Term sheets present a high-level summary of the precise terms and conditions that will be detailed in the longform legal documents for an investment round. In this article, the first in a series focused on the key considerations for the founders of a company during the course of an early stage investment transaction, we consider what founders should be thinking about during the term sheet phase.
Although term sheets are largely speaking not legally binding documents (even once signed and dated), it is generally very difficult to deviate from the agreed terms listed in them. For example, if an agreement exists in a term sheet to give an investor a seat on the board of a company but during subsequent negotiations, the individual ceding the seat on the board changes their mind, it will be very difficult to convince that investor that they are not entitled to it, because the investor proceeded on the understanding that they would have all the rights listed in the signed term sheet.
Term sheet templates
Most deals follow similar principles, with a clear “market standard” in place. That allows the use of templates, which helps when comparing term sheets. The British Venture Capital Association (BVCA) has a set of model documents that broadly cover the most commonly used terms.
What influences terms?
Deals with investors are strongly influenced by how much competition there is. We are currently seeing many overseas investors investing in UK technology, chiefly for the diverse and ground-breaking innovation that is being generated but also because the current position of the pound creates exceptional value for money. This is accelerating competition between investors, which often allows UK tech founders the opportunity to negotiate better deals.
Some key terms founders should consider:
- Valuation – Founders ought to have an idea of their company’s valuation in advance of negotiations to ensure that not too much equity in the company is given away. That demands careful consideration of how much money they aim to raise, what they need it for, how long it will last and what milestones they are aiming to achieve. It is advantageous to raise enough money to avoid needing another funding round in a short space of time, but also to avoid raising too much money and end up giving away too big a piece of the pie. It’s a fine balancing act. Founders ought to bear in mind that the investor offering the most money does not necessarily mean they are offering the best deal.
- Founder restrictive covenants – these usually apply for the entire period founders are engaged by the Company and then up to one or two years after they leave. They are designed to protect the company and prevent founders from leaving to join a competitor or stealing any of the company’s customers, employees or key suppliers. It’s worth checking the terms are not unduly restrictive.
- Board control – investors often request a fund manager or representative on the board to have their say in key business decisions. It is worth considering their experience and value they may add to the company and how will that affect the composition of the board, w responsive and co-operative they are and whether they are likely to be a good personality fit.
We strongly recommend founders take legal and tax advice before signing a deal sheet, not just to check for major legal or tax issues, but to help plan practicalities and avoid unnecessary pitfalls that can be tricky to rectify.
In addition, as early as possible during the term sheet negotiation stage, the founders should check that an investor is aligned with their principles, objectives, culture and requirements. Beyond the honeymoon period, you will want an open and constructive relationship.
Clients with a tight legal budget often want to avoid legal expenses at this stage, but seeking lawyers’ advice on the term sheet before signing can help avoid delays and disruption later down the line and therefore provide cost savings.