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22 March 20216 minute read

Top ten tips for financing term sheets

When it comes to angel and venture capital financing, the principal document between the issuer and ‎investor(s) is the term sheet. As with letters of intent for buying or selling a business, a good term sheet ‎will outline the key terms and conditions of a transaction so the parties can be on the same page before ‎spending the time and money finalizing final legal documents. Here are some key tips for financing term ‎sheets:‎

1.‎ Don’t give away the farm

Angels and venture capitalists are sometimes reluctant to sign confidentiality agreements because they ‎are in constant contact with multiple entrepreneurs, which leaves them vulnerable to claims that they ‎transmitted confidential information between parties. This requires a balancing act by entrepreneurs, who ‎must demonstrate why a product or company is unique without giving away their secrets.‎

2.‎ Binding or not?‎

The essence of a term sheet is that it is a set of terms that the parties anticipate agreeing to or hope to ‎achieve. It is, by definition, written before a formal contract has been executed. As such, term sheets ‎are not generally binding and any terms that you want to be binding should be explicitly set out. ‎

3.‎ Terms to include

Certain sections are common and recommended for a financing term sheet. Some of these sections will ‎be binding even if the term sheet itself is not – these include:‎

  • Expenses - who is responsible for paying what?‎
  • Confidentiality - the company will be providing a lot of sensitive information and the investor ‎may have competitor companies as part of their investment portfolio. ‎
  • Exclusivity - is the company entitled to search for other investors while negotiating this ‎financing? Like with a purchase and sale transaction, you don’t want your hands tied for longer ‎than is necessary, and especially if negotiations with the investor start to go sour. It is advisable ‎to limit the timeframe as much as possible (30 to 90 days is typical) from execution of the term ‎sheet, providing incentive to the investor to close the deal in a timely manner.‎

Other sections that are not usually binding if the term sheet is non-binding, but are important ‎nonetheless, include the use of proceeds (what will the investors’ funds be used for) and securities law ‎requirements (if the company is not a reporting issuer, the investor must fit within one of the private ‎placement exemptions).‎

4.‎ Build a functional capitalization (“cap”) table

You will want to include the issued and outstanding securities (including any options or convertible ‎securities) and the anticipated numbers following completion of this round of financing. It will be ‎beneficial to everyone if these numbers are prepared in a table or spreadsheet that allows the investor to ‎see each party’s basic shareholdings and fully diluted shareholdings, and allows certain inputs to be ‎adjusted. As the valuation of the company or pricing of the offering gets negotiated, or simply to run ‎‎“what if” scenarios, a well-produced cap table can be a powerful tool.  ‎

5.‎ Pick the right kind of security

The most important aspect of a financing term sheet will be what the investor gets for its money. Is the ‎investment for debt or equity, or a hybrid of the two? What will the security look like - simple common ‎shares, whereby all shareholders share equally in the growth and liquidation of the company? Preference ‎shares, with or without warrants or cumulative dividends? A debenture that is convertible upon some ‎triggering event such a sale of the company? What you end up offering will largely depend on the ‎market and the type of investor you’re looking for (for example, individual vs. institutional).‎

6.‎ Raise enough money

Fundraising is extremely time-consuming and you almost always need more money than you think you ‎do. There are certain sunk costs associated with raising money, such as professional fees, subject to ‎the next point, it’s always better to spread these costs over more invested dollars. Most importantly, ‎once this round of financing is complete, ensure that  you have enough funds to get you to a new ‎‎(higher) valuation for the next round. ‎

‎7.‎ Take care in your valuation

Raising as much money (or more) than is necessary will need to be balanced against how much of the ‎company you are prepared to give away. You will need to determine what percentage of the company ‎the investor will get for what he, she or it is investing; this will require a determination of the fair market ‎value of the company. This aspect of the term sheet is a negotiation and an iterative process, so be ‎careful not to lead with your best offer and price. Do your homework on what is comparable and what is ‎market, and always have a financial advisor assist with the valuation exercise. (Keep in mind that the ‎fully diluted number of shares should usually take into account an additional “float” for employee options ‎‎(a common way to incentivize key employees, which is essential to increasing value in the long run).) If ‎founders give up too much too early, they risk losing their drive to create value for all shareholders.‎

8.‎ Investor rights

In addition to the type of security, investors will be looking for what rights will be attached to the ‎securities offered. These rights may include a board seat, consent rights (over certain material ‎decisions), pre-emptive rights on future share issuances, tag-along and drag along rights, and a long list ‎of additional less-common requests.‎

9.‎ What’s market?‎

Similar to the US with its suite of documents courtesy of the NVCA, Canada has a suite of ‎financing documents provided by the CVCA. These documents include a term sheet, subscription ‎agreement and shareholder agreements.‎

10.‎ Always have a plan B

As with most negotiations, how successful one is in achieving a good result depends on the leverage ‎one has and the options created. It is critical to have a backup plan in case an investor is "off market" or ‎attempts to get too friendly a deal. Having the power to walk or back away from the table is key; not ‎having the power to do so is potentially crippling.‎

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