Angel financing – Term sheets (part 3)

In the final part of this article series on term sheets, I’ll cover some of the remaining terms typically found in a term sheet.

Use of proceeds
When investors put their money into a company, the general expectation is they are providing capital to take the company forward and help grow the business by funding hiring of more developers, purchasing advertising, attending trade shows, etc. To get the company to its current state, founders may have invested a lot of their time in sweat equity, not drawn a salary, etc. However, just because there is an infusion of capital, it does not necessarily mean it should be used to re-pay past efforts. Remember, investors are investing in your company at a certain valuation at the point of investment. Rolled into this valuation is all of the work to date to get the company to its current point. To cover this, the term sheet will usually give some broad points on use of proceeds and may specifically state proceeds are not to be used to re-pay any debt the company may have. So if this is an important consideration for your situation, you will need to work out something with the investors and in return most likely give a reduced valuation.

Board of directors
A term sheet will usually stipulate the expectations on the board of directors for the company. Most notably the size of the board, how many seats management can have, how many seats investors can have, and stipulations on the number of external directors. The term sheet will most likely call for the formation of a compensation sub-committee of the board and specify who can be on it.

Management
The term sheet may call for employment contracts for key management positions to provide protection if an employee were to leave through non-compete and non-solicitation clauses. The term sheet may specify the allocation of a stock option plan for key employees and set out the vesting schedule.

Control
The term sheet will lay out actions that either require shareholder approval or board approval. Examples would be: changes to the shareholder’s agreement, changes in the board structure, issuance of new shares, issuance of dividends, company wind-up, change in core business, sale of the company, assumption of debt, entering into any large contractual assumptions.

Targets
The term sheet may lay out a mechanism for investors to take control of the company if management does not meet targets. i.e. it could state if in X years, the company has not reached profitability, the company must either buy out the investor’s shares or investors can take full control of the board. This gives investors protection that if the company has not taken off, they will either get their money back or can take control of the company to try get it on the right track.

Future financing / sale
The term sheet will specify that for any future financing requirements, investors get first right at investing. The term sheet will also have a drag-along provision where if a specified percentage of shareholders agree to sell to a buyer (assumed to be an acquirer of the company) then all other shareholders are forced to also sell their shares. The term sheet will have a piggyback provision that if a shareholder has found a buyer of their shares, other shareholders can also participate in the sale on a pro-rata basis.

Information access
The term sheet will state that investors are entitled to receive regular financial statements, budgets, etc.

Legal fees
The term sheet will generally state that the company is responsible for paying its own legal fees associated with the investment closing and the investor’s legal fees associated with the investment closing. Because of this, you should factor legal costs into the amount of financing you are raising and probably want to set some maximum caps for both lawyers.

Exclusivity
The term sheet may require a period of exclusivity where while the deal is under work. Meaning during this period you agree not to be actively pursuing other financing options.

These are the main points of a typical term sheet. As you can see there are a lot of potential trade-offs that can be made. Investors may feel strongly about certain points and management may feel strongly about other points. Coming to a landing on the term sheet will be a matter of give and take.

In my next article I will discuss investor management. To view an organized index of all angel financing articles as well as see a roadmap of future articles, click here. If you have any comments or suggestions for future articles feel free to contact me: craig at mapleleafangels.com