Posted on April 27, 2020
Berytech brings you everything you need to know about due diligence and term sheet negotiation, written by Constantin Salameh, Senior Coach and Investment Advisor. This blog is a wrap up of a #FinanceFridays workshop.
There are two different key dimensions that matter in due diligence and term sheet negotiation: Economics (financial returns) and Control (freedom to take decisions). Find out more below.
A term sheet is a written document that includes the important terms and conditions of a debt, convertible debt and/or equity investment transaction. The non-binding document summarizes the key points of the agreement between both parties prior to executing the shareholders agreement.
Term Sheet balances the following 2 dimensions:
The term sheet is all about balancing the terms related to Economics or financial returns that the investors will get and the Control terms that restrict the founders’ ability to decide.
What are the types of term sheets ?
Valuation. Two valuation concepts to understand consist of Pre-Money Valuation (the value of the company before the investment is made) and Post-Money Valuation (the value of the investment after the investment is made).
Capitalization Table. A Cap Table is an overview of the total capitalization of the company. It tracks the equity ownership of all the company’s shareholders.
Funding Rounds. A company typically goes through different funding rounds (debt and/or equity) as it scales and transforms. Each funding round has a new term-sheet and shareholders’ agreement.
Preferred Shares. Preferred shares have typically more claim to the company’s assets than regular shareholders (A Class shareholders or original shares and B class shareholders with less voting rights than A Class shareholders) which can be of importance in the event of liquidation.
Liquidation Preference. Co Liquidation preference gives the investor the right to take out money before any other shareholders in a liquidation or an exit event. We have two types of liquidation preference : Participating Liquidation Preference (typically 1x) and Non-Participating Liquidation Preference.
ESOP. The Employee Stock Option Program (ESOP) is set-up to give a selection of top staff an option to buy shares of the company at a certain (subsidized) price at a particular time. Investors can require the founders to set aside anywhere between 5% to 10% for the ESOP from the founders’ equity shares.
Anti-Dilution. The objective of the anti-dilution clause is to protect the investor from dilution in case the company issues new shares in a later equity round at a price lower than the price paid by the investor in a prior equity round. Anti-dilution provisions protect the investor against a down-round by adjusting the prices of the shares to avoid diluting his equity shareholding position. Typically, Broad-Based Weighted Average Anti-Dilution clauses are the standard. Other options include Full-Ratchet Anti-Dilution clauses.
Exit Provisions. Investors and founders will generally both wish to work towards a successful exit of the company they co-own. As the time perspective might differ between the two parties and most investors must legally exit within a specific timetable (5 to 7 years), investors will include an exit clause in the term sheet to force an exit as and when they want. You have different types of exit clauses including forced sale, dragging founders out and forcing redemption.
Reserve Matters. Early stage venture investors take a minority equity stake in the company that they are investing. It is important for them to protect their investment through Reserve Matters, which are a list of matters that can only be implemented with the consent of the investor. Most of these matters are focused on limiting the founders’ ability to take cash out of the business (CAPEX/OPEX investments, compensation of CXOs, etc.). Founders must work with investors to make sure that the list of reserve matters is reasonable.
Vesting Period. Investors are keen to ensure that the founders earn their equity over a “Vesting Period” of 3 to 4 years (25% per year over 4 years typically)
Board of Directors. Board of Directors run the company and take all strategic decisions (approval of the strategic plan and budget, approval of audited financials, major investments, etc.). The CEO is appointed by the board and all major authorizations are given by the board. Investors typically ask for a board seat to make sure that the proper governance foundation is in place.
TAG/DRAG Along. These are exit provisions used to protect shareholders’ rights. TAG Along clauses allow a party (minority shareholder) to tag along with other shareholders in the event the other shareholders are selling their shares to a third party. Drag Along clauses can be onerous as they allow the party (minority shareholder) at either a price agreed between the parties or at a price offered by a third party.
Due Diligence is a vital procedure in mergers and acquisitions aimed to confirm the validity and integrity of various aspects about the company
Due Diligence is used to:
Due Diligence sounds impressive but ultimately it translates into basic common-sense success factors such as ‘thinking things through’ and ‘doing your homework.’
Types of Due Diligence in M&A Transaction
Due Diligence process is comprised of several types of Due Diligence with different level of Management Team and Functions involved across the process
Due Diligence Checklist
The checklist enables the due diligence process to ensure that the right choice of the investment is being made. This is not exhaustive.
The most difficult thing in any term sheet negotiation is to make sure that you strip it of the emotion and deal with the facts. Get your facts right and keep your ego out !
The due diligence and term sheet negotiation processes are critical moments to get to know your potential investor in depth. Depending on the clauses that they push (or don’t) you will get a good feel for what they really stand.
About the author
Constantin is Senior Coach and Investment Advisor with Berytech, providing financial and management advisory services to several companies in Lebanon. He has a 35-year track record in funding, developing and transforming corporations, SMEs and startups across the world. If you have questions, please email him.