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.
Valuation: Before and after
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
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
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
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