Investor rights. Guide to Term Sheets Part 3
This is the third article in a series of blog posts where I talk about the basic concepts of Term Sheet. You can read the other parts here:
1. Valuation, ESOP, Liquidation Preference, Dilution. Guide to Term Sheets
2. Shares, Protective Provisions, BoD. Guide to Terms Sheets, Part 2
3. Investor rights. Guide to Term Sheets, Part 3
In my previous posts, I described the main concepts of the economic and administrative characteristics of the Term Sheet. In this final article, I suggest discussing the conditions and rights that will help you reach your financing goals while maintaining healthy relationships with the investor.
Exclusivity clause
Often, a ban on negotiations with other investors (exclusivity clause) is added to the Term Sheet before the transaction is completed. This allows the investor to focus on a comprehensive due diligence, check documents, and prepare new ones without fear that they will have to enter a new round of negotiations, having already spent a lot of resources. But it is important to understand that there are bad investors who can take advantage of this condition and thus, on the contrary, bargain for better terms from the company. Such investor can wait indefinitely and not invest, whereas each day of delay is very critical for the company and both sides are well aware of this. Pay attention within the document to such phrases as “upon satisfactory completion of due diligence”, “upon approval by the investor’s Investment Committee”, or “wire transfer of funds from the LP to the Fund’s account “ — as they may serve as means for unfriendly manipulation. This is overall rare but still common practice.
Tip: Look carefully at the exclusivity terms (ban on competitive negotiations). It is important that it meets your expectations for the timing of receiving money. This is necessary so that you could have a “plan B” and can protect yourself from an unfair investor.
Information rights
Most often, the Term Sheet includes the right to access the company’s key metrics, financial & management reports, as well as financial plan. This is a required condition, since the business results can be evaluated just by these documents. However, you need to determine the frequency of reporting. Most of our portfolio companies send us reports at least once per quarter, while some of the most responsible ones on a monthly basis.
Tip: don’t treat an investor as a malicious inspector who will punish for any misdeed. An investor is a partner. Therefore, it is important to build a transparent management and financial structure. If the company is not ready for this, then you need to think about whether it needs a third-party investor at all.
Preemptive rights
The preemptive purchase right is the investor’s right to pre-emptively purchase shares in the next financing round. In this regard, it is important to discuss two things during negotiations: 1) how much shares the investor should have in order for such right to be granted (typically granted to majority shareholders) 2) how much shares should be offered to the investor (usually as a proportion to the current share ownership, which allows the majority investor not to lose other rights that depend on the percentage of ownership).
Tip: if you plan to become a genuine partner with an investor and assume that your cooperation will last long, then this right will be useful to you. You should also keep in mind the right of first refusal (ROFR): if one of the shareholders wants to sell their shares, they must first offer to buy their shares to the current shareholders, and not to third-party investors or companies. This right is convenient for everyone, as it is a protective mechanism against unfriendly acquisitions.
Drag-along rights
This clause in Term Sheet may have the following wording: “Until the time of Qualified placement, if the Investor, together with any other shareholders who jointly hold more than X% of the voting power, intend to sell all or part of their shares in the Company in good faith and on commercially advantageous terms at any time, may require other shareholders to sell all or part of their shares, as determined by the Investor at the price per share, and on terms similar to the price and conditions offered to the Investor.”
If the majority of shareholders want to sell the business on commercially favorable terms and, in addition, find a buyer, the minority should not object. The law protects the majority owners of shares from possible unfriendly actions of minority shareholders.
Tip: you should pay attention to the percentage of voting power and the mechanism for determining the “good faith” of the transaction.
Tag-along right
This right is the reverse of the previous one. May be written as follows: “until a Qualified placement, the Investor has the right to join the sale of shares by founders of the Company in proportion to his/her number of shares by price per share and on terms the same price and terms offered by the selling shareholder»
This mechanism protects minority shareholders. When the majority sells their shares, minority can join the sale under the same conditions.
Tip: these are the standard rights and you should not be afraid of them. It is only important to check whether everything is described correctly. It’s recommended to show them to the lawyers.
Dividends
For most venture investors dividends are not the major source of income, given that in most VC-backed companies all profits are reinvested into growth. Usually dividends clause serve just as an additional point for negotiations as they are a “nice bonus for the investor” in the case of a sale of the company.
The standard wording may be as follows: “the holder of preference shares is entitled to receive (non-)cumulative dividends in priority over the ordinary share holders calculated as the amount of X% of the purchase price annually. Also, holders of preferred shares must participate in any distribution of dividends on ordinary shares, in proportion to the number of shares they receive as a result of conversion” — X usually ranges between 5 and 15 percent.
How does this work in practice? Let’s imagine the company gets $1 million investment, and the rate is 5%. Let’s say the company grew 10 times in 5 years. Then when selling the company the investor should get:
1,000,000*10 + 1,000,000*0.05*5 = $10,250,000 which means an additional $250,000.
Tip: this clause should not become a deal breaker. However, the only point that should definitely be fixed is the approval of the dividends pay out by a majority vote of the Board of Directors.
The list of Term Sheet clauses can be continued, but as of now we’ve covered all the major ones. It is important to understand that each investment transaction is always individual. However, the universal rules says the more clauses you discuss before signing, the lower the probability of misunderstandings, disputes and unpleasant conversations you’ll get in the future.
We are super keen to hear your comments, feedback or any questions.
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