All start-ups face a major problem when it comes to early stage investment. They have to make crucial decisions that are relevant only for the distant future. Therefore, in conducting negotiations with potential investors, start-ups must always bear in mind the entire process they have embarked upon – and ensure that the current investment will not prove an obstacle at some future stage.
Although the legal structure and process of venture capital investments will vary from one company to another, depending upon the company's existing legal structure, its goals, and the investors' requirements, there are typical issues and terms that arise in most cases.
Today, Enable begins a serious of columns that will highlight some of these issues and terms, and the main milestones of the process.
Inital Disadvantage
Negotiations with venture capitalists to establish the basic investment terms are typically done directly by the principals without attorneys present. The venture capitalists have the advantage of experience, and understand the various terms. The management team of the start-up usually lacks such familiarity with the important investment terms, and without preparation and some coaching, will often be in no position to appreciate their significance.
Term Sheet
The financing process, from the legal point of view, typically begins with negotiation and drafting of the term sheet. Therefore, entrepreneurs must understand what a term sheet is all about and its role in the investment process. The term sheet is the initial document, which sets forth, in outline, the major terms and conditions on the basis of which the investment is to be pursued.
Although the term sheet may take a variety of forms, it is intended to accomplish the following purposes:
- To reflect the agreed valuation of the business and to quantify the proposed allocation of that value between the entrepreneurs and investors.
- To summarize key financial and legal terms of the transaction which will serve as the basis for preparing definitive legal documents.
- To impose enforceable legal obligations upon the parties – like prohibiting negotiations with other parties pending the completion of the transaction (no shop, or standstill).
- Most importantly, the term sheet should be used by the venture capitalist to make sure that the concerns of the entrepreneurs – which if not addressed will turn into "deal killers" - are resolved. This includes issues like composition of the board of directors, terms of employment for the entrepreneurs, and relocation of the company and/or of the entrepreneur.
Some Key Terms
The terms of investments differ from one case to another. However, there are common provisions, and examples of some typical provisions are discussed below:
- Registration Rights - These rights allow investors to force the company to register the investors’ shares for sale to the public at the exchange commissions. Such rights afford the investors liquidity by enabling them to sell their shares to the public. Registration Rights may be granted in two forms:
(i) Demand Registration Rights, which enable the investors to force the company to register their shares for sale to the public at any time; and
(ii) Piggyback Rights, - which allow investors to "piggyback" their shares in a public offering conducted at the initiative of the company.
The significance of Registration Rights may be overlooked at the financing stage, but they may prove to be highly cumbersome later on, particularly in the case of Demand Registration Rights. This is due to the fact that a demand for registration may be instigated at a time which is not favorable to the company. Such process when forced on the company may be substantially detrimental. The costs involved are considerably high, and the registration process is time consuming – especially for the management team.
- Pre-Emptive Rights - These entitle the investors to a right of first refusal with respect to any issuance of shares in the company, subject to the conditions agreed upon. In this manner, the investor is afforded some protection against dilution.
- Right of First Refusal - Entitles the investors or other shareholders to a right of first refusal to purchase shares being transferred by other shareholders in the company.
- Warrants - These are options granted by the company to third parties, or members of the company, for the issuance of shares in the company, under certain conditions and at pre-determined price. Warrants may be granted to existing shareholders, others advancing bridge loans to the company, or to investors who actually purchase shares from the company, in which case the warrants are issued as part of a "package".
- Participating Preferred Shares - In many instances, investors, especially capital venture investors, may require to be issued participating preferred shares. Such shares normally carry preferences and rights that are not attributable to other shares, such as a preference in distributing the company’s assets in certain events (the company’s liquidation or sale).
It may well be that rights allocated to investors will be granted to holders of Preferred Shares. It is often the case that in a particular company there will exist more that one class of Preferred Shares, in which case each class may have different rights and preferences or different ranking with respect to particular rights and preferences.
Next week, Enable will cover due diligence, the closing, and reveal a few "tricks" that entrepreneurs need to watch out for.
Published by Israel's Business Arena on September 28, 1999