In our previous blog, we discussed the different methods of raising finance for start-ups and scale-ups. But, what happens after a potential investor has been identified?
Before the investor funds the target company, the investor and founder will negotiate a term sheet. This is a document which sets out the key terms of the potential investment. This article examines common provisions included in investment term sheets and considers what positions are "market standard" for venture deals.
Where an investor has the benefit of a liquidation preference, if proceeds from a sale or winding up of the company are being distributed to shareholders, that investor has the right to receive a distribution of the amount that it has invested (or a multiple of that sum) before the other shareholders receive their share of those proceeds.
Non-participating preferences are the most common form of liquidation preference. These entitle investors to receive a set amount (most typically an amount equal to their aggregate investment amount (a 1X liquidation preference)) on a sale or winding up. However, having received distributions equal to its preference amount an investor with the benefit of a non-participating liquidation preference will not be entitled to participate in distribution of any remaining proceeds. This type of liquidation preference offers downside protection to the investor, but does not impact upside returns.
The upside is in the conversion. Shares carrying a liquidation preference are often convertible meaning that if the investor would receive a greater return on an exit if they held ordinary shares, they can elect to convert their preferred shares into ordinary shares immediately before the relevant exit, and receive their pro-rata share of the proceeds.
It is not unusual for an investor to request a seat on the board as an "investor director". The rights of investor directors (including investor director veto rights) are likely to require renegotiation as the company grows, but it is often sensible to tie the right to appoint a director to the relevant investor maintaining a minimum percentage of the equity.
Where there are multiple investors in a transaction, investors may rely on a "lead investor director" to represent their interests at board level.
Deal fees, such as legal fees, are usually passed onto the company by investors. These typically amount to 1-2% of the investment. An investee company should try and insert a cap to deal fees in the term sheet.
Founder vesting relates to the period for which founders must wait before they fully ‘own’ their shares. The shares ‘vest’ over a pre agreed schedule and, if a founder leaves the business before the end of that period, a proportion of that founder’s shares will be capable of being acquired (often at a discount to market value). The purpose of this is to incentivise the founders to remain with the company for a minimum period of time – if the founder leaves before their shares have vested, the unvested shares can be acquired at a discount and used to attract a replacement.
The vesting schedule, the value payable on a compulsory transfer (including the Good and Bad Leaver categories that determine what value founders will receive) and triggers for acceleration of vesting all go to value and are likely to be key areas for negotiation in a term sheet.
Share option schemes
Many investors will expect founders to offer share option schemes to incentivise their employees. Such schemes allow participants the option to acquire shares in the company at a later date and at a pre-approved price for the purpose of attracting and retaining the best talent. A reserve for share options of 5-10% of equity is fairly standard.
Investors will also be interested in whether share options dilute only existing shareholders and so form part of the pre-money valuation (the value of the company prior to the investment) or dilute both existing shareholders and incoming investors and so form part of the post-money valuation (the value of the company after investment).
There is not a "standard" position in respect of dilution of the option pool; however, this an element that would likely be covered off in the term sheet.
There are a number of different types of share option schemes available to companies, but the most tax advantageous for employees is an Enterprise Management Incentive Scheme (EMI Scheme). Provided the strict requirements are complied with, options issued under an EMI Scheme are not subject to income tax or national insurance payments, and only capital gains tax is payable by the employees on the sale of the shares arising from the exercise of the options.
Exclusivity is another key element of a term sheet – this sets out the period for which the parties agree to stop all conversations with other potential investors in relation to the transaction. An exclusivity period of 4 weeks may be expected by the investor however some investors may demand a longer period.
Right of first refusal
Investors may propose they be granted with pre-emption rights over shares in order to protect against the issue of new shares which may dilute their shareholding as well as the transfer of shares to third parties. Whether this is required will depend on the circumstances of the transaction.
Investors may ask for anti-dilution protection to provide them with additional downside protection. An anti-dilution mechanism works to compensate an investor who invested at a higher price per share than the price of a future fundraising round, i.e. a 'down round'. In the UK such compensation is usually in the form of 'bonus shares' issued to the original investor to increase that original investor's shareholding to offset the dilutive effect of the down round. The alternative, more common in the US, is to change the conversion ratio at which preference shares are capable of converting into ordinary shares. The method of calculating the number of bonus shares or adjustment of the conversion ratio is normally either a 'broad-based weighted average' or a 'full ratchet', with the former being the most common and less dilutive to founders.