Strong Fundamentals

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Coming to terms with your terms

Martyn Holman

Investment Partner

So, your company is growing quickly. You’ve strengthened the team and brought in key execs from previously successful growth companies. Unit economics are break even and accelerating into positive territory. Churn is at an all time low, and your new US business unit is setting records for sales growth. You have term sheets for new capital and they all appear to be offering similar things. Or are they?

Key takeaways 

  • Certain terms can fundamentally impact the headline valuation delivered on a term sheet

  • A high headline valuation for your business may well not be the best set of terms

  • It is critical to understand the holistic impact of the terms and to model scenarios in which terms might create adverse outcomes

  • Terms are generally provided to give additional protections to larger minority investors, and that includes Director appointments

Even with a very similar headline valuation, term sheets can in fact mean fundamentally different things for an early stage business. This article runs through some of the main topics of term sheets, arranged as you might find them in a typical Series A funding. It focuses on the impact these terms might have on your business, and why it is important both to understand them, and compare them on a holistic basis...not just to focus on the headline number.

Your Term Sheet

General offer terms

Valuation

Headline valuation is perhaps the most visible component of any term sheet, but the largest number does not necessarily mean the best deal. There are a number of other components that will impinge on this in many different ways. It is critical you take a holistic view.

Fully Diluted

Most share price offers will be quoted on the basis of a “Fully Diluted” share capital. This means that the number of authorised options and other equity instruments, not just shares is taken into account in the number. This is important to understand, particularly when the term sheet is calling for you to also expand your option pool as part of the round, or to convert any pre-existing loan notes prior to completion.

Share options

One common approach at Series A is to require companies to expand their share option pool as part of the round. New authorised share options will generally be counted in an “unallocated” pool and the board given the authority to allot them to new hires.

Whilst this is usually a sensible move given the likely need to hire and incentivise new talent post raise, expanding the share option pool prior to the round will dilute only the existing investors, with full benefit to the new investors. The effect will be to reduce the share price paid on a “Fully Diluted” basis by the new investors at any given valuation, who will therefore receive more shares for a given investment amount.

This earlier Path Forward article explains the key factors a business should consider in establishing a new options scheme.

Conditions

Investors will attach various conditions to a term sheet, to the extent that there is in fact no contractual commitment to funding the business. These conditions will often relate to satisfactory legal documentation, due diligence, “Warranties” (see later), approvals (of investor and other investors as necessary), no material adverse change in the circumstances of the company, and service contracts for executive employees to name but a few. It is important to remember therefore that a term sheet is not a commitment, but an expression of intent, and companies should maintain all momentum until the deal is closed.

Share terms

Share class

Often at Series A, the concept of a Preference Share will start to appear in funding term sheets. A Preference Share is a share that takes some form of priority (preference) in the return of capital to shareholders, and will in most cases be one of two types - either Participating on Non Participating.

A Participating Preference Share will claim its preference before returns to other shareholders, and will then also take a pro rata share of subsequent returns. The effect of such an instrument is to increase the effective return to the holders of the share and so to reduce the pro rata value of the existing ordinary share layer under any scenario.

A Non Participating Preference Share will give its holder the right to claim a preference before returns to other shareholders or to take a pro rata share of subsequent returns. The effect of such an instrument is to give some degree of downside protection to the investor, since the right to preference would generally only be taken up in the event that the business or its assets is sold for less than the valuation paid by the investor. As such the pro rata value of the existing Ordinary share layer is only affected in the case of such a downward valuation.

As an example of the impact of these share classes on returns, consider a simple example of a company of 100 shares valued at £100 with 10 shares invested at the last round with a preference:

Participating Preference Share

Non Participating Preference Share

As demonstrated above, a Participating Preference will give an investor a substantial returns multiple at the expense of the Ordinary share investors, particularly at lower exit values (relatively speaking), whereas returns for Ordinary shareholders are only depressed on the downside (less than the investment valuation) for a Non Participating share class.

Consents

Investors will generally seek to retain a veto over certain actions of the company in order to protect themselves and their investor. Often these consent regimes are split into two - Investor Consents and Director Consents.

“Investor Consents” are likely to cover the major strategic decisions that a company may wish to execute. Examples include amendments to the Articles, changes which impact the rights of the investor share class, incurrence of debt (usually above a given threshold level), acquire a business or move to sell the business, or increase the level of share capital. Such consents will usually require the vote of a certain threshold of the new class of shares in which the investor is participating and will usually require formal legal documentation and signatures (and hence a high administrative overhead for operating within them). In effect Investor Consent regimes give a veto to the new class of shares and significant amounts of control over the actions of the business. 

“Director Consents” are likely to cover the more day-to-day aspects for which the investors also wish to maintain some degree of control. Matters will usually cover incurring capex above a threshold level, granting of stock options, changing a business line, appointing key executives or materially adjusting compensation of such. Such consents will usually be a majority board Director vote to include the relevant Investor Director, and will often be implemented by email to aid speedy decision making. Again however, a Director Consent regime will place  significant operational control in the hands of investors.

Anti-dilution

Quite often injected as a form of downside protection at Series A and beyond, an anti-dilution clause provides for the issue of bonus shares to certain investors in the case that money is subsequently raised at a lower share price. Given that any new future investors will not want to be diluted immediately post raise for this issue, the cost of this dilution is borne entirely by the earlier investors and founders prior to the completion of such future round.

Anti-dilution calculations come in different forms, but most commonly are based on a broad weighted average share price (such that the beneficiary ends with sufficient shares that their holding valuation is unaffected by the downward change in share price).

Such clauses tend to polarise opinion, and often investors in future rounds may include terms to the effect of removing or waiving such anti-dilution. It is worth noting that tax incentivised investors in the UK cannot benefit from anti-dilution.

Change of control

There are various terms which investors seek to cover scenarios in which the control of the business transitions to a third party. These clauses are often contained in the company Articles and apply to all shareholders of the company, but their construction generally favours larger minority groups of investors.

A “Pre-emption” right is a fully common term in most company Articles which serves to give existing shareholders the first right to purchase newly issued shares in the company. This is commonly expected by most investors, giving them the opportunity to maintain their percentage stake in the company and right to participate in future fundraising. 

A “Drag Along” clause will provide that if a certain proportion of shareholders (say 50%) vote to accept an offer for purchase of the company, then all shareholders can be forced to accept the offer. This ensures that a small, probably concentrated group of investors of a business can self determine their exit, rather than requiring that all investors are aligned. This can mean that as a founder of a business, you could be forced to sell against your wishes. Or, from a more positive perspective, the inclusion of a Drag clause ensures that small investors cannot necessarily block an exit that the majority favour.

A “Tag Along” clause will provide that if a certain proportion of shareholders, say again 50%, are electing to sell their shares to a third party, then all shareholders can sell a pro-rata of their own shares. This ensures that certain shareholders are not able to favourably sell their shares to others without first enabling other shareholders to take the same opportunity.  

A “Right of First Refusal” is an innocent looking clause often included in term sheets from strategic investors. The clause is intended to give an investor the first right to purchase (secondary) shares, or indeed the entire business, should a legitimate offer for the same be received from a third party. In effect these clauses, discoverable in any due diligence process, will in fact often discourage offers from acquirers since it adds uncertainty at a point they are forced to show their hand in valuation in an acquisition process. In our experience, these clauses should be treated with some degree of caution.

Governance & other terms

Board

Investors will often want to dictate the size, frequency and shape of boards. Larger minority investors, generally above 10%, will usually wish to appoint a Board Director to oversee their investment. Whilst most investors will point to the value that an experienced investor will bring to a company board, it should not be forgotten that Investor Directors wear two very different hats. Firstly in their Director capacity they have a fiduciary duty to represent all shareholders, but this may at times be in conflict to their interests as a representative of their own fund. The role is hence part monitoring, and the implications of this should be understood by all entrepreneurs seeking investment from a VC.

Fees

Investment costs should not be under-estimated when raising capital. Investors, particularly at later stages, will often require that professional fees, often encompassing lawyers and due diligence, be met by the investee company. In a round with say 3 institutional investors it is not difficult to see circumstances in which these fees might be in excess of £50k.

Some funds will levy fees to cover their board appointments - often this is part of a funds’ business model, or sometimes a fund may appoint external third party individuals to oversee their investments and the fee arrangement then is made directly with the individual to be appointed. This can be in the order of £15-20k for a typical Series A raise.

Some funds may also levy transaction fees for the capital raise, typically in the range of 2-5%. All of these fees serve to reduce the level of net capital available to the business and can be upwards of 10% of the round in some extreme cases. Effectively this serves to reduce the effective pre money valuation of the business as the same number of shares are being issued for a lower level of net cash in.

Along with many other leading funds, Forward Partners does not levy any fees on its investment companies. This earlier blog post explains more about the Forward Partners model.

Warranties

Investors will generally require the key executives of the investee company to personally warrant, and for the company itself to warrant, that certain key items claimed during the investment process are true. A warranty is therefore a guarantee given by the company and the executive, against which they might later be sued if items are found not to have been true and can be proven to have caused material disadvantage to the investor.

Warranties are often many and varied, and will include for instance that there has been no material adverse change in the fortunes of the business, that the company is able to issue the shares, and that IP in the business is validly owned. There will often be a lengthy process of “Disclosure” against these warranties, so that certain items are not used by investors to sue the company in the future.

If there are circumstances you are likely to have to disclose to investors it is best to raise them early in the diligence when they can be dealt with constructively. Disclosing significant adverse events such court proceedings or tax liabilities at the 11th hour risks derailing the entire investment.

Conclusion

Raising capital is a like any other contracting process or RFP (Request For Proposal). Where you receive multiple proposals, it is likely that they will differ along multiple dimensions making direct or straightforward comparison very difficult. A high headline valuation for your business may well not be the best set of terms.

You will likely need to model a range of scenarios and test the impact of the terms on your business within these scenarios. The end choice will be determined by your particular set of circumstances. Good luck.

Martyn Holman

Investment Partner

Martyn’s early career was spent as a consultant with the leading strategy consulting house, Boston Consulting Group. He has since developed a wealth of experience with technology based growth businesses and joined Betfair in its infancy as Director of New Ventures. Whilst at Betfair, Martyn founded and spun out LMAX Exchange, a leading multilateral trading facility for FX trading. During his time at LMAX, Martyn held the role of COO, driving market structure, product strategy, market development, commercial and international strategy and sales and corporate development. In 2012 Martyn joined Google as NPS Sales Operations North & Central Europe before joining Oxford Capital in 2013 where he led investment strategy. During his tenure, Martyn led investments and was Board Director for businesses including Linkdex, Outplay Entertainment, Kobojo, and import.io.

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