Lifecycle of a Business - Demystifyng the Term Sheet
Setting up and running your own business is an amazing achievement. It requires vision, creativity, motivation and stamina. On occasion, it can even bring you fame, riches and fortune. But it can also result in reams of paperwork and cause sleepless nights. And as someone once said to me about children “It doesn’t get easier, it just changes”, so the same can be said for your business throughout its lifecycle. From setting up to exit, it will force you to consider issues that you might not previously have known anything about and it will need you to make many decisions, sometimes very quickly. What it certainly is not is mundane.
With this in mind, the corporate team at Forsters, together with some of our specialist colleagues, has written a series of articles about the various issues and some of the key points that it may help you to know about at each stage of a business’s life. Not all of these will be relevant to you or your business endeavours, but we hope that you will find at least some of these guides interesting and useful, whether you just have the glimmer of an idea, are a start-up, a well-established enterprise or are considering your exit options. Do feel free to drop us a line or pick up the phone if you would like to discuss any of the issues raised further.
So far, we’ve covered “First Things First” and “Directors: Lights, Camera, Action!” But now, let’s consider financing your business – “Show Me The Money”.
Demystifyng the Term Sheet
You’ve considered your fundraising options, have all your records and documents in place and have an investor in mind, so now it’s time to consider the term sheet.
Your term sheet sets out the fundamental terms of the commercial deal you have struck with your investor(s). Getting it in a shape that everyone is happy with will make for a much smoother execution of your funding round, allowing it to take less time so that you can get back to growing your business.
If you’re bootstrapping your way to an early round of funding, you may think twice about reaching out to an advisor to discuss your term sheet, perhaps wanting to hold off until it’s agreed commercially. I would, however, encourage you to reach out for an initial discussion before signing up to your term sheet, even if just for another perspective on what you’re signing up for.
So, what should a term sheet include?
Valuation
The valuation will set out how much of the equity is being given to the investor(s).
The term sheet may reference the “pre-money” value, being the amount the company is valued at before the funding round closes, and the “post-money” valuation, being the company’s value after (and including) the funding.
Whatever terminology is used, it’s important to understand what you’re agreeing to give to the investor, and whether this is on the basis of the issued share capital or the fully diluted share capital (such that the term sheet may say they’re receiving 10%, but actually, on an issued basis the investor may have more, having factored in the dilutive effects of convertible instruments such as options and warrants).
Option Pool
While the detailed terms of the incentive plan may come later after closing an early round of funding, the term sheet will often set out the percentage option pool to be made available to incentivise key staff. Founders should note how this percentage is calculated (will it dilute everybody or not?).
Investor Shares
The class of shares which investors will receive should have their key rights set out. Is everyone investing for ordinary shares, or will the investors receive preference shares with specific rights?
Preference shares in this context will typically have voting rights and have a priority return over the ordinary shares on a liquidation / exit event. If applicable, the term sheet should set out this priority return (known as a ‘liquidation preference’). It’s customary for investors of preference shares to have a 1* preference, meaning that they receive their investment back first. That said, in recent turbulent markets, there are instances of investors looking for more than this.
Whether they then participate or not in the balance of any proceeds should also be set out, noting that if they are non-participating (as is common), such that they only receive their liquidation preference, they will likely be convertible or entitled to the amount they’d receive had they been ordinary shares (therefore the preference affords the investor a downside protection).
Anti-Dilution
Investors often seek anti-dilution rights, which may include a ratchet such that, if there is a ‘down round’ in the future, the investors are issued more shares in line with that ratchet. Founders should ensure that the term sheet sets out the applicable type of ratchet, and that they understand what it means.
It's customary for the ratchet to be what is known as a broad based weighted average ratchet.
Founder Vesting
Investors will expect to see good leaver and bad leaver concepts with a vesting schedule for shares held by founders setting out a founder’s entitlement if the founder leaves the company. We would encourage founders to discuss expectations here with the investors early to ensure alignment.
Board Composition
Including who will have a board seat and against what threshold is common. Boards are typically founder-led in their early stages with more board control given up in follow-on rounds as new investors come in and as independent directors are added.
Veto Rights
Investors will typically expect to have a set of investor veto matters, for which a percentage of the investor pool has to vote in favour for the company to action the matter. There may be shareholder matters and also investor director consent matters.
Founders may also wish to seek founder consent matters, although this is not always acceptable to investors.
Warranties
While the detail of the warranties (contractual promises to investors, e.g. that you’re not currently involved in any litigation) will be in the long form documents, we would encourage founders to consider who will be giving warranties and agree this and the overall liability cap upfront with their investors. Previously, founders often had to give warranties by reference to a salary multiple, however more recently the market has moved to having only the issuing company provide the warranties.
Share Transfers
The term sheet should include reference to certain share transfer matters, to the extent they are to apply. For example, pre-emption rights (and who they are for, e.g. everyone or certain investors), drag along rights and tag along rights (and what threshold triggers these rights) and co-sale rights.
Information Rights
While investors may be represented on the board, they will typically expect to have contractual information rights to enhance the limited information a shareholder in a UK company is typically entitled to see. Setting out what investors will receive, and whether this is for all investors or for those that hold a certain percentage of the equity, will allow you to be aware of the administrative burden of complying with this moving forwards.
SEIS / EIS Tax Reliefs
If the round is going to be raising money from investors looking to obtain SEIS/EIS relief this should be acknowledged, and the founders should take advice on what this is likely to mean in terms of structuring and process for them and what the investors may expect.
For more information about these tax reliefs, see here.
Finally, it’s worth being aware that the majority of the term sheet is typically not legally binding, although it may contain certain parts which are, for example, provisions relating to confidentiality and, if you’ve agreed this with your investor(s), exclusivity for a period of time.
Please get in touch if you would like to talk about your funding round and how we can team up to achieve your objectives.
Disclaimer
This note reflects the law as at 30 November 2023. The circumstances of each case vary and this note should not be relied upon in place of specific legal advice.