Contributed by: Samvad Partners
Congratulations! You just received a term sheet for an equity financing in your company. It is a short document (though not always so) brimming with legal and financial jargons. It looks daunting. How would you negotiate the document?
As a general thumb rule – focus your time and attention negotiating three or four high level issues that could have a significant impact on you and your company.
Broadly, some of these issues could be categorized in five buckets – valuation, corporate governance, economic rights, restrictions on transfer of securities and exit rights. Let us look at some of these issues below.
Company valuation
Valuation refers to the value of your company before the fund-raising. Valuation, however, is a nebulous concept and is often negotiable. This is especially true for early-stage companies raising financing.
Lower valuation of your company would effectively increase your cost of raising capital because of the dilution in your shareholding of the company. To a large extent – the outcome of any discussion on valuation would be driven by your knowledge of your company, the sector in which your company operates and the competition.
Early-stage companies that incur losses during the initial years of their operations would benefit by creating future projections of their valuations at or around the time when an investor is likely to exit. This could help push the valuation upward.
A key point often overlooked by founders is the creation of unusually large employee stock option pool in the fully diluted pre-money valuation of the company. This effectively dilutes only the founders’ shareholding in the company.
Economic rights
Liquidation preference
Liquidation preference clause comes into play when an investor exits the company on the occurrence of a liquidation event (liquidation event, among other things, includes winding-up or liquidation of the company and transfer of all or substantially all of the company assets and shares (by way of sale or merger)). It entitles an investor to receive an agreed return prior to and in preference to the founders and other equity shareholders of the company. This effectively helps an investor protect its capital in a low-return exit.
Without dwelling on the different types of liquidation preferences – in the Indian context – it is common to provide an investor with 1x non-participating liquidation preference. This effectively grants an investor the right to recover an amount equal to its invested capital on the occurrence of a liquidation event. Once the investor is paid-off, the remaining proceeds from the liquidation event can be distributed to the other shareholders of the company.
Founders should be wary of giving any other type of liquidation preference to investors (other than 1x non-participating liquidation preference).
Anti-dilution protection
This is another provision that has become ubiquitous in venture capital deals. Anti-dilution right protects the value of an investment when shares are issued by the company at a price per share that is lower than the price paid by an existing investor (also commonly referred to as ‘down-round’).
Anti-dilution protection is achieved by making an adjustment to the conversion price of preference shares held by investors – essentially, an investor will end up with a larger stake in the company to offset any economic loss pursuant to a down-round.
Nearly all venture capital term sheets (outliers apart) provide anti-dilution protection to investors on a broad-based weighted average basis. This methodology (expressed in the form of a formulae) considers the effect of a down-round based on the entire fully diluted share capital of the company (as opposed to a narrow-based weighted average valuation that excludes options and warrants resulting in a larger reduction to the conversion price).
If you see the words “narrow-based” weighted average anti-dilution protection or “full ratchet” in your term sheet – please do consult your lawyer. The latter is least favourable to the company and founders because the conversion price is adjusted to the price per share issued in the down round (on a Rupee-for-Rupee basis).
Corporate governance
Board composition
Venture capital investors often ask for a board seat based on their post-closing percentage holding in the company; however, founders must ensure they retain majority of the board seats on closing of the financing round. Board control is especially important in early-stage companies.
Early-stage companies often have a three-member board (two board seats held by founders and one board seat held by investor) or a five-member board (three board seats held by founders and two board seats held by investors). Founders retaining board control, however, becomes a challenge in growth-stage companies or companies that have received multiple rounds of financing.
In certain instances, both founders and investors hold equal number of board seats and agree to mutually appoint an independent director on the board to break deadlocks. Such independent director would be a person who does not hold any shares in the company and does not have any other interest in the company.
Affirmative voting rights
Certain actions, both at board and shareholders’ level, cannot be undertaken without the affirmative written consent of the venture capital investor. Again, this provision has become ubiquitous in venture capital deals; however, the scope and contours of this provision is negotiable.
Founders must endeavour to limit the list of affirmative voting matters to issues that directly affect an investor. Matters that tend to affect the operations of the company must be excluded (to the extent possible) or qualified with monetary thresholds to ensure day-to-day operations of the company is not hampered.
Restriction on transfer of securities
Reverse vesting of founder shares
In early-stage companies, investors often require founders to subject their shares to reverse vesting provisions (viz., founders must earn back their shares by continuing to remain in the employment of the company). This is designed to incentivize founders to stay back in the company.
The number of founder shares subject to reverse vesting and the vesting period itself, however, is negotiable. Founders can take credit for the time they have spent building the company and negotiate reducing the number of shares subject to reverse vesting or shorten the vesting period.
An important point often overlooked by founders is acceleration of vesting of their shares in the event of termination of employment without cause, death or disability or change in control.
Exit rights
Exit waterfall mechanism written into a term sheet requires the company and founders to provide an exit to investors often on a “best-effort” basis (as opposed to a binding legal obligation to provide such exit – you should be wary of such binding legal obligation). An exit, among other things, would depend on the market conditions at that point of time.
Another trap to avoid is accepting the right of an investor to exercise a put option on the founders (this could be written into your term sheet as another mode of exit in the exit waterfall). This creates personal liability for founders and is best avoided.
It is important that you carefully work through the terms in a term sheet to understand its ramifications for the founders, company, and management. Some of the other provisions in the term sheet such as information covenants, right of first refusal, co-sale right etc., are common; however, it is important to carefully examine the impact of these clauses. Many of these terms will inevitably get carried forward to future financing rounds.
Contributed by Samvad Partners
The above article has been authored by Mr. Siddharth Seshan(Partner) and Ms. Vineetha Stephen(Associate)
