In the last article of this series, we discussed certain basic aspects to be kept in mind by founders in their run up to the first funding round. The immediate next objective would be to get a term sheet. Being offered a term sheet from a VC fund is no small feat. Till such time, all that the founders had been discussing with the VC fund was money – the amount of funding the startup needs and the possible valuation of the startup. But the term sheet comes with certain other terms and conditions – what are those terms and conditions?
Before we dive into the terms and conditions of a term sheet, it is essential to understand the timelines and strategy to deal with a term sheet. Most VC funds may imply to founders that the term sheet is a ‘take it or leave it’ offer. Is that correct? – usually not. Also, likely that the VC funds will expect the founders to execute the term sheet within a day. Will the founders not be given time to go back and check with their in-house and external teams? – certainly. But, keep in mind, the sooner the founders sign it, the better.
Term sheet – the halfway mark
A term sheet contains indicative set of terms and conditions on which a VC fund intends to invest into a startup company. Getting an offer from a VC fund in the form of a term sheet is a major milestone achieved by founders. Many first-time founders do not realize that each VC fund has to follow their own set of internal compliances, approvals etc., before rolling out a term sheet to an investee company. It is only in very rare instances, owing to some major concerns, that VC funds will walk away from a deal after the term sheet is signed. In that sense, getting a term sheet signed is halfway through for the founders. It signifies that the investors are keen to participate in the startup’s business and its product/service. That is also why it is important that founders conclude negotiations and sign the term sheet at the earliest.
Signing the term sheet
In some instances, founders get overwhelmed on receiving a term sheet from a VC fund and end up signing the dotted line without understanding its implications. The term sheet sets the groundwork for the broad principles that will form the basis of the first round of agreements that founders will sign. Founders will do well to realize that the first round of documents also forms the starting point for every subsequent round of negotiations for future funding rounds. Founders’ ability to negotiate is dependent on various factors such as – the amount of interest the investors have garnered in the company’s product/services, the size of the round, the market standard vis-à-vis the ticket size, other co-investors and their asks etc. That said, most term sheets in India are standard and barring certain key provisions it should not be controversial.
Understanding the term sheet
Founders should clearly understand the commercials that have been agreed and the basis on which investments are being made. It is also useful to remember that most VC funds would have made multiple investments already in other start-ups. They are also aware that there is broadly an acceptable market standard for most provisions. So, even if the starting position on some provisions may be a bit aggressive, founders will have the leeway to push back towards more market standard provisions.
Understanding market standards
It is important to gather a generic understanding on the customary provisions in the market. The market standard for each funding round is different. Rights that can be claimed in a Series C round may not be possible in a Series A round. Merely because some other startup or founder has got some special rights does not mean that every startup or founder can claim them. The risk position for the VC fund is higher in the early rounds. As the startup grows and builds its value, the initial investors get de-risked. To that extent founders need to build in better protections for themselves in future rounds, as the business grows in value.
Key provisions of the term sheet
Keeping the above in mind, apart from certain standard provisions (such as jurisdiction, exclusivity and confidentiality), all other terms in a term sheet are legally non-binding. Generally, in the first round, the ability to negotiate may be limited. Therefore, choose your battles – the founders should only put up material points for negotiation at the term sheet stage and leave the details to be discussed in the definitive agreements. To give you a bird’s eye view, some of the material points which the founders should review thoroughly are liquidation preference, governance rights, founders’ liabilities and restrictions and exit obligations. While it is important to keep the provisions in the term sheet at a conceptual level, the founders should not agree to something in the term sheet on the assumption that it can be reversed during negotiation of the definitive agreements. It is not unheard of for investors to accommodate any deviations from the term sheet if there are genuine concerns. But it is always an uphill task to reverse or materially deviate from a position agreed in the term sheet.
Founders need to balance their interests but at the same time ensure that they get the term sheet signed at the earliest. A prior understanding of the various terms and market standards on some concepts would help them in achieving this balance. In the subsequent parts of this series, we will touch upon each of the terms, their meanings, key negotiation points, the agreed market standard with respect to each provision and the ideal balanced outcome.
Arun Mohanty | Principal Associate, Veyrah Law; Ajay Joseph | Partner, Veyrah Law
Views expressed above are for information purposes only and should not be considered as a formal legal opinion or advice on any subject matter therein.