If you’ve ever watched ‘Shark Tank’ on television, you’ll remember the tension between entrepreneurs trying to make a successful pitch and sceptical multimillionaires judging if their product would be a viable investment.
More so during the COVID lockdown, you might think that trying to find a financial backer would be foolish, but not so. Investors always are alert for investment opportunities and innovative brains, especially in times when fear is high. According to the Crunchbase website data, the Australia and New Zealand venture capital markets, collectively, are growing. In the first six months of 2020, Australian venture funding reached $927 million, up 39% compared to the same period last year. Some 62% of that funding went into later-stage rounds, compared to 47% in the first half of 2019.
Related: You can still Raise Capital in 2020
When you eventually find the investment angel or venture capitalist who aligns with your company’s vision and mission, that is only the beginning. They will hand you an Investment Term Sheet. This will be one of the most critical documents that you'll ever sign.
It outlines the specific conditions between you and the investor, what you are giving the investor and what they are giving to you. It also states the guidelines of what you will both do to protect the investment.
An Investment Term Sheet will include such items as: who is issuing the stock; the type of collateral being offered; the valuation; the amount being offered; shares and price; what happens on liquidation; voting rights; board seats; conversion options; anti-dilution provisions; investors rights to information; who will pay legal expenses; non-disclosure requirements; rights to future investment; and signatures.
There are 6 things you need to know about the Investment Term Sheet:
1. Company Valuation
This outlines what an investor thinks your company is worth. There are 4 key components:
- Pre-money valuation: an estimate of its worth before investment
- Post-money valuation: an estimate of its worth after investment
- Capitalisation table: percentage of ownership between you and investor
- Price per share: the per share value of your company’s stock.
2. Liquidation Preference
Investors naturally want protection from risk so they usually ask for ‘invested capital liquidation preferences’; that is, if your company should fail, they are paid a return on their investment before other shareholders receive payout liquidation funds.
3. Binding vs. Non-Binding Agreements
Term sheets can be entirely legally binding or non-binding. They can also contain provisions that are legally binding or non-binding. Legally binding term sheets and provisions require both parties to fulfil the terms outlined in the Investment Term Sheet. Anything non-binding is regarded as an understanding between the parties.
4. Option Pools
An option pool is the amount of stock a company sets aside for employee compensation and other internal matters. Companies may set aside up to 10% of the total stock for this. You might also consider an Employment Share Scheme (ESS) where employees are able to buy shares of the company at a discount, or the right to buy and sell shares at an agreed price and date.
5. Participation Rights
Participation rights grants investors the right to ‘participate’ in future equity sales of the company they’re investing in. This is an important part of the Term Sheet for two reasons:
- either the company is doing well and it gives the investor the opportunity to participate in new funding rounds that are much better than earlier ones; or
- the company needs an extra investment boost to carry it through hard times.
6. Common pitfalls and how to avoid them
A term sheet itself (without signatures) is not an executed deal, or even a promise. There is still due diligence to be done. Don’t think that you must work it out all on your own. Hire a commercial lawyer from the start. They will work for you so that your rights and responsibilities are clear and protected. They can negotiate better terms on your behalf and alert you to what are known as ‘unfair conditions’.
Your investors may be the right ones but, at the same time you are wanting them to invest, they are looking to save. In the term sheet, be alert for harsh debt financing and convertible note terms that could bankrupt you;
- Asking for too large of a controlling stake (which could indicate you’ll be replaced);
- Terms that can limit further fundraising; and
- Investors that simply want a short and hot exit are all warning signs to slow down and reconsider your options.
The meeting where the term sheet is produced could be long and exhausting. If you show signs of wanting to wrap things up, investors may aim to tire you out. If you see this happening, hang in and be patient.
Both sides should be able to walk away without impacting the reputation of either side. Better still, a healthy investment may proceed in an exciting new venture. Either way, the term sheet should facilitate a win-win for both sides.
Related: The Elevator Pitch is critical for Entrepreneurs and Startup Founders
Have you noticed our #FridayExpertTips... here's one that relates to #Technology
"Many Startups succeed because they've identified a niche and have cornered that market. By discovering a service or product no one else has thought of, or at least effectively pulled off, you give your company a shot at success."
This information is accurate on the day it’s published and is subject to change as the situation around Coronavirus (COVID-19) evolves. Our conclusions may not be valid if there is any change in those facts, circumstances and assumptions. Accordingly, neither Azure Group Pty Ltd nor any member or employee of Azure Group, undertakes responsibility arising in any way whatsoever to any persons in respect of this alert or any error or omissions herein, arising through negligence or otherwise howsoever caused.