Negotiating Term Sheets
One of the hardest things for a start-up company is the process of bringing in new external investors. One of the main reasons for this is that the company is often at a severe negotiating disadvantage compared with the investor, who has usually made many other investments and understands the process. A start-up company, on the other hand, may have never had to go through the process before.
A start-up presented with a term sheet has no idea of whether the document is fair or not. In addition, many start-ups are desperate for money and therefore are not in a strong position to ask for changes to the term sheet. Consequently they think they have no option but to accept the investor’s terms. And that can be a recipe for disaster.
It almost goes without saying that a start-up company should not be desperate for money when seeking investment. Instead the company should plan well in advance of its need for funds, as this alone will enable the company to turn down potential investors whose terms are too avaricious and choose someone whose terms are better balanced and fairer.
Being “investment ready” is an important prerequisite for a start-up company. The company’s house needs to be in order in every respect, so that an investor’s due diligence review can be a quick and straight-forward exercise, nd there is no scope for the investor to reduce his valuation of the company or the asking price.
Apart from having good financial accounts, the company’s statutory records need to be accurate and up-to-date. The ownership of the company’s ideas and intellectual property also needs to be watertight. This means ensuring that no employees, shareholders or contractors (past or present) have any claim on the company’s IP. For example, any ideas created before a company’s incorporation will automatically belong to the creator and will need to be transferred to the company in writing. Waivers and releases of claims from employees and third party may also be needed. Obviously it will be cheaper to get waivers from current employees and contractors. It is not surprising that former employees often ask for payment in return for signing a waiver or release.
The start-up also needs to be confident of the strength of its business proposition. If it has a new idea, it needs to be able to prove to an investor that: (1) the idea really is novel and not just a copy of someone else’s idea; (2) it has never been done before (or if it has, the new way has a better chance of commercial success); and (3) it does not infringe anyone else’s patent (or if there is a challenge, it can be countered with evidence of prior art that is strong enough to defeat that patent). More on this subject can be found in my article, Some thoughts on investing in start-up companies.
With a comprehensive report showing the strength of its intellectual property and competitive position, the start-up will be better able to negotiate with an investor. And instead of being desperate for money, the start-up will be able to show that its business is a worthwhile investment with a reduced risk of failure.
All this means that, when a term sheet is presented (and it is nearly always happens that it is the investor rather than the start-up that prepares the first draft), the start-up will be better able to negotiate terms.
As for the term sheet itself, a common version in use in New Zealand is the one approved by the New Zealand Investment Fund for use where its Seed Co-investment Fund (SCIF) invests with members of the investment angel community. Simmonds Stewart have published a series of blogs in which they discuss SCIF term sheets (see http://simmondsstewart.com/blog/), all of which I agree with.
I would add that the SCIF term sheet, with its onerous, investor-oriented provisions, seems to reflect every bad deal ever done by any investor in the past.
Even if the SCIF term sheet is modified as suggested by Simmonds Stewart, my view is that it will remain biased heavily in favour of the investor with respect to the following provisions:
- Not binding: The term sheet is expressed to be “not legally binding … and there will be no obligation to issue or subscribe for shares in the Company until a binding investment agreement is signed by the parties”. This gives the start-up no confidence at all that a deal will be done, as the investor can walk away at any time. The term sheet should only be conditional on the investment agreement being signed. In addition all parties, including the investor, should be obliged to negotiate the formal agreement in good faith.
- Conditions: The SCIF term sheet contains a host of conditions that need to be satisfied before investors are committed to putting their money in. Some conditions are reasonable, while others are unnecessary, especially if the company has already taken all of the steps referred to above to become investment ready”.
- Anti-dilution: Simmonds Stewart have discussed the anti-dilution clauses that appear in the SCIF term sheet. I agree that these clauses should apply only for a limited period where the company subsequently issues shares (other than employee shares) at a price lower than that paid by the investor. Of course, if the start-up has a report showing a strong IP and competitive position, this will justify a strong company valuation and reduce the investor’s ability to negotiate a lower issue price.
- Directors: I have commented in another article (Constitutions for Start-Up Companies) on how the board of a start-up company should be structured, especially with regard to independent directors.
- Protective provisions: The “Protective provisions” listed in the SCIF term sheet are designed to give the investor a power of veto and substantially alter the balance of power in the start-up company, at both board and shareholder level. My personal view is that an investor’s voting power should be purely proportionate to his shareholding, in which case there should be no need at all for the protective provisions. Again, if the start-up is properly investment ready and has a strong IP and competitive position, the investor’s position need not be any different from that of the founders.
- Drag-along rights: In my article, Constitutions for Start-Up Companies, I commented on drag-along and tag-along rights. As a matter of principle, I see no need for them, as the pre-emptive rights procedure in the constitution has stood the test of time. If an investor wishes to sell his shares, he can offer them for sale under that procedure. In no circumstances should an investor have the sole right to force a sale of the company, if for no other reason than that the investor’s rationale for a sale is likely to be totally different from that of the founders. For example, an investor may be prepared to sell his shares at a loss if it frees up cash for another investment. In any event, I have only ever seen drag-along rights applied twice in my 30 years of legal practice. And I have never seen tag-along or “co-sale” rights used at all.
- Employee escrow: My article, Constitutions for Start-Up Companies, also briefly addresses the “key person escrow” provisions. Following the principle that every person’s shares should have the same weight and value, a founder should not be prevented from selling his shares any more than the investor should be prevented. If the investor thinks the start-up’s business is good, he should invest on the same terms as the founder. If, despite this, sale restrictions must apply, they should (a) apply to the investor as well and (b) be able to be removed by a vote of all directors and without the investor having a power of veto.
- Exclusivity: A prospective investor should not have an exclusive dealing period within which to negotiate a deal, as this will seriously compromise the start-up’s ability to negotiate. In any case, if the start-up really does have a solid IP and competitive position, it should be free to go through a competitive bidding process.
In summary, a start-up company needs to be investment ready well before it needs someone else’s money. It should start by getting its house in order and commissioning a report on its IP and competitive position so that, when a term sheet is presented, the start-up is in a strong position to negotiate fair investment terms.