At Almax, we have reviewed and negotiated many term sheets on behalf of our clients. Term sheets are the first major step in a financing transaction and where material terms of the deal are negotiated. It defines the parameters and conditions between the investor and the investee. The term sheet reflects so much more than simply the scale of the investment and valuation of the target. It dictates much of the structure of an investment and the ongoing involvement of a funder. This can be a point of fierce negotiation, so it is important that you go in prepared fully prepped and understand the parameters to which you are likely to accept investment. It is also important – where possible – to build competitive tension in the process as this will give more data points on the market expectations regarding your valuation in particular. Please note: It is paramount to seek the advice of the solicitor or legal aid to ensure that you have that cover.
So, what to be aware of?
Preferred stock is a different class of equity that has a higher payment priority than common shareholders (i.e. founders). These shares can have unique terms and conditions that do not apply to other classed shareholders. Importantly, preferred stock sits above common stock in the debtor hierarchy, so holders enjoy the benefit of having their money returned before other stockholders. This is a forgotten formality if all goes well but when distressed, it makes a material difference.
Liquidation preference determines the magnitude of the pay out that an investor can receive upon a liquidation event, before other shareholders. As the name implies, liquidation preferences determine the hierarchy of returns upon a liquidation event, such as a sale of your company. Liquidation preferences allow investors to define the initial magnitude that they are guaranteed as a pay out. It is important to fully understand this as it will impact your returns.
Participation rights are inserted to determine investors’ pay out after their liquidation preference is fulfilled. Non-participation is the most founder-friendly option as it forces the investor to choose between its liquidation preference or its pro-rata share of the business. If participating preference stock is issued, the investor receives opportunities for further upside after their liquidation rights have been fulfilled. Participation can be Full Participation (investor first receives their liquidation preference and then a pro-rata share of any remaining proceeds), Capped Participation (participation rights are capped at a defined multiple) and Non-Participating (investor must choose between their straight liquidation preference or a pro-rata share of all proceeds). This is a vital clause that determines the share of economic proceeds.
Dividends are shares of profits that are paid out periodically and most commonly associated with blue-chip stocks such as Vodafone. A key characteristic of preferred stock is that it contains a fixed dividend percentage. Discretionary stocks are most founder-friendly i.e. you choose when to pay out dividends. The other forms fixed and cumulative give you less control on this matter and can favour the investor.
Anti-dilution clauses protect investors from their ownership percentages being diluted if the company value falls. This acts as a contingency for the investor to mitigate lower valuations in the future.
We have taken a look at only five key clauses – every term sheet is different and also largely depends on the investment e.g. stage of the company or project finance vs. venture capital, therefore (we repeat) always seek advice when reviewing a term sheet.