It’s a scenario any new entrepreneur dreads.
After finally getting start-up capital to get a venture off the ground, the company’s owner suddenly realizes he had essentially signed off to the investor a huge chunk of the profits and control of the business.
Although these conditions would be spelled out in the contract, their beginnings can be traced to a document known as the term sheet – a non-binding record outlining the material terms and conditions of a business agreement.
Perhaps it’s because of the term sheet’s non-binding nature that many business owners mistakenly take the document for granted, according to Arshia Tabrizi, principal of Tabrizi Law Office, a Toronto-based legal firm specializing in start-up agreements for companies in the information technology (IT) field.
“Term sheets may not be binding but they set the terms of future agreements,” Tabrizi said. Once sighed, he said, term sheet conditions “can be very hard to [opt] out of.”
Tabrizi was part of a panel that discussed strategies for closing investment deals at a workshop for entrepreneurs titled: The Rules of Engagement recently held by the Innovation Synergy Centre in Markham.
Term sheets are typically bullet-point agreements stating how much the investor is willing to invest and what the investor’s stake in the business will be.
The document can be as brief as two pages or detailed enough to cover more than 20 pages. Depending on the signatories, the paper can include other details such as: the company’s valuation, the structure of investment, executive compensation, board composition, legal expenses, as well as confidentiality and exclusivity clauses.
The term sheet could guide lawyers in the preparation of a proposed final agreement or contract.
On the plus side, a business owner could look on a signed term sheet as signifying an investor’s willingness to put money into the venture. But other details may have potential negative implications for the entepreneur, Tabrizi said.
He urges business owners to pay especial attention to the following:
Business owners should ensure the exclusivity clause does not unduly constrain their ability to seek alternative funding, Tabrizi said.
Such clauses typically restrain a business from seeking other sources of capital for anywhere from 30 to 90 days until a final agreement is struck.
The lawyer advises business owners to push for an exclusivity period that favours them rather than try to seek other funding behind the investor’s back.
“Although investors do not generally sue for breach of a term sheet, the business owner could be stuck with the legal fees.”
Another area that business owners should pay close attention to is the valuation formula.
This determines the value of the company and deals with how much money the investor is expected to provide and the amount of shares in the company the investor gets.
“Beware of liquidation preferences highly favourable to the investor,” Tabrizi warned.
For example, he said, a term sheet could state that an investor is prepared to put $1 million into a business in exchange for one-fourth of the company. An owner might think if the company were to be later sold for $5 million the investor would get around $1.25 million.
Some liquidation preferences, however, could state that the investor would first get the initial $1 million investment plus the one-fourth cut from the remaining $4 million.
Owners must be clear on the nature of the investment. Is the money being provided as a debt or in exchange for equity in the firm?
Be sure the terms of the loan or privileges attached to the shares will not undermine your control of the company or the business’ health. Make sure the investor’s special rights are reasonable.
Board structure and compensation
As they are providing money for the company, investors will demand a say in its leadership. While it may not go into the fine details, a term sheet can specify an investor’s preference for the company’s board of directors.
Tabrizi said business owners must make sure they have trusted people on the board. Compensation packages for board members and key employees must also be agreeable to the owner.
“The important thing is the owner does not give away full control of the board.”
Make sure a pre-money and post-money capitalization table is attached to the term sheet. This document will show who owns how many shares before the money came in and after the capitalization.
This will be valuable in preparing the final agreement.
It is important that entrepreneurs seek expert advice before getting into any negotiations regarding investment, according to Shaun McIver, president and CEO of Streamlogics Inc. a Webcasting applications and services firm based in Toronto.
He was also part of the panel.
“Many business owners are experts in their field, but in these negotiations it’s vital that they involve people who specialize in the area.”
A seasoned capitalization negotiator can streamline the process and help owners identify key points that need special consideration or issues that can be potential problems, McIver said.
Many investors prefer to deal with companies that have a seasoned negotiator or advisor onboard, said Ken Paige, chair of Maple Leafs Angels, a group of private investors based in Toronto.
He said negotiations with companies that are unprepared for the process often takes five to six months, while better organized firms tend to close deals in two to six weeks.
Businesses can also seek the help of an intermediary – not necessarily to identify potential investor but to handle the initial negotiations, says Jordan Dolgin, partner and chair of Wilson Vukelich LLP a law firm based in Markham, Ont.
“Since a term sheet can lock you with one investor, it’s vital that your negotiator knows the market.”
Tabrizi, however, advises against hiring an intermediary. “They typically take a six to 10 per cent cut off the deal and some investors are turned off by the presence of an intermediary.”
Should a business owner determine that the term sheet conditions are not favourable, he or she can back out of the agreement.
“It’s unlikely that an investor would push for a closing. But under the conditions of typical term sheets you’ll usually have to pay for the legal fees,” Tabrizi said.