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Legal: Talking term sheets


AA08-Feb-Mar-2005-fineprint_largeVenture capital financing is a complex transaction and involves significant commercial risks for all parties. Many founders simply sign the term sheet presented to them by a venture capital fund without fully understanding the impact of provisions such as price ratchets, participating liquidation preferences, redemption rights, lock-ins, drag-alongs and put options. It is critical to ensure that you are fully aware of all these issues and obtain legal advice from an appropriately experienced solicitor before you sign the term sheet.

The following major issues are likely to arise in the negotiations:

a) investment:
The term sheet should clearly specify the amount being invested, the pre-money valuation of the business and the number and type of shares to be issued to the investor.

b) preference shares:
Investors tend to favour preference shares because the protection conferred is not reflected as a liability on the balance sheet (as it is in the case of a convertible note). Preference shares often provide a preferential right to dividends (which may be cumulative).

c) liquidation preference:
Venture capitalists are now frequently receiving a ‘participating liquidation preference’. This means that on a liquidity event they will be returned their original investment and will then participate in the balance of the proceeds on an as-converted basis as if they had not received the preference payment.

d) tranches:
Investors may wish to make their investment in tranches, with each payment conditional upon the company achieving certain milestones (such as a sales or product development target).

e) directors:
Investors will seek to appoint one or two directors to the board and will want veto rights over certain strategic decisions (such as raising further capital, hiring/firing key staff, settling litigation, entering into material contracts, adoption of business plans).

f) anti-dilution:
Investors also request anti-dilution protection, which adjusts their holding in the company to offset some or all of the dilution caused by a ‘down-round’ (ie, a future investment at a lower price than the investor paid). A ‘full price ratchet’ gives the investors the full benefit of the new lower price, as if they had made the purchase at the later lower-priced round. This can be extremely dilutory to the founders, particularly if the down round only raises a small amount of money.

g) restrictions on sale of shares:
As the value of the company is often closely linked to the expertise of founders and key employees, investors will usually ‘lock-in’ the founders’ shares until such time as the investors have sold their interest.

h) facilitation of sale of all issued shares:
A trade sale may be frustrated if minority shareholders refuse to sell. This is particularly important as many bidders will make their offers conditional upon receiving 100 percent of the issued capital so they can form a tax group. Drag-along clauses compel minority shareholders to sell their shares if more than a specified percentage of shareholders (usually 75 percent) accept the third party offer.

i) pre-emption:
Investors will require a pre-emptive right to invest in future issues or transfer of shares. The company should ensure that these rights do not cover the issue of shares under an employee option plan or as part of a merger or strategic partnering deal.

j) exit strategy:
Investors are driven by the need to realise the value of their investment and will want the right to force a trade sale or float within 3 or 4 years. They may also ask for the right to force the founders to buy them back (put option) or to force the company to redeem their shares. Granting a redemption right may stifle future rounds of investment as new investors will not want to see their funds used to pay out existing investors (they would much rather it used to grow the company).

Nick Humphrey is a partner with Deacons and specialises in private equity. He has acted on over 50 investments/buyouts for some of the leading funds in Australia. He is the author of “The Penguin Small Business Guide”, was the chairman of the Innovation Forum and is currently on the management committee for ANZA Tech Network (for Australian companies seeking to expand or raise capital in the US).