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How to decode a term sheet

May 27 2013, 18:17   |   By Entrepreneur

By Sushanto Mitra

In the world of startup venture funding, a term sheet is a major milestone that founders look forward to but when they finally get the term sheet, most of them are disappointed. The primary reason for this is the misunderstanding of the role of venture funds. Venture funds, at the end of the day, are for-profit organizations who aim to get better returns than mutual funds and bank deposits by investing in high growth companies at an early and risky stage.

The basics
The way they try to mitigate risk is through domain knowledge of the industries they invest in and also by having special powers to change non-performing managements. Do keep in mind that venture funds need to return the capital to their investors in six-eight years time. Therefore, they will eventually want to either sell the company to larger players or in a rare event, list the company in the stock markets. Given the high risk of investments, only 10-20 percent of the investments return money to the funds, with a majority of companies either closing down or having no exits.

Valuation: Before and after
The most important thing that companies look at is the valuation figure. In ----early-stage companies, valuation is at best an inexact science, given the lack of market and financial track record of these companies. Usually, the valuation number is more of a function of what stake the venture fund would like to own in the company and the expected valuation at the next stage than anything else. Hence, if a company could potentially be valued at $20 million in the next round after two years, investors would only be okay with a valuation lower than $10 million valuation today so as to get a decent return. On the other hand, if investors wish to invest $1 million today and want to have a 25 percent stake in a startup company, they will offer a $4 million valuation post investment, which is the post-money valuation. The pre-money valuation in this case would be $4 million minus $1 million, that is $3 million. In other words, the pre-money valuation is what the investors have valued your company as it stands today prior to the investment while the post money is the valuation after adding what they have invested.

So if investors define a minimum ROI of 25 percent compounded annually and the original investment made four years ago was $1 million, then investors would want to get $1 million compounded at 25 percent per annum which turns out to be $2.44 million. So if your company is sold for $10 million today, only the balance $7.56 million, that is $10 million minus $2.44 million, is to be shared by the founders and the other shareholders. In case the company is sold at less than or equal to $2.44 million, the rest of the shareholders get no money back and the investor takes all the proceeds from the sale. This means that only if the company is sold for more than $2.44 million do the founders get any returns from the venture. If the company's sale fetches no money or leads to losses for the investor, there is no obligation on the part of the founders to make up the investor's losses.

Key terms: The tag and the drag
Ensure the investors are able to sell their shares to external buyers if a public listing is not possible. These include terms that ensure investors can sell their shares whenever the founders sell their shares. This is known as the tag along right. The drag along right is a right that many entrepreneurs frown upon. With this right, investors have an option to force the founders to sell their shares along with investor shares to a buyer of the company's shares. This right can typically be exercised after five to seven years from the investment where investors have not been able to exit their shares. From a VC point of view, they have an obligation to return the principal to their own investors within a period of time. They would also like to liquidate all their holdings before that date so as to be able to return the capital. By this clause, they hope to be able to sell their shares even if the management is unwilling to sell their own shares.

Similar to the drag along right is the liquidity preference that investors wish to have in the event the company is liquidated or sold. Here, most term sheets define a rate of return on the original amount invested in the company. If a company is sold or liquidated at $4 million and the original investment is of $1 million made four years ago, the term sheet may define a return of 25 percent per annum of $1 million which on compounded basis requires $2.44 million to be returned to the VCs. Later, the monies are available to you, the founders and the other shareholders.

The term sheet also includes certain management actions that require the assent of the venture funds. These include appointment of key executives, deviation from the agreed business plan, and capital expenditure beyond a certain level or starting a new line of business, among others. This is to make sure that the money the company has raised is used for its operations as agreed originally with the venture fund. If the company's performance nosedives, the fund can take corrective actions which may also include a change in management in some cases. This action is rarely taken as it is difficult to find a new capable team for a startup. The term sheet also has an exclusivity period during which the investors conduct a due diligence of the company's business with legal and accounting firms. This ensures that the company's assets and liabilities as presented to the investors is an objective picture of the company's status and also that there are no hidden liabilities or regulatory violations that the company may ave committed. The exclusivity period of 45-90 days is the period where the company agrees not to approach other investors for raising capital without the permission of the venture fund. This clause makes sure the company is not shopping for a better deal during the due diligence period.

Negotiate and verify
In practice, most venture funds are willing to look at some of the clauses where the entrepreneur has objections. The basic character of the term sheet is rarely changed and the entrepreneur has no other option but to live with them if they wish to raise money. Post the term sheet signing and due diligence, the venture fund and the company, along with the founders, sign a shareholders agreement defining in legal terms the arrangements.

These terms and conditions are the basic elements of the term sheet and are required customization for each company and situation. It may make sense to share your term sheet with your legal advisors or friends who have been through this process. Even if it takes time and money, it is best to fully understand the terms and their implications before signing. Taking legal help is always a good idea rather than to repent at leisure.

Views expressed here are not necessarily that of the organization

Sushanto Mitra is the Director at Hyderabad Angels

> Entrepreneur India April 2013
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