Introduction
When a startup seeks external funding, investor agreements play a crucial role in shaping the relationship between the founders and the investors. The term sheet is a preliminary document outlining the key aspects of the investment deal. While it is non-binding, it serves as the foundation for the final, legally binding investor agreement. A well-crafted term sheet can help prevent disputes and misalignments down the road. In this article, we’ll cover the key clauses you should include in your startup’s investor agreement to ensure that both you and your investors are on the same page.
1. Valuation and Investment Amount
The first key clause in an investor agreement is the valuation of your company, which sets the stage for the amount of equity the investor will receive in exchange for their capital.
- Pre-money and Post-money Valuation:
- Pre-money valuation refers to the company’s value before the investment is made, and post-money valuation includes the new capital that will be invested.
- These valuations determine how much of the company the investor will own. For instance, if an investor is contributing Rs. 500,000 to a startup valued at Rs. 50 lakh (post-money), they would own 10% of the company.
Why It’s Important: Establishing a fair and realistic valuation is vital, as it impacts both the investor’s potential returns and the founder’s equity stake.
2. Equity Ownership and Percentage
Equity ownership outlines what percentage of the company the investor will own after their investment. This is calculated based on the post-money valuation and the amount of investment.
- Dilution: When new shares are issued in future funding rounds, the investor’s percentage of ownership may decrease unless anti-dilution provisions are included.
Why It’s Important: Investors want to ensure that their share of the company is proportional to their contribution, and founders must be aware of how future rounds could impact their ownership.
3. Liquidation Preference
Liquidation preference is a crucial term for investors. It specifies the order in which stakeholders are paid in the event of a liquidation, such as when the company is sold or dissolved. Investors with liquidation preference are paid before common stockholders, which means they have a priority claim on the company’s assets.
- 1x Liquidation Preference: This means the investor gets back their original investment before anyone else is paid.
- Participating Preferred Stock: Investors may get their liquidation preference plus a share of any remaining proceeds.
Why It’s Important: Liquidation preference ensures that investors are protected if the company does not achieve the desired level of success or is sold early.
4. Board Composition and Control
Investors typically seek some level of control over the company, particularly when it comes to major decisions. This often takes the form of a seat on the board of directors or the right to appoint board members.
- Board Seats: The term sheet should specify how many board seats the investors are entitled to. Founders may retain a majority, but investors will likely request at least one or two seats to influence decisions.
Why It’s Important: Board composition helps balance control between founders and investors, ensuring both sides have a say in major business decisions.
5. Voting Rights
Voting rights determine the scope of decisions that investors can participate in. Investors generally want to be able to vote on matters that could affect the company’s value or their investment.
- Major Decisions: Investors may want the right to vote on:
- Mergers and acquisitions
- Issuance of new shares or changes to the company’s capital structure
- Sale of the company
- Amendments to the bylaws
Why It’s Important: Clear voting rights protect both parties by establishing which decisions need the investor’s consent, ensuring alignment on major corporate actions.
6. Anti-dilution Provisions
Anti-dilution clauses protect investors from dilution in case the startup raises funds at a lower valuation in the future (a down round). This clause adjusts the conversion rate of the investor’s preferred stock to ensure they maintain their ownership percentage.
- Full Ratchet Anti-dilution: This provision adjusts the price at which the investor’s shares convert to common stock to the new lower price, providing more protection for the investor.
- Weighted Average Anti-dilution: This adjusts the price based on the weighted average price of the new shares issued, offering a more balanced approach.
Why It’s Important: Anti-dilution provisions offer a safeguard for investors, ensuring their stake in the company does not shrink disproportionately during future funding rounds.
7. Founder Vesting
Founder vesting ensures that founders stay with the company and continue working toward its success. Typically, vesting occurs over a period of four years with a one-year cliff. This means founders earn their equity gradually, with a portion of their shares vesting only after they’ve been with the company for a year.
- Vesting Schedule: A typical vesting schedule might look like 25% of shares vesting after the first year, with the remaining shares vesting monthly or quarterly after that.
Why It’s Important: Founder vesting motivates the founders to stay committed to the company and discourages them from leaving shortly after receiving their equity.
8. Exit Strategy
An exit strategy outlines how and when investors can cash out their investment. Common exit routes include:
- Initial Public Offering (IPO): The company goes public, and investors can sell their shares on the stock market.
- Acquisition: The company is acquired by another business, and investors are paid according to their equity stake.
- Secondary Sales: Investors may also have the option to sell their shares to other investors or through a secondary market.
Why It’s Important: Both founders and investors need to agree on the potential exit strategies early in the process to align their goals for the future of the business.
9. Warrants and Options
Warrants and options give investors the right to purchase additional shares in the future at a predetermined price. These instruments are often included in investor agreements as an added incentive.
- Warrants: These allow the investor to buy additional shares at a fixed price, usually for a period of several years.
- Employee Option Pool: Often, the investor will request that the company allocate an options pool to attract key talent, with the percentage usually coming out of the founder’s share.
Why It’s Important: Warrants and options allow investors to increase their ownership in the company if it performs well, providing them with further potential upside.
Conclusion
Negotiating an investor agreement is a pivotal moment in your startup’s journey. Each clause in the term sheet carries significant weight and can have long-term implications for the future of your business. By understanding and properly structuring key clauses such as valuation, equity ownership, liquidation preferences, and board control, you can ensure that both you and your investors are aligned and set up for success. Remember, the term sheet is just the starting point, so it’s essential to work with legal professionals to finalize the agreement and protect both parties’ interests.