Preparing Term Sheets: What is current market practice?
Investors and founders are typically concerned with three key areas when preparing term sheets: (1) valuation and investment terms, (2) transaction specific conditions and diligence and (3) who gets control.
Preparing a term sheet can tease out each party’s respective position and, once negotiated, should record the balancing point the investor and the founder strike.
Of course, as to where the balance lies is down to market conditions, an investor’s own appetite for risk and the strengths and weaknesses of the target company.
That said, trends inevitably emerge and this short note seek to build on this helpful report published Mountside Ventures on the state of affairs in 2022.
What is market standard in 2022?
- Ordinary Shares v Preferred Shares: If investors want to retain the tax benefits of EIS (Enterprise Investment Scheme) then they will have to settle for ordinary shares, which will rank equally with all other shares.
Alternatively, if EIS is irrelevant to an investor (say, because it is non-UK or is a non-EIS VC fund) then most of the time, that investor will want its shares to have preferred rights. These might be enhanced voting rights or anti-dilution protection on a later funding round at a lower valuation. However, the most commonly sought preferred right is a liquidation preference.
On a Series A funding round, most investors seem to be prepared to settle for a ‘non-participating’ preference right, which entitles them to receive their return first on a sale or a winding up of the company. A minority of investors go further and ask for a participating preference – also called ‘double dipping’ – under which the investor not only gets its investment back first, but also its pro rata share of the surplus. Double dipping is less common than it used to be.
- Deal Fees: Legal fees tend to be 1 or 2% of the investment. In most cases, the investor’s legal fees are charged to the target and netted off the investment.
- Board Representation: The extent to which investors ask for board representation depends on what stage the target company is at. Board seats are generally required at Series A. They are preferred for Seed or Series B.
At an earlier stage, a list of reserved matters may be used instead of directorship as this affords investors a veto right, and indirectly, therefore, a degree of control.
- Founder vesting: Founder vesting is a common feature of VC investment. The principle is that a founder’s full equity share will build up (or vest) over a minimum commitment period, commonly 3 or 4 years. If the founder leaves the business during the commitment period, they lose the unvested portion of their equity share.
Investor terms vary on founder vesting, but the most common period is that founder shares vest monthly over 4 years. Some investors allow a percentage of founder shares (often 25%) to vest on day 1, others on the first anniversary of the investment.
This mechanism is used to motivate founders to stay involved in the business. The vesting period, frequency and percentage of shares subject to vesting are all open for negotiation. Another important consideration is whether there are (or should be) “good” and “bad” leaver provisions as these will affect the price at which any repurchased shares are bought back.
- Share Options: Share options 5-10% option pool.
Options are a great way to incentivise staff. The report notes there is no standard position on whether the new option pool dilutes the existing shareholders only or also the incoming investors. However, more investor-friendly term sheets will ask that the options are allocated only to pre-money shareholders (i.e. they will not dilute the new investor).
- Right of First Refusal (ROFR): To protect against dilution, investors will usually require a right to participate pro rata in any future equity fundraising (a so called ‘pay to play’ right or right of first refusal).
- Growth shares: Growth shares are granted to employees and enable them to participate in a release of value above a certain threshold amount (usually called a ‘hurdle’). Growth shares are not that common but are used where a company’s business does not allow it to qualify for off the peg share option schemes, such as EMI.
- Founder warranties: Investors will almost always require founders to give key warranties about the business: e.g. level of debt, ownership of intellectual property, company not subject to any litigation.
- Equity ratchets: Equity ratchets broadly serve one of two purposes: to protect against investor dilution, or as a performance incentive for the founders/management team. In the first case, a ratchet is a mechanism to maintain an investors percentage shareholding if the company carries out a later fundraising at a lower valuation. These are less common than they used to be. In the second case, a performance ratchet increases founder/management equity if certain milestones are hit. These performance ratchets are quite common.
- Tranche Funding: Investors may not want to invest all funds at once. Accordingly, it may be that funds are advanced over a certain period or when the target company achieves certain milestones.
- Environment: ESG or sustainability clauses are generally not being included at this stage but over time we expect this to change.
The report says typically 8-12 weeks. However, this is perhaps misleading as there are many factors which will affect the time scales – how many investors are there, how ready is the target, raise amount, time of year, is there a term sheet etc.
Legally binding or not?
The following tend to be legally binding:
- Confidentiality provisions: A target company will likely be revealing commercially sensitive information to the investors and it should insist that it is kept entirely confidential. If the term sheet does not state that this is legally binding, you should ask for an NDA.
- Exclusivity: Investors may ask for exclusivity so that they can conduct their transaction due diligence. This is generally reasonable as investors will be dedicating significant resources to the deal and will want some protection again the founder speaking with other potential investors. The report notes that the exclusivity term is normally around one month. We echo this view and would flag that this need not be set in stone and if a delay is caused by something beyond the control of either party, the exclusivity period can easily be extended.
- Fees: as noted above sometimes investors’ fees are covered, but other times each party pays their own costs.
The other practical point to consider is whether there are any management fees. The report notes the following in terms of the different types of investors:
- Angel Networks: 5-10%
- VC Funds: N/A for Target.
- EIS/VCT Funds: Arrangement Fees (1 – 4%) and an annual fee of 2% for up to 3 or 4 years.
- Crowdfunding: 6 – 8% plus maybe 2%.
- Venture Debt: 1 – 3% of the loan plus interest.
Take a read of the presentation if you want to learn more or do reach out if you would to discuss a term sheet or any questions you may have on your investment round.
If you are new to this, take a read of: Entrepreneurs – 6 things to know about your first funding round – Boodle Hatfield