Getting expert advice

Finerva spoke to Director Lizzie Frost, about the important role a term sheet plays in laying the foundations for the relationship between founders and their investors.

What’s your advice for start-ups drafting an initial term sheet?

My first piece of advice is not to download a term sheet template off the internet. These templates tend to be full of investor jargon, and will probably not be suitable for the business, particularly at the early stages of investment when terms really can be pretty straightforward.

At this early stage, investors tend to be family, friends, and/or perhaps a few angel investors. They are investing in the founders, the ideas, and will probably not be too aggressive on terms. As such, the initial term sheet should be kept simple and clear, i.e., one class of share, everyone with equal rights, everyone investing on a level playing field – very straightforward and uncomplicated.

I think the key here is to keep it straightforward at the beginning and particularly make sure you understand the maths. Founders need to be clear how much of the company they are giving away, which obviously is not something you want to get wrong when you are further down the line of an investment negotiation. Particularly important when you are hoping to incentivise your employees by way of options – make sure everyone is aligned as to whether the option pool is taken into account before or after the investment.

Building trust between founders and investors

At this early stage, it is about trust and all about the founders. Investors are investing in the founders. They must trust that founders are not going to waste money and that they are going to build something meaningful.

At London Law Collective, we see companies who know they need investment, but are not always clear on what to do and how to start. Our advice is to start by drafting a term sheet so that when they are ready, they can present investors with terms that they have set out from the start. At this point, you can make the rules! If you can demonstrate a clear understanding of your idea and have a solid understanding of what you are asking investors for, that will create more trust.

What provisions would you insist on including in a term sheet? 

You want the term sheet to be as close to the final terms of the deal as possible.  You want to avoid confusion or protracted negotiation after the term sheet, either during the drafting of investment agreements or worse, after the round has closed. By this stage it could be too late, so it is crucial to make sure that the term sheet is clear and agreed by both sides. The clearer you can make your term sheet, the less likely there are going to be any surprises down the line.

Provisions I would insist on, include:

• the class of share being offered (and the economic rights if a new class of share);
• making sure both parties know exactly how much of the company the investor will hold post-investment;
• information rights that the founders can realistically provide;
• a summary of your shareholders’ agreement and constitutional documents (making sure they are streamlined); and
• if you are going to agree to investor consent rights over the running of the business, including these as a prescriptive list.

As a founder, you want to have freedom to grow the business in the way you want. There is a balance here because the investor doesn’t want to have invested in one business, for it suddenly to become something else. It is always constructive to have a discussion around consent rights and not a “take it or leave it” approach.

It is great when we see an investor and a founder talking to each other and building a relationship. This means that when things are going well, the investor can be very light touch.  If you have established a good relationship from the outset, then if things do become more difficult for the company later on, a trustworthy relationship exists that will hopefully generate a more positive discussion when those difficult conversations happen.

What are the terms which might seem unpalatable for founders, but are perhaps ‘market’ and hard to negotiate away with investors?

Founders will find certain provisions that are added as ‘market’. It is a very easy argument for an investor to make and insist that they include it in all their term sheets. This is the easiest way for them to try and push these less agreeable terms through. My advice to founders would be to suggest testing them and ask questions such as:

Why do you need this provision? And why is it appropriate for this business?

Sometimes you win, and that’s good. And sometimes they’re bullish, and they don’t let it past. The terms that tend to be asserted as ‘market’ tend to be provisions relating to the founders’ shares.  For example, requiring founders to earn back their shares, i.e., reverse vesting provisions, over the next three or four years (locking them into the business). Or perhaps subjective leaver provisions that could see a founder leaving the business they have built with no shares and no exit proceeds. For founders, these are unpalatable terms, and this loss of freedom can contribute to a more difficult relationship with an investor.

Other things that are unpalatable are the terms that place an investor’s funds on an uneven playing field, such as liquidation preferences, anti-dilution rights, and other preferential terms on shares. None of these terms are nice to see in documents, particularly at the early stages of investment, even though we understand they are a way for investors to protect themselves.  It is very important for founders to remember that the terms of one investment round will set the bar for the next one – once a term is included in a company’s investment documents, it is almost impossible to remove it as the next investor will expect to be offered it as well.

As a firm, London Law Collective generally advises founders rather than their investors. If however the role was flipped and you were advising the investor from the company’s perspective, what would your advice be to venture capitalists evaluating an investment?

We would advise a VC to look beyond their standard terms of investment. They should look to the business, look to the founders, and look to the ideas that are being generated. Investors should try and adapt their terms rather than insisting on model documents or template non-negotiable provisions that might negatively affect the relationship with the founders and aren’t actually appropriate for the investment. Basically, think about what is really important.

Of course, this does depend on where you are in the evolution of the company and how many investors (and what type of investors) are involved. However, we believe there should always be a little bit of give and take.

We really enjoy working with investors and venture capitalists that are prepared to negotiate and look at the business rather than just the spreadsheets and the models. It is much more interesting for all parties if there’s a bit of a collaborative discussion and a realistic evaluation of what the business is trying to do and why they’re trying to attract investment.

Our advice is that one size does not fit all, and I don’t think that businesses should ever be treated that way. I believe that every business and every set of founders are unique. The idealist in me wants investors to trust the business and not seek to stamp preferential ‘market’ terms on a business that is still growing and needs support rather than jargon.