As one of the most active UK law firms within the venture capital (VC) ecosystem, Shoosmiths’ VC team are leading industry experts, with extensive experience of helping founders to scale with confidence. Our team regularly advise clients across all stages of their life cycle, working with start-ups, founders and investors - with unparalleled knowledge across fundraising, governance and investment activities.
The below resources aim to help you unpick the legal implications of the funding process to ensure your business is investor ready.
Commonly known as ‘heads of terms’, term sheets outline the crucial aspects of a proposed investment and defines the commercial terms agreed in principle between an investor and the investee company. Not only does the term sheet focus negotiations and the significant considerations to the parties, it allows them to consider the viability of the deal.
An effective term sheet will help to emphasise potential deal-breakers, as well as operate as both a time and potentially expense-saving tool. A comprehensive term sheet can be considered valuable groundwork for the subsequent transaction, forming the basis for the final legal documentation. It can also be challenging to renegotiate the terms contained within it, so it is crucial to formulate a thorough summary of the agreed position from the outset and engage legal advisors at the earliest opportunity.
An overview of the main components of the term sheet can be found below with links to our related articles, each containing further in-depth guidance.
These provisions outline the order of priority for payment of any proceeds upon an exit, liquidation, winding up, or other ‘deemed liquidation’ events, such as a sale of the company assets. They will often provide that investors hold a preferred right to return of capital, ahead of ordinary shareholders. This entitlement is usually an agreed multiple of the investor’s original investment value. This is often a 1x multiple. However, in certain circumstances a higher multiple might apply. Liquidation preferences can also either be ‘participating’ or ‘non-participating’ depending on whether the investor has the right to a share in the remaining capital distributed to ordinary shareholders.
It is crucial that detailed consideration is given to preferences because this will directly impact on any return that investors and ordinary shareholders alike receive upon an exit or other liquidation events. Further, preferences can carry significant tax implications if the investor is seeking certain reliefs such as EIS or VCT treatment and need to be drafted in a compliant way to ensure the tax reliefs are not lost.
Vesting is where the founders of the business earn their ownership in the company over time. Depending on the specific terms, equity will be obtained by the founders at scheduled intervals (i.e. months) or, occasionally, upon attainment of certain performance indicators. The rationale behind this is to motivate founders to continue to contribute to the success of the business and to deter them from making an early exit. If an early exit does occur, then vesting acts to safeguard against the possibility that a founder will depart with an amount that far exceeds the value of their input to the business and provides room on the cap table for a replacement executive to be hired and incentivised.
Leaver provisions require an employee’s equity to be converted into deferred shares with no economic value or voting rights (or transferred) if they leave the company before the investor’s exit. This ensures that a replacement can be found without diluting other members’ shareholdings and again acts as a motivational tool to retain key equity-holding employees. Such provisions typically define a ‘good’ or ‘bad’ leaver upon an employee’s departure and depending on how that person is treated will impact the number of shares to be lost and/or the value they receive for their shares. A bad leaver is one that is generally dismissed for misconduct or is otherwise accountable for their departure from the company. A person will generally be deemed a ‘good’ leaver if there is no ‘fault’ attached to their withdrawal (such as incapacity due to health reasons).
Term sheets usually also refer to ‘anti-dilution protection’. These provisions seek to protect the value of the investor’s investment in the company from decreasing if future fundraising occurs at a lower valuation – commonly known as a “down-round”. To protect investors from this a mechanism is often included whereby, investors will receive a “bonus issue” of shares or an increase of the ratio at which preferred shares convert into ordinary shares in a down-round to compensate them for having invested at a valuation that has proven to be too high.
Despite rarely taking a controlling interest, venture capital investors generally require some influence over the running of the company to ensure that their investment is protected. Common management controls relate to board structure, investor consents and information rights. Often, investors will appoint at least one individual to sit on (or sometimes just observe) the board and oversee decision making. It may also be necessary to obtain investor consent before certain key decisions can be implemented. As well as this, information rights regularly stipulate that investors are entitled to be provided with annual business plans, monthly accounts and financial forecasts so that the investor can monitor the growth and performance of the company.
Generally, term sheets will set out that the founders are unable to transfer their shares without investor consent. They will also require investors are given ‘pre-emption rights’ (also known as the right of first refusal) if either a purchase of the shares or a further issue of shares is proposed, in each case to protect the investor’s shareholding and position from being diluted. Additional restrictions on sale of shares come in the form of ‘co-sale’ and ‘drag and tag’ provisions.
- co-sale rights allow investors who have not taken advantage of pre-emptive rights to sell their shares on the same terms as the founders;
- tag-along rights allow investors (which are usually minority shareholders in a venture capital investment), to sell their shares alongside majority shareholders (such as the founders) on a change of control; and
- drag-along rights give the majority shareholders the right to sell their shares and force remaining shareholders to join in the sale on those same terms (which is typically subject the consent/veto right of the investor).
Term sheets will also refer to the type and/or depth of warranties to be given in the legal documentation by the company and potentially founders. Warranties are statements of fact that are contractually stated to be true. There are certain standard warranties that are usually given including: (i) that the caps table is accurate; (ii) there is no ongoing litigation; (iii) the company is licensed to carry out its business (as appropriate); and (iv) the company has title to its assets. The ‘disclosure exercise’ conducted by the company and founders will seek to qualify any inaccuracies against the warranties (which are largely in a market-standard form).
The volume of documentation will largely be driven by the complexity of the deal. At a minimum we would expect the following:
- a subscription agreement documenting the terms of the round and mechanics of the investment;
- a shareholders’ agreement which all shareholders (including the founders and investor) and the investee company would enter into to regulate the ongoing relationship;
- new articles of association of the company (which would contain provisions such as the liquidation preference, pre-emption and drag/tag-along rights); and
- corporate authorities of the investor company recording the entry into the necessary deal documentation.
Whilst term sheets are not generally legally binding, they typically provide for specific exceptions. These relate to responsibility of costs and expenses and terms of confidentiality. Further, an investor may expect the investee company to enter an exclusivity period, where the investee company is obliged to negotiate only with that investor for a certain defined period of time.
It is vital that professional advisors are engaged at the earliest opportunity to assist with term sheet negotiations, not only to add value and advise on the terms but to ensure that the deal is properly guided from the outset, ensuring a swift closure of the deal.