Of Termsheets and Prenuptial Agreement

Some VC funds provide a termsheet before delving deeper in to the due diligence process. For some VC funds the term sheet is the holy grail of the investment process which is issued only after the investment committee has given the green signal to proceed ahead with an investment case.

The fundraising process is equivalent to an arranged marriage process. It all starts with an initial meeting over coffee to get acquainted and understand some mutual aspects:

  1. Family Members / Relatives [ Founders & team | General Partners & investment team]
  2. What are you currently doing [Stage/Idea of the Venture  | Fund’s investment strategy]
  3. How much do you earn  [Monetisation | Investment Sweet Spot]
  4. Plans for the future  [Founders’ vision  | Fund’s vision for the venture]
  5. Expectations  [Termsheet : ) ]

Based on the information exchange, the two of them decide whether they want to get engaged and married. Similarly, VCs after meeting several entrepreneurs and Entrepreneurs after meeting many VCs will finally meet their soul mates. Some unfortunately do remain bachelors/spinsters.

Following is a simplified pictorial representation of the fundraising process.

Some VC funds provide a termsheet before delving deeper in to the due diligence process. For some VC funds the term sheet is the holy grail of the investment process which is issued only after the investment committee has given the green signal to proceed ahead with an investment case.

When an entrepreneur gets the first termsheet he has mixed emotions. The first one is that of his faith, in his venture, being reinforced. A termsheet sends a gush of adrenalin through the entrepreneur.

When these feelings sink in, terror strikes when the entrepreneur starts reading & understanding the termsheet. Entrepreneurs often feel they will lose control and many get paranoid thinking ‘What if the Investor exercises any of those “dangerous” rights and pulls the plug on the venture.’

Like Uncle Ben tells Peter Parker in Spiderman (a little modified) – With Huge Investments come Huge Responsibilities! In this 4 part series I will write about what the significance of the Term sheet, the various terms included, deciphering these terms and share a typical Series A termsheet. This is to help entrepreneurs understand what are industry norms & what terms to be careful about and the future impact of these terms.

So, what is a Termsheet?

A termsheet is a summary of the terms of investment an Investor proposes before making the investment. Yes, termsheets are negotiable(not carved in stone). Entrepreneurs should share with VCs the terms they are unable to decipher or even have concerns about.

Termsheets are non – binding in nature. This implies, for any reason either of the parties wish to withdraw from the process they can do so without any legal obligation to accept the money or invest it. The binding agreements are the definitive agreements – Shareholders Agreement (SHA) and Share Subscription Agreement (SSA).  The definitive agreements are constructed based on the framework provided by the Termsheet. [I will not be covering the definitive agreements in this series of blog posts]

The following points cover only the essence of a Termsheet.

  1. Valuation of the company & proposed investment amount [Typically the VC fund leading the round issues the TS and other co-investors follow the lead. They might propose certain specific terms required by them]
  2. Type of securities to be issued [Common / Preferred Shares; Convertible Notes, Options and Warrants]
  3. Rights of Investor [Various inspection rights, Right of First Refusal (RoFR), protect interests in further rounds of funding, antidilution, reserved matters]
  4. Vesting of Promoter shares [Allocation of founder shares to the Founding team]
  5. The Board structure and voting rights [Representation on the company board, decision making process on important issues, voting and other veto power]
  6. Exit for Investors and distribution of the proceeds [Liquidation preference & participation rights]
  7. Indemnification, Representation & Warranties by the Founders & Company
  8. Effect on the capitalization of the company pre & post investment [Scenarios showing distribution on shares – Promoters, Investors, ESOP Pool, etc]
  9. Guidelines for the next round of funding [Seniority rights, RoFO, pro-rata investment rights,
  10. Assignment of IP [Prevalent while investing in technology companies with crucial patents which affect the business]
  11. Milestones to be achieved [In case of investments in tranches – Milestones will be based on performance – user base, revenue, product development, team size, geogrpahical expansion, etc]
  12. Bearing of the expenses incurred during the Investment process [Who bears the legal expenses if the deal goes thru or doesn’t go through]
  13. Closing Conditions [Investors normally include certain closing conditions which when adhered with will trigger the fund transfer]
  14. Confidentiality and Exclusivity [Restrictions on interacting with other interested Investment parties after having signed the termsheet & discussing the definitive agreements]

In the Part 2 of this series I will share a typical Series A termsheet. This termsheet is a typical one that VCs  issue. Certain funds may demand some extra rights or put in some specific clauses to capture the fund’s minimum requirement or the risk involved in the investment or could be a legal requirement for fund (if the investing entity is a foreign one).

Parts 3 & 4 will have a closer at some of the important terms and how an entrepreneur should interpret these terms.

Look forward to your feedback and do share suggestions on structuring the rest of the posts for this series. Till then like singer Bobby McFerrin says Don’t Worry Be Happy!

[Kulin Shah worked with Reliance Venture Capital for 3.5 years before starting his entrepreneurship journey. The article has been reproduced from Kulin’s blog.]

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