Terms of a term sheet

Simple explanation
Implications to early stage companies
Liquidation preference Liquidation preference defines how monies received on liquidation are going to be split between different classes of shares. [Just like different categories of creditors will have different rights in terms of liquidation.]The term sheet will specify what ‘preference’ the investor will get over ‘common stock’ owned by the entrepreneur/founders/existing share holders. E.g. the term sheet may suggest that, in the case of a liquidation, the investor will get 2x their investment before the balance, if any, is split between common share holders.

A liquidation preference may also allow the investor to instead convert their holding into the proportionate % of common shares and sell, if it is higher than the money they would get on selling at the price they would get if sold at the preference value.

In some cases, if the term clarifies, the existing investor may be allowed to convert to common stock and hold their holding. They would do this if they believe that the new buyers of the company will increase the value of their holdings.

Liquidation is not necessarily only if the company fails. It could be merger or a strategic sale or whatever. In these situation, what level of preference multiple is offered will decide what is left for the entrepreneur [and other common share holders] in case of liquidation.In case where the investor is allowed the option of converting to common shares AND holding on to their shares, it may casue issues with the acquirer if they do not see value in the investor holding on or if there is a strategic interest clash.

As with every other term, the negotiating power of an entrepreneur with a proven track record [professional career record or previous successful entrepreneurship experiences] wil be higher than the negotiating power of a relatively newer entrepreneur. In bad times, the prefernce multiples asked could be ridiculous.

Drag Along This term requires the minority share holders to sell their equity to an acquirer if a majority of the shareholders agree to a sale.To illustrate with an example, if an entrepreneur owns 40% of the company with 2 VC firms holding the balance 60%, if they decide to sell their stake, this clause will force the entrepreneur to also offload his/her shares, even if he/she did not want to exit. Implications are obvious. If the company does not do well and if the investors decide to bail out with whatever value they can realize, the entrepreneur would be forced to sell his/her stake even if they believe that there is merit in continuing with the venture.Sometimes an investor may want to exit because the venture [or the domain] does not fit into their strategic thinking any more. In this case, if the investor wants to exit, even if the going is good, the entrepreneur may have to sell his/her stake.
Preference shares Preference shares are shares that enjoy more previliges than common shares. These could be in availining dividends before common share¬† or preference share holders may also have greater rights to the company’s asssets and proceeds in the event of liquidation. Here too, the implications on the entrepreneur are based on multiple factors including the multiple of liquiditation preference, if it is included, etc.In most cases, simple preference shares which give an investor rights over assets in case of liquidation and dividends before common share holders are not considered unfair by entrepreneurs as it represents only a fair demand that the investor is seeking to protect his/her capital and the entrepreneurs acceptance indicates a high level of confidence in the venture to allow an investor to protect his/her capital.
Indeminity Well, this is a pretty straight forward one in which the investor who sits on your board seeks an insurance cover to as an indeminity cover should there be a legal case and the investor needs to protect himself/herself. Depends on how much protection is sought and how much the insurance premium is, and how that amout is in relation to the amount that is raised.I.e. the investor and entrepreneur need to evaluate if and if yes, how much, indemnity insurance makes sense. Especially if it is going to cost a lot and if the amount of capital raised is little.

Also, if the capital is raised for, say, concept testing where the exposure to liability is nil or limited, then it may not make sense to invest in insurance premium [again, if the capital raised is limited]

Anti- Dilution Anti dilution protects the investor’s capital in case the entreprenur decides to, for reasons of market conditions or strategic relevance or whatever, to accept capital from a new investor at a valuation that is lower than that at which the investor had invested.In a situation where a subsequent round is raised at a lower valuation, anti dilution right allows the company to revalue the original valuation and thus issue additional shares to the investor. This, in my view, is a fair clause and entrepreneurs should be condifent enough and acccept it. Fighting this clause would necessarily mean lack of confidence in estimating a higher value for the equity in subsequent rounds.
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