Elie Boujaoude discusses term sheets at the UK-Lebanon Tech Hub. (Image via Antoine Abou-Diwan)
Although a term sheet is not legally binding, it sets a roadmap for the completion of the investment so entrepreneurs raising cash should negotiate the document very carefully.
“[A term sheet] is much better from the investors’ perspective. They have the money and they are the ones imposing the rules,” said Elie Boujaoude during a workshop at the UK Lebanon Tech Hub in Beirut on Wednesday.
As investors are minority shareholders, a term sheet is designed to optimize their exit. It protects investors’ rights, aims to ensure proper reporting and governance of the company, and the way proceeds are used.
“You can’t use the funds to buy a house or pay for a wedding,” Boujaoude said.
To safeguard their investment, investors conduct the due diligence process early on. This means verifying the founders’ claims.
“If you tell them ‘I have a super technology’, they will check that it is a super technology,” Boujaoude said. “If you tell them you have invested a million dollars of your money, they will get an auditor to audit your books.”
Boujaoude cautioned listeners from getting lost when negotiating the valuation of the company.
There are many methods to determine the value of a company, and “in some cases investors decide what share they want in your company and then they try to justify it with a valuation method”.
Entrepreneurs seeking cash should differentiate between a pre-money valuation - the value of the company before cash was raised - and a post-money valuation or the value of the company after fundraising.
To avoid diluting their shares in the company, entrepreneurs need to negotiate pre-money valuation rather than post-money valuation, Boujaoude said.
On that note, just two provisions in a term sheet are binding — the exclusivity clause and the confidentiality clause. An entrepreneur is prohibited from disclosing that she has signed a term sheet, and is prohibited from shopping the term sheet around to get a better deal.
A ‘liquidation preference’ does not mean that the company has gone belly-up and needs to be liquidated.
Rather, the term refers to any possible scenario where control or assets of the company radically change. For example, the entrepreneur may be thinking of selling the company, major assets of the company, a controlling share of the company (50 percent or more), or merging with another company and losing controlling power.
‘Investors' liquidation preference’ requires the entrepreneur to to pay the investor first.
“If the investor paid $500,000 and you sell for $700,000, the investor gets his $500,000 back and shares $200,000 with you on pro-rata basis,” Boujaoude said.
Anti-dilution clauses protect the value of the investor’s investment and cannot be negotiated away, he said. The clause is only triggered if the company issues shares at a lower value than what the investor paid.
Should this happen, the company will need to give the investor additional shares to offset the loss of value.
To further protect their position, investors can require entrepreneurs to seek their approval before they take certain decisions.
“You and the investor are not equal,” Boujaoude said. “The investor has more rights than you. The investor can block certain decisions. The investor can impose certain decisions.”
Matters that typically require investor approval include the liquidation or dissolution of the company, amendments to legal documents, the issue of new shares and changes to the size of the board of directors.
Investors typically try to make the company pay the legal fees associated with closing an investment.
“Make sure fees are capped and payable only upon consummation of deal,” Boujaoude said. “You cannot imagine what a lawyer can charge.”
Should the company be successful enough to go public, an investor lock out prohibits investors from selling their shares for 180 days after the initial public offering.
“What signal are we giving the market,” Boujaoude asked, rhetorically. “We got a good value — let’s sell and run.”
Tag-along rights ensure that the minority shareholders — investors — can ‘tag-along’ on a transaction. If the founder is selling part of his stake, tag-alongs allow investors to participate in the deal under the same terms.
Drag-alongs sound similar and but are potentially more problematic.
“This is probably the ugliest part of term sheet,” Boujaoude said.
If an investor decides to sell his stake, and convinces a sufficient number of shareholders who collectively own 50 percent or more of the company, they can force all shareholders in the company to sell their stakes.
“You cannot negotiate this away,” Boujaoude said.
He advised entrepreneurs to try to negotiate a higher drag-along threshold, like 70 percent.
Though term sheets have many standard elements, entrepreneurs seeking cash and resources can try to negotiate, and it doesn’t just have to be for funding.
“You can take in-kind investment,” Boujaoude said in response to a question from the audience. “But go for the cash.”