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November 23, 2020
4 min read
Once an investment opportunity is analyzed, negotiations is an important next phase in many private M&A transactions. A term sheet is created precisely for this purpose. It contains the material terms and conditions of the agreement. Although the term sheet is non-binding in practice, it acts as a starting point for both parties to discuss and eventually, agree to. Here are the most important items of a term sheet:¹
¹Sources: US National Venture Capital Association, Harvard Business School
Type of Financing
Startup founders do not always offer common equity as the investment instrument for venture capital investors. Here are other widely-used instruments:
Notes and Other Credit Facilities are debt arrangements that guarantee payments based on a fixed interest rate, and which take precedence over equity. Convertible notes are a form of interest-bearing debt that allows the investor to convert the instrument into equity sometime in the future and upon satisfying predetermined and negotiated conditions.
Simple Agreement for Future Equity (SAFE) Notes allows for seed investments without interest rates or maturity dates. Like an option or warrant, it allows the investor to buy shares in a future round.
Preferred shares are a form of equity ownership with a fixed dividend rate. Deals of this kind typically specify participation and cumulative features. In early-stage financing, preferred shares usually come with a conversion feature into a fixed number of ordinary shares upon the fulfillment of certain conditions.
Valuation is an important consideration not only to fix the price, but for investors to determine their ownership interests after the investment.
Pre-Money Valuation is the monetary value of the company prior to investment. The most common methods used in startup valuation include (1) market multiples such as the standard earnings multiple method, (2) discounted cash flow, (3) cost-to-duplicate, and (4) comparables.
Post-Money Valuation, on the other hand, is the sum of the pre-money valuation and the amount invested. Thus, if a startup company has a pre-money value of $1,000,000 and it received investments of $250,000, then it
will have a post-money value of $1,250,000.
Other terminologies include up, down, and flat rounds, which are all used to compare the value of the current financing round relative to the previous round. For example, a flat round means that the shares issued at the current financing round are at the same valuation as the previous round.
Rights and Provisions
Here are some of the most commonly discussed clauses in term sheets.
Pre-emptive Rights or Right of First Refusal are rights of investors who hitherto hold at least a specified number of shares to purchase a company’s new shares before they are offered to other investors. In other words, they protect investors from reductions in ownership interests.
Management and Information Rights is a stipulation, typically in the form of a letter issued by the company to the investors, that may include the following: for the company to provide investors with access to certain information (e.g. budgets and financials), for the investor to be allowed to advise or consult the company, and for the company to meet with investors throughoutthe year.
Reserved Matters lists special matters that require approvals from key persons like the Board of Directors or investors before founders or management act on a decision. These typically allude to (i) altering the rights attached to investors’ shares, (ii) involving material capital or operational expenditures, or (iii) changing the nature of the business. On the other hand, Protective Provisions grant investors the right to block or veto certain company decisions.
Anti-Dilution Provisions are clauses designed to protect preferred shareholders from down rounds, or later issuances of stock at a lower price than the preferred issue price. Typically, price is adjusted when preferred shares convert into common shares.
While this article covers a few basic terms, it is important to evaluate M&A transactions on a case-to-case basis and to take a tailored approach to negotiating deal terms. For startup founders, terms must align with the capital requirements and partner needs of the company. For investors, terms must be negotiated hand-in-hand with concerns arising from due diligence. Other globally-accepted practices can be found in online resources such as the US NVCA Venture Capital Resources website.
Moreover, negotiating deals in an economic crisis such as the current COVID-19 environment requires some adjustments. Changes in revenue projections, timelines, and crisis management are just some considerations that may have important implications on the negotiation process. For such considerations, Golden Gate Ventures and Cooley LLP reminds founders and investors alike to (i) acknowledge how COVID-19 affects the business, (ii) prepare detailed financial forecasts under different scenarios, and (iii) work hand-in-hand through different contingency plans.
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