being appointed, unless approve by the investor.
Conduct of Business
A typical investor will require consent rights in respect of certain key business decisions, allowing them to veto certain courses of action. These consent rights should be balanced to allow the investor the ability to block decisions which may fundamentally alter the business, while allowing the founders freedom to run the business day to day. It is important that founders carefully consider the consent rights sought be investors to ensure that they retain sufficient flexibility to grow the business as intended.
Information Rights
Investment terms will usually provide an investor with certain information rights. This will typically entitle the investor to a copy of the annual accounts, copies of management accounts and monthly “board pack”. Publicly back and socially influenced equity funds may have additional reporting requirements, such as confirmation of number of jobs created or safeguarded in a certain area. The investor will likely also have the right to be informed of the occurrence of any significant development (such as the commencement of litigation).
It is important that founders agree the contents of the monthly “board pack” and management accounts at the start of the investment, to ensure that they are in a position to comply with the investor’s requirements.
Management Commitment and Restrictive Covenants
The investment documentation is likely to require a commitment from founders to dedicate all their working time to the business.
The documentation will usually include restrictive covenants (or non-compete provisions). These clauses prevent founders from poaching customers, suppliers or key employees, or competing against the company in general. Typically, restrictive covenants will continue to apply for so long as a founder holds shares and for further a period of two to three years thereafter.
Share Transfers
Most investors will require restrictions on the transferability of shares. It is not uncommon for founders to be prevented from transferring their shares entirely, or to be restricted to only being able to transfer shares to direct relatives or family trust.
Where the transfer of shares is permitted, the investment documentation will invariably contain a pre-emption procedure, requiring shares to be offered first to existing shareholders. In certain circumstances, an investor may require a right to nominate an “invitee”, such as a new employee, to have first right to acquire the shares. Even once the pre-emption procedure has been followed, the investor is likely to retain some level of veto over shares being transferred to third parties.
Exit Provisions
Equity investors are typically focused on the eventual exit from their investment (as the main means of realising a return on the funds they invest). Many equity funds stipulate that they expect an exit event to occur within five years of their initial investment, although there are an increasing number of funders willing to take a longer term view. An exit does not necessarily need to involve a sale to a trade competitor. Over recent years, “secondary” transactions, involving a larger equity fund buying out the incumbent investor, have become an increasingly popular exit route, with listing on AIM providing another alternative of providing investors with liquidity without requiring a change in management.
Typical investment terms will require the founders to alert the investor if they are approached by a prospective buyer or secondary investor. The investor may also require a right to appoint adviser to seek an exit after a certain period of time.
As a universal rule, institutional investor will not provide warranties on an exit, meaning that the founders alone will need to warrant the position of the company on a subsequent sale or investment.
Drag and Tag
“Drag and Tag” provisions are common in most equity investments. A Drag Along right allows a majority of shareholders to force a minority to sell to a third party purchaser, on the same terms as agreed between the third party and the majority. Certain investors will require a right to force a drag unilaterality after a certain period of time.
A Tag Along right provides minority shareholders with the right to “tag along” in any sale which would give a third party control of the company. Any investor with a minority stake is likely to insist on a tag along provision, so that they can participate in any sale agreed by the majority shareholders.
Anti-dilution
Anti-dilution provisions are a mechanism to protect investors in the event that the Company goes on to carry out a ‘down round’, a round at a lower valuation than the current round. The provision looks to award the investor with further shares to reflect the position they would have had had they originally invested at the lower valuation.
Leaver Provisions
The terms of most equity investments will require founders to sign up to leaver provisions, which will require the founders to put up the shares for sale should they leave the company in the future. This is typically one of the most negotiated aspects of an equity investment.
A typical approach is for a departing founder to be classified as either a Good Leaver (where he can be required to sell his shares for fair market value) or a Bad Leaver (where he can be forced to sell his shares for the price he paid for them (provided this is not higher than the current market value, in which case the lower figure will apply)). The line between Good and Bad leaver is often subject to extensive discussion between founders and investors. It is important to understand at an early stage the investors proposed approach to leaver provisions.
Step-in
Many investors will require “step-in” or “swamping” rights as a condition of their investment. Such rights give the investor an ability to take control of the company if certain default events occur (such as a breach by the founders of the investment documentation or an insolvency event).
For more information please contact Daniel Hayhurst or another member of the technology team.
If you haven't seen our North West Tech Funding report, this is available for download on our dedicated page on the Brabners website. We have also prepared a video around the report's findings which is available on our video hub.
