22 Power of Ideas

THE ECONOMIC TIMES | MUMBAI | FRIDAY | 26 JULY 2013

Essential Components

The term sheet, which denotes an intention to invest by a venture capitalist, is a slim handbook that rarely has more than a dozen pages. But for an entrepreneur, it is often a vindication of the of a Term Sheet business idea as well as evidence that the startup is a success. While one of the most coveted documents in the startup universe, it is also complex and has the potential to spring up nasty surprises, especially for the novice. Valuation Liquidation If an entrepreneur is not careful, the term sheet could end up destroying the Preference Startups are valued business instead of building it. Though non-binding on both the investor differently before This is the amount of money they receive funding that holders of preference and after the money and entrepreneur, it is important because it lays down the broad contours shares or the investors get comes in. The prewhen a company is sold money valuation of how the investment will be made and under what terms the business partly or fully. For instance is a monetary an investor puts in Rs 11 crore estimate of various will be run. It also reveals the value of the startup, the expected return into a startup and asks for a factors ranging two-fold liquidation preference. from the strength Subsequently if the company is on investment, the money set aside to hire new employees and the of the founding sold for Rs 25 crore, the investor team, competitive would get Rs 22 crore as his returns. voting rights of an investor. landscape, This would leave the entrepreneur intellectual property with just Rs 3 crore despite holding a and the size of the Harsimran Julka and Peerzada Abrar majority share in his company. market. TIP Once an investment turn the spotlight on what an entrepreneur is made, the final Be realistic about the goals that you value of a startup is must know and look out for in a are promising to the investor. Dont derived by adding promise liquidation preference that the amount invested term sheet. you cannot fulfill later to the pre-money
K Ganesh, serial entrepreneur

What
Accompanies a

Term Sheet
Shareholder Agreement
A contract made between shareholders of a company regarding their stake in the company and the rights they hold on the board of the firm. It also contains clauses which protect interests of investors in case of a stake sale or a dispute

Founders Employment Agreement

valuation. Experts said the percentage of stake that a founder cedes must be based on the postmoney valuation. I know of a startup which had to shut down in 18 months as they had diluted too much stake in the first round of funding; no investor would touch them for a second round, said Sunil Goyal, cofounder and MD at YourNest Angel Fund. TIP

ESOP Pool
Investors typically bet on the jockey or the entrepreneur rather than the horse, which is the company. To ensure that the jockey has a support team backing him, investors push for stock option pools to be set aside. But this allocation is normally made from out of the share held by the founder. However this ESOP pool may never be fully utilised, leaving a hole in the stake of a founder. Experts are of the view that it is best for startups to have a hiring plan for a period of about 18 months with a smaller ESOP plan. TIP

Dont focus only on valuation and exclude other terms

says Anjana Vivek, Founder-Director, VentureBean Consulting

Founders must ensure that even the investor dilutes his share for a bigger and better team that is hired later.
Sharda Balaji, FounderNovoJuris Services

Valuation is often a trial and error game and it helps if entrepreneurs talk to others who have raised money from the same investor.
Ankur Singla, FounderAkosha

Founders Shareholding
A term sheet provides the investor with a tool to ensure founders do not leave prematurely. This is done by ensuring that only a portion of the shares owned by the founders can be diluted immediately, the balance is normally locked up. Experts said this clause in a term sheet must be scrutinised by an entrepreneur to ensure that he gets at least half his shares immediately with the balance being vested within four years. TIP

Many founders tend to take a onedimensional view and focus on valuation to the exclusion of all other terms and conditions. It is important to unbundle the various terms and conditions and set out what is musthave, good to have and not wanted and which clauses one is neutral to. This knowledge will help negotiate the best possible terms. The higher the valuation and more the money raised, the more onerous are the clauses one can expect.

Investors are wary of letting the founders go for fear they will start up once more or join a rival. This document defines the mandatory length or term of a founders employment, compensation, shareholding, ownership of intellectual property held by a founder as well as non-compete provisions in case of an exit.

Restated Articles Of Association

This defines the business a company will carry out. And is often restated every time a company raises fresh rounds fo capital as it lays out the powers granted to board of directors and the pattern of new shareholding.

Entrepreneurs must retain the right to be able to sell a part of personal equity to generate some cash in the initial days.
Sunil Goyal, CEO, YourNest

Tips to

Get It Right
the First Time
Term sheets symbolise the start of a relationship. If you wish to compare offers from multiple investors, say so and ask for time. Keep it simple and make sure you are not signing a multi-page document for a small amount of funding. Investors can retain all rights in a detailed term sheet forcing you to ask for permission to even buy a printer. Find a good lawyer who can decode a term sheet from your perspective. Valuation is not everything. Choosing a strategic investor or a marquee fund can help your startup grow faster. Raising too much money, too soon at too high a price can force a startup to shut down early. Watch the numbers in your term sheet. In Real Life
K Ganeshs CustomerAsset, a tech support firm, had raised a second round of funding from an European investment firm during the dotcom bust of 2000. Since funding was rare, CustomerAsset agreed to a drag-along clause. The same year, the investor imposed exercised the option on CustomerAsset. I did not know, being new to VC terms and jargons any better. I would have , in hindsight insisted that an investor can implement the drag along (clause) only after a specific amount of time. It pays to be patient. After being rejected by nearly 40 venture capitalists, Narayan Babu of app maker Dexetra met Vijay Shekhar Sharma, founder of mobile internet Services Company One97, at a technology event. Impressed by Dexetras technology, Sharma offered a term sheet for an investment of Rs 1.5 crore the very next day.

Jargon Explained
DOUBLE DIP A renowned venture fund told us a term sheet from them means it is written in stone but after two months of due diligence and they delaying the process; it is not a definitive agreement
Sandeep Aggarwal, CEO ShopClues

An investor who asks for a two-fold return on investment while stating his liquidation preference can also slip in a clause on double dip. For instance, if a company is sold for Rs 25 crore and the investor gets Rs 22 crore, in a double-dip clause the founder may have to part with even a share of the Rs 3 crore that he is left with.

DRAG -ALONG CLAUSE

In case an investor wants to sell his stake in a company he can force a founder and other investors to follow suit.

EARN-OUT MODEL
An investors stake in a startup automatically increases in case it fails to reach specific milestones.

TRANCHING
Money is released in tranches based on targets making equity a form of structured financing.

PAY TO PLAY
In this clause an existing investor must invest in follow-on rounds to retain his rights.

RIGHT OF FIRST REFUSAL

The right to invest in subsequent rounds of funding rests with the first investor.

ANTI-DILUTION PROTECTION
This allows an entrepreneur to maintain his stake even after subsequent rounds of funding.

Dont breach the trust

says Alok Mittal, MD of Canaan Partners

What to Watch out for in a Term Sheet

realistic in their projections, otherwise they run the risk of losing a significant share of their company. Venture capitalists also enjoy various rights at the Rajat Mukherjee board and shareholder level, including nominating Partner director(s) on the board and anti-dilution rights that proKhaitan & Co tect them from further rounds of funding at a price lower than that what they paid. These ought to be understood and negotiated to ensure that the day-to-day operations Once a draft term sheet is received from a venture of the company do not suffer. capitalist, many entrepreneurs feel that the deal is Also, every investor intends to exit a company at a done. From a legal perspective, it is only beginning. valuation that ensures a pre-agreed minimum multiple of A typical term sheet is a non-binding document invested capital or a fixed internal rate of return. Entrewhich sets out the framework for the initial investpreneurs should understand that they are underwriting ment and the relationship between the parties the investment by accepting hard put and drag-along going forward and is a precursor to the definitive options. documents to be executed after completion of due Most term sheets also ask entrepreneurs not to solicit, diligence. Most investors prefer using a convertible instrument and to cease any existing negotiations, with other parties. Investor rights should be negotiated at the term sheet linked to the performance of the company which stage to ensure that there are no surprises once parties enables them to get a higher shareholding in case performance targets are not met. Promoters must be sign on the dotted line.

Understand the Investor

Kanwaljit Singh
Co-founder Helion Venture Partners

Most of the time, term sheets fall due to the breach of trust by entrepreneurs. In one case, an entrepreneur called in to say that she was going out of town for 10 days, after receiving a term sheet from us. Next we hear, is that she had signed a competing term sheet. In such cases, our doors are always closed for such people for all future rounds. After all its a relationship of trust.

A term sheet which is a formal expression of intent by the investor naturally leads to high expectations among entrepreneurs. However, in our experience it is quite common for entrepreneurs to focus only on the commercial terms in the term sheet while the rest is at best skimmed through or partially understood. What is forgotten at times is that the term sheet is also the start of a journey between the investor and the entrepreneur. As investors it is also our responsibility to ensure that the entrepreneur is signing off on the term sheet with full knowledge and comprehension of the various clauses and not just the key

valuation terms. As early stage investors, we are typically investing in a business at a stage when the model is not yet fully proven and in effect we are backing the entrepreneur to build the business. A lot of the protective clauses therefore are a means to provide comfort to the investor on how the business is getting built since they are not involved in the day to day operations. Similarly, the entrepreneur also needs to appreciate that an institutional investor brings in more stringent requirements of corporate governance and board process which they may not be used to following prior to the investment. In summary, the term sheet is a key trigger of a relationship between the entrepreneur and the investor which could last for five to seven years. It is very important that this relationship is built on the foundations of trust and common understanding between them and both parties must invest time and effort in ensuring that there is complete agreement and buy in on the terms they are agreeing for the investment.