After a week of negotiations, I thought I'd provide some guidance to startups when they are seeking investment. A term sheet (ie. an investor's offer) generally lays out the amount of investment, the percentage ownership that the investor is requesting, and a series of terms that are required as part of the investment. Once the terms of the investment are agreed upon and the document is executed, the terms are incorporated into the company's operating documents and additional legal paperwork is also completed. (ie. Shareholder Agreement, Securities Purchase Agreement, Amendments, etc.) A consistent issue that I see with startups is that they begin trying to negotiate terms in the term sheet that they don't fully understand. If you don't understand what a term means, It does not make you look bad if you say that and ask for clarification. What does make you look bad is when you start negotiating it and don't know what you're talking about and end up wasting time and energy. If you're confused, ask for practical examples of when a specific term may be exercised to better understand. Investors will appreciate that.
Some common terms that startups often don't fully understand are as follows:
- Redemption Clause: This type of clause is usually structured in a way that allows investors to make the company buy back their shares after a certain period of time with interest. A scenario when this could occur is when the business starts growing and the founders start drawing a $500,000 a year salary instead of taking a reasonable salary and infusing the rest of the money back into the business to grow it. We call this a lifestyle business. (ie. the founders get paid a healthy salary but are no longer incentivized to grow the business and sell it where investors can make a return) It is a rarely exercised clause, but it protects investors' interests.
- Dividends Clause: This type of clause can be incorporated in certain situations with the redemption clause discussed above. This clause discusses the amount of interest that accrues on a yearly basis. For example, in the Redemption Clause scenario, let's say that the agreed upon dividend was 8% per year. This would mean that when the investors required the business to pay them back their investment plus 8% per year, the business would be required to do so. Startups often get this confused thinking that this clause makes the investment look more like a loan, instead of an equity investment. This is not the case because if the company grows as planned, then it would never need to be exercised. It is only to protect investors' interest in a downward scenario.
- Reporting Requirement: Another term that startups often try to negotiate on is reporting requirements. This clause lays out how often companies must provide financial/business reporting to their investors. Usually, investors require reporting on things such as the company's current valuation, are they raising capital, how much are they raising, what is their revenue growth, etc. This is usually performed on a quarterly basis. Startups should recognize that investment funds have a fiduciary duty to their investors to provide investment results information at certain points throughout the year. The goal is not to be overly burdensome on the business, but to keep track of its growth and provide help where needed.
- Voting Rights: The voting rights clause lays out when an investor has the right to vote on certain issues within the business. This could be on things like issuing new classes of stock, whether a company should get acquired or not, approving a transaction outside of the normal course of business (ie. don't be an artificial intelligence company and open a new line of business using company funds to give hot air balloon rides. It doesn't fit your business model...lol) There are a plethora of practical scenarios that could occur for why investors ask for voting rights in different areas. A lot of these terms are standard and they are not put there to hinder growth, but instead ingrain you as partners for your success and protect investors' interests.
Aside from the common terms I see startups attempt to negotiate, I often see another issue that businesses should pay attention too. Usually, when an investor presents a term sheet, the startup will bring it to their legal counsel to review. Their attorney will come back to them with a bunch of suggestions and terms that they advise the company to negotiate. An issue here is that often times, startups will be strapped for cash in the earlier phases of the business, so their legal counsel will be a general practice attorney that may have zero experience in private securities transactions. In this scenario, the suggestions to the company are not always accurate or well thought out due to a lack of experience in the space. This ends up wasting time, energy and money. I'd definitely recommend that startups find a solid attorney early on in the business that has experience with these types of transactions. It will make a world of difference as your business grows.
Another thing that happens a lot when negotiating term sheets, is that companies will get bogged down in the weeds of the terms, instead of focusing on the bigger picture. Do not think that investors are putting terms into their investment offering that are trying to screw over your business. Why would an investor do that? Really...think about it for a minute, because startups get so attached to wanting to have it their way on certain terms, that they forget the biggest part of what they are trying to accomplish. You are attempting to receive investment and develop a successful partnership with your new investor. An investor would be shooting themselves in the foot if they were trying to do anything except help you create a massively successful business.
So the moral of the story is as follows:
- Stay educated
- If you don't understand a term, ask questions
- Don't waste time negotating terms that don't matter
- Hire experienced attorneys at the beginning of the business
- Never forget that an investment is a partnership with your business and creating a successful company is directly aligned with investors' interest of making a return