knowledge 9 June 2020 |

COVID-19: The Impact on Term Sheets for Investments

What is a term sheet?

Term sheets are a statement of the principal terms on which an investment will be completed.  The purpose of the term sheet is to ensure that the fundamental terms of any deal are agreed, before the parties invest time, effort and resources on the more technical aspects of the deal, such as due diligence or the transaction documents themselves.  They are sometimes known by a variety of other names, such as a heads of terms, a letter of intent, or a memorandum of understanding. Although typically not a legally binding contract, certain terms in the term sheet will commonly be expressed as being legally binding – these are usually terms around exclusivity and confidentiality. 

What is contained in a term sheet?

The term sheet will be the basis on which the transaction documents that complete the investment are based.  As such, the term sheet will typically state (in summary form) the key aspects of the deal, including the parties, the amount of the proposed investment, the details of the shares being granted to the investor in return for the investment (such as the number of shares, voting rights or directorships associated with the shares), the value of each share and the pre-money valuation of the company. The term sheet also provides for how the investment will be delivered (e.g. in one payment, by reference to milestones, or some other mechanism) and the timetable for completion, including any long stop or final completion date (by which the deal must be completed, or the parties can walk away).

How are term sheets being affected by COVID-19?

One of the apparent effects of the COVID-19 pandemic is the creation of a more investor-friendly business environment and this is being reflected in term sheets. That said, start-up companies should compare the short term gain of investment against the long term impact for the company and its existing shareholders/founders and are reminded that they can (and should) negotiate the terms of the term sheet – remembering that if an investor is interested in the company, there is a reason for this. Some of the ways in which we have seen terms sheets reflect the more investor-friendly environment include:

• Increased stakes

  Investors may need to be persuaded to invest based on an offer of a higher stake in the company.  Some conservatism is being shown by investors in early stage companies, who are looking to achieve a bigger stake in the company for the same level of investment when compared to pre-pandemic expectations.

• Tranche funding

  In order to guard against the more risky strategy of delivering a large investment as a single lump sum, investors are increasingly providing funding in tranches.  This approach allows an investor to withhold portions of their funding until certain key dates or performance milestones are met.

• Anti-dilution protection

  Even before the pandemic, investors commonly sought to protect their equity position by requiring anti-dilution protection. Put simply, this mechanism provides the investor with protection against a “down round”, being a subsequent funding round by the company at a lower valuation to the one placed on the company by the investor. If a down round occurs, then the investor receives additional shares to leave it with the same equity stake its original investment would have provided at the lower valuation. Many versions of this protection exist, with some being much more investor friendly. The current pandemic is likely to see more investor-friendly anti-dilution protection arise and, unfortunately, it is also likely to mean that more down rounds will occur, as some companies will struggle to maintain their pre-pandemic growth trajectory.

• Liquidation preference

  While some investors will be happy to invest in ordinary shares, others will require their shares to have a preferred return on an exit or liquidation.  The mechanism through which this is achieved is common referred to as a ‘liquidation preference’ and, despite the name , it is actually most commonly used on the occurrence of an exit through a share sale as the means by which the proceeds of the exit will be divided between the different share classes.

  Liquidation preferences for investors can be calibrated in many different ways, but most will fall into one of the following broad categories:

  (a) Downside Protection

   The purpose of this type of liquidation preference is to give an investor a better chance at recovering its investment if the exit valuation achieved by the company is not as high as hoped for. Downside protection means that on a triggering event the investor gets paid first up to the amount they invested and before all other shareholders share in the remaining exit proceeds.   For example, if proceeds of €10m were generated from an exit, and the investor invested €5m for a 25% shareholding, downside protection would allow the investor to be paid its €5m first and the remaining shareholders holding 75% would share in the remaining €5m.  By contrast, if the exit generated €20m, the investor would still only receive €5m, because this downside protection only gives priority of payment, not a higher percentage payment.  

  (b) A “single-dip” preferred return

  This is a true preferred return, which gives the investor a higher return than its pro rata equity percentage.  The investor will typically hold a convertible preference share that will allow the investor to receive on an exit, in priority to all other shareholders, a multiple of its investment amount.  The investor has no further right to participate in the proceeds of the exit.  These preference shares will typically be convertible into ordinary shares at the option of the investor, so the investor will calculate, based on the proceeds generated by the exit, whether they will receive more on the preferred return or more if they converted their preference shares into ordinary equity and took a pro rata percentage of the exit proceeds.  Accordingly, this type of liquidation preference gives the investor both downside and some upside protection.

  (c) A “double dip” liquidation preference

  This is the most penal type of liquidation preference.  This allows the investor to take its preferred return in exactly the same way as a “single dip” preferred return, but in addition, the investor can then participate pro rata in the balance of the proceeds.  This kind of double-protection had largely fallen out of favour, but may make a return as the COVID-19 pandemic weakens investor enthusiasm in early stage companies.

  These provisions are vitally important to get right in the term sheet, as it could mean that a pro rata percentage shareholding in share terms is actually much higher in real economic terms.  It is also common that terms like this are given to one investor, future investors will tend to look for the same, if not better terms.  

• Good leaver/ bad leaver provisions

  Good leaver/bad leaver provisions dictate what happens to a founder’s shares if they leave the company.  An investor may seek to include these provisions so that the company’s executive team are properly incentivised to develop the business following a fundraising. These provisions can often deter an executive from leaving if they require them to transfer their equity if they leave.  The provisions may also determine the price at which transfer takes place based on whether the leaver is a “good leaver” or a “bad leaver”. The most common position is for a good leaver to be paid fair market value for their shares and a bad leaver to be paid the lower of fair market value and nominal value for their shares. If good leaver/bad leaver provisions are required, in negotiating these terms, a founder may consider insisting on time limits applying and limiting any mandatory transfer requirements to bad leavers only.

• Veto Rights and Board Membership

  There is always debate about the level of control that an investor has in the company after investment. The term sheet should set out clearly the level of oversight that the investor will have. Due to the (perceived) rebalance of negotiating strength to investors, it is likely that investors will seek more control and influence over the board and its composition, as well as the range of matters that require investor consent.  Founders should think carefully about the level of control they are willing to cede to investors – once control of the board is given away, it will be very difficult for founders to regain it at a later point.

Key takeaways

Despite the negative impacts of COVID-19 on the availability of capital for start-up companies, founders continue to raise money and on-board investors. In doing so, we recommend a robust term sheet is negotiated at an early stage to ensure all parties are aligned on the terms of the investment. Ultimately, the best way to protect your interests, is to carefully consider, interrogate and negotiate the term sheet and, if required, seek advice from your trusted advisors.

How can we help?

McCann FitzGerald is ready and willing to assist clients in addressing all of their concerns in respect of the terms of investment and of any legal issues their business may face.  Please contact any member of the McCann FitzGerald Start Strong team to assist.

Also contributed by Donncha Sexton