Crafting Term Sheets That Stick
Like a good plate of kacchi biryani, the right ingredients with the right proportions make all the difference.
I love Dhaka in December. Great weather, outdoor parties and seemingly unlimited delicious kacchi biryani served during weddings. Congratulations to all our entrepreneurs and members who are getting married this wedding season. Godspeed to members and friends in town who have to attend all those weddings back-to-back.
But as I write this post in the final week of the month, I can’t help but think of Yogi Berra, that “It’s deja vu all over again.” We had so much to look forward to in the New Year that is now being threatened with the rise of Omicron and the return of cancelled flights, lockdowns and general uncertainty.
At Bangladesh Angels, we’ve been trying to get back to normal. I’m back on the ground in Dhaka, holding face-to-face meetings and in-person presentations with colleagues, members and entrepreneurs. Despite the holidays, we’ve been busier than ever. As we speak, we have several equity term sheets in hand.
Having looked at quite a few this year, I think it’s good to have a conversation on founder-friendly and -unfriendly terms that both angels and entrepreneurs should look out for in those term sheets. Though not exhaustive, here are a few:
Board seats for small positions
The rule of thumb is that a 10% stake should be the threshold to obtain a board seat. Often, one investor might represent an aggregated pool of investors, such as an angel syndicate, who collectively might pass the threshold. But unless someone brings a genuine depth of experience and expertise that would help the company in getting to future rounds, be it through deep subject matter expertise to grow the company or fundraising experience to bring money into the company, entrepreneurs should be stingy with board seats for smaller stakes. This can also be a negotiating tactic to raise ticket sizes.
Large boards can be cumbersome and hard to manage for an entrepreneur, and can distract from the day-to-day of running a business. It also has implications for official decisions, such as having quorums for board meetings, or signatures for board resolutions.
Directors should also be clear on the ‘ask’ from the startup and whether they can actually commit to the 'ask' in terms of hours & involvement, before taking the board seat.
Information and inspection rights
In Bangladesh, the standard customary information right is that all shareholders would get access to the annual report (audit). Anything beyond that, be it quarterly or monthly reporting, should be written into shareholding agreements, though also a good practice for entrepreneurs to follow.
Inspection rights are more onerous. An investor or an aggregate pool of investors with inspection rights have the right to look into a company’s accounts, or visit their office or operations, at any given point in time. Our recommendation, once again, is that a minimum 5% threshold be set, otherwise a company will be distracted answering calls for inspection from investors holding single digit stakes or even lower.
“Interestingly, the Bangladesh Companies Act does not set a threshold and grants sweeping rights of inspection to members including compelling inspection. One suggestion is for companies to work around this and add what is comfortable to them into the Articles of Association. On a practical level, we haven't seen this right exercised unless there is a dire shareholder dispute situation,” according to Anita Ghazi Rahman-Islam of Legal Circle.
Veto rights
Most strategic decisions should be made at the board level. The board in turn may delegate certain decisions to the management, within set parameters. But sometimes, certain sensitive issues might be reserved for an additional layer of approval by a minority of shareholders. What’s an appropriate example? Let’s say there’s a group of investors who came in together during a round holding convertible preference shares (CPS), whereas the founders and other early investors might hold common, ordinary shares. To prevent the ordinary shareholders, who collectively control the majority of the company and presumably the board, from adversely changing the rights of the minority convertible preference shareholders, it might be written into a term sheet and investment agreement that such changes must be approved by the majority of CPS holders. This is called a reserved matter.
The issue is when a small minority of investors insist on having veto power and reserved matters over other shareholders for strategic business decisions that affect all shareholders. For example, having veto power over exit or liquidation events, or share sales, even when the board has approved them.
In-kind investments and advisory shares
I’m not a fan of in-kind investments being included in term sheets, especially if they are non-core to building the business or product. For example, I’ve seen angels (not ours!) try to entice entrepreneurs with “office space” when it’s a clear ploy to have a grip over the company by having them close.
Of course, if the angel is providing something genuinely useful to the entrepreneur, that the entrepreneur would have had to procure anyways as part of their funding request, at below market value, this might be considered as an appropriate in-kind investment. Perhaps an angel has a technology team, and their time is being used to complement the company’s tech team to build the product and platform faster or more effectively. That’s one example.
Even then, in-kind investments should not be counted the same as cash and should also be vested over time as advisory shares rather than given upfront, and crystallized into a separate advisory share agreement between the company and the investor.
Speaking of advisory shares, an entrepreneur might sweeten a deal to a particularly important or critical angel with extra points on their shares. This is acceptable, but our advice is to follow the guidelines set out by Founders’ Institute, and keep advisory shares to between 0.25-1% per advisor, depending on the stage of the company and the extent of services being provided, and vested over time.
Guaranteed exits
An equity investment into a company at the end of the day is a bet over multiple years. The upshot is that it can return the original investment manifold. The downside is that the company may go under. This is the risk that everyone on the cap table, including founders, takes. Investors insisting on guaranteed outcomes - be it an exit multiple, or a time period, or both - go against the spirit of this exercise. Those wanting guaranteed outcomes are best served investing in debt and debt-like instruments, perhaps to cash flow-positive SMEs, and less into cash-burning startups, in addition to the regular gamut of savings instruments.
Too many tranches
I think having a tranche schedule makes sense as a means to see how the founders actually execute on their plans and treat investors once cash comes in. But I’m not a fan of having too many tranches, spread over too many months, especially if those tranches are tied to business performance. Why?
My view is that as an investor, you are investing in the company to achieve such metrics. If the company and founders could achieve them on their own, then that negates the point of raising money. I think having governance-related conditions is more effective. For example, many founders promise that they would resolve compliance issues such as unpaid or unfiled taxes or audits, without a timetable. Another important document is a founder’s agreement, with clawbacks for founders who leave. Resolving each and every single compliance issue uncovered during due diligence prior to an investment may not always work. But they might be structured as a condition subsequent in investment agreements, and tied to follow-on tranches after an initial tranche. This initial tranche can be given and sit on the company’s books as a liability called “share money deposit” that can be legally refunded based on certain conditions.
Having too many tranches over a long period of time (6 months plus) is also fundamentally unfair to an entrepreneur. The entrepreneur needs the funds as soon as possible to execute on his or her plans. Paying out a tranche six months or later does not help them. If that is the intent, then the investor and entrepreneur should negotiate a new, separate transaction, at a different valuation, for those later funds to account for the subsequent growth in the company. My recommendation for angel rounds is for two tranches, over 2-3 months at most.
Fundamentally, most of these issues stem from trust, or lack thereof. Setting all these conditions is a proxy for the fact that an investor fundamentally does not trust the founder. And if such an investor cannot trust an entrepreneur to consult them from time to time, share information, manage funds effectively, achieve business objectives or give an exit, then maybe it’s best for him or her to pass on the investment. Another option? Invest with a larger, more experienced investor or investment group who would do the legwork, as a limited partner in their funds or in sidecar vehicles, or a member in their syndicate.
The flip side for the entrepreneur is that in a market where liquidity for startup capital is still a challenge (though improving all the time), it may not always be prudent to fight on every single one of these points. Founders naturally want high valuations, with high ticket sizes, within a short time frame with the best terms. Angel investors, on the other hand, want to contain valuations, minimize risk through smaller tickets spread over many companies and take their time getting to know the company and doing due diligence. Until Bangladesh becomes a true founder’s market, with multiple investors - local and foreign, institutional and individual - competing against each other to get into rounds - a founder needs to be able to balance these four elements and decide what is worth sacrificing and what is worth fighting for. Given how our peer markets like Pakistan are going, that day is coming sooner than we think.
Besides, there will be bigger fishes that will come in later rounds and negate or neutralize the terms set by previous investors, especially angels, with their own preferential terms. That’s also my advice to angels when pushing for such terms: You can always try to put them in there, but assuming you want the company to continue growing and raise follow-on rounds of capital, which is the point of investing in startups, be prepared for new investors to come in and change them. The question then becomes, how much energy do you want to spend negotiating for terms that may or may not stick long-term, that nevertheless make the company potentially un-investable or unattractive to invest in the meantime.
Many thanks to Anita Ghazi Rahman-Islam for her insights and quote for this post.