Author: Abu Cassim
9 October 2022
Jozi Angels Term Sheets
In some of our previous articles, we’ve discussed what angel investors should ask before investing. Once an ideal investment opportunity has been identified and it’s been decided to move ahead, a term sheet will be drawn up that lays out the basic terms and conditions for investment.
A term sheet is usually a non-binding agreement intended to facilitate discussions, negotiations and agreement in principle regarding an investment between the startup and the investors. In other words, the purpose of a term sheet is to get the parties on the same page, establishing the broad parameters in respect of an investment. This includes, the instrument to be used, the amount to be invested, details of the parties, the timing of the investment transfer(s) and a high level explanation of how the funds will be used.
A well-written term sheet is critical as it will ensure investor-entrepreneur alignment, which in turn provides the foundation for a positive relationship. At Jozi Angels, our experience has been that no two deals are the same. Each is unique in some respect with terms shifting in the negotiation process to suit both parties. With this said, this article aims to explain some of the key terms included in our term sheets.
As to be expected, the first part of our term sheet identifies all the role players: the startup as a legal entity, its founders, the investors, and the syndicate lead; as well as the principal investment, which not only specifies the total investment amount and that of each investor/syndicate, but also the timing of the investment. Investments can be made in tranches based on performance milestones or time.
Where equity is being purchased, that is a priced round, the company valuation is then documented. It’s important to get the pre-money valuation (the company’s value before funding) and post-money valuation (the company’s value after funding). The valuation will inform the percentage of ownership across all parties: founding team, previous investors and new investors. Investors have a bias towards preferred equity, which tends to carry preferential dividend and liquidity terms over ordinary shares.
Control and oversight measures are also mentioned. This could include a seat on the board, regular meetings with the team, access to view accounts and bank statements as well as protective provisions (also known as restricted measures) which are business decisions which require the investor’s approval. For instance, the company may not randomly change the nature of their business, issue new shares, liquidate, or merge with another company without the prior written consent of the majority of investors.
The term most favoured nation clause specifies that should the company issue any convertible notes, equity or similar instruments that have rights, preferences, or privileges that are more favourable than the terms extended to the investors, the company will be required to provide equivalent rights to the investors.
Investment prerequisites or conditions precedent (CPs) are the company matters that need to be resolved before any funds are transferred. These may, for example, include finalising the operating license of the business, moving across to a particular accounting platform, executing employment contracts or other items along those lines.
The anti-dilution rights protect the investor by preserving their ownership percentages in subsequent investment rounds. This is particular relevant in what’s known as a down round, where the new investment is done at a lower valuation. These anti-dilution protections are implemented on either a full ratchet basis or weighted average basis. The full ratchet anti-dilution lowers the price per share to the price paid in the down round, while the weighted average method (which is the more popular of the two) adjusts the conversion price based on a formula and is not as severe.
The liquidation preference relates to the pay-out order in the event of liquidation or liquidity event which could include an acquisition or change of control. In this scenario, the investors get their money back first, ahead of other shareholders or debtholders.
We further specify the documentation which will be used to clinch the deal (e.g., a subscription agreement, syndication agreement, updates to the memorandum of incorporation or the shareholders agreement, convertible note agreement, resolution passed by the company’s board, etc.).
The company and its founders may also agree to certain information rights, visitation and regular meetings. Recall that an angel investor brings three things to the table: knowledge, networks and capital. It’s at these regular meetings that this value is extracted. The knowledge and the networks often prove to be more valuable over time.
Investors require clarity on how their investment will be used. To this end, the use of proceeds clause provides a breakdown of the company’s intended expenditure. For instance, 25% towards marketing; 25% towards IP consolidation and registration; and 50% towards salaries.
The founder restraint clause prohibit the founders to compete with the company, or have any interest in a competing company, without the written consent of the majority of investors. Investors need to be assured that the founders of a startup are committed to make their company successful. To this end, they want founders to commit their time. The key man clause specifies the period of time which founders have committed to invest in their business.
General terms are outlined at the end of the term sheet. These include agreeing to confidentiality, the governing law in South Africa, arbitration, legal expenses, the status of the term sheet as a non-binding agreement, no shop (engage with other investors), and next steps.
Lastly, the cap table, or capitalisation, illustrates how many shares of the company each stockholder holds, as well as the type of shares (preferred or ordinary). This gives investors a sense of their partners in the business.
Some of the terms listed above relate to priced rounds, while others relate to convertible notes and SAFEs. It’s unlikely that you’ll see all the above terms in a term sheet. As mentioned previously, no two term sheets are ever the same.
Although a term sheet may seem overwhelming at first, it’s a critical step towards establishing a good understanding between investors and founders, as well as setting the stage for the due diligence and legal documentation to follow.