Demystifying the Term Sheet: What founders in Hong Kong need to know

You’ve grown your company and lined up your prospective investors – congratulations! Now it’s time to prepare your Term Sheet.

Your Term Sheet is the first thing your investors will see as part of your funding round. It’s a simple but all-important document that summarises the key terms that will define your negotiations with investors, shape your funding round and set the tone for your relationship with future shareholders.

What is a Term Sheet?

A Term Sheet is a short document that bridges the gap between a ‘back of the napkin’ agreement with your investors and the reams of legal docs spelling out every detail of the deal.

Term Sheets are not intended to be legally binding, but they represent an in-principle agreement that guides the more detailed negotiations to come. Investors will typically agree to and sign the Term Sheet before the remaining agreements are created.

A short and simple Term Sheet covering just the basics might get you in the door quickly – but be aware that things can easily fall apart when you get down to the details later. In our experience,  going into detail on the deal terms upfront can be more efficient because you’ll quickly discover whether or not an investor is the right match for your company. That said, a lengthy set of upfront requirements might mean you never get past first base.

💡 Tip: When you do your funding round on SeedLegals, you can build a Term Sheet that hits the sweet spot between too much information and not enough. It’s easy, fast and fully compliant – and you can check in with an expert anytime.

To help you understand the terms and clauses you’ll be working with, we’ve put together this simple jargon-busting guide.

1. Valuation

The company valuation is simply how much equity you’re giving away in exchange for the investment amount. It’s critical that you and your investors are on the same page about whether you’re referring to ‘post-money valuation’ or ‘pre-money valuation’.

• Pre-money valuation is how much your company is worth before the investment under discussion.
• Post-money valuation is how much your company will be worth after the proposed investment in your company.

A pre-money valuation vs a post-money valuation can make a significant difference to the size of the equity stake your investors take away.

Let’s say your investors want to invest $100,000 in your company.

If your pre-money valuation is $1 million, that means your company will eventually be valued at $1.1 million after investment, and your investors will end up holding 9% in equity.

If your post-money valuation is $1 million, that means your company is currently valued at $900,000 and your investors will take home 10% in equity.

It might seem like the difference between the two is mostly mathematical. But it’s important to know which yardstick you’re referring to when speaking with investors. That way, everyone’s on the same page and knows exactly how much equity everyone will ultimately have.

2. Ordinary shares and preference shares

There are two main classes of shares you’ll come across frequently in early-stage fundraising rounds: ordinary shares and preference shares.

• Ordinary shares are ordinary because they don’t get special treatment compared to other share types. All ordinary shareholders have the same entitlement to distributions from the company (such as dividends) in proportion to the number of shares they hold, and no ordinary shareholder has priority over another.
• Preference shares get priority over ordinary shares and give the holder certain rights. These rights help protect early-stage investors, who are taking significant risks in investing in companies that might not be generating revenue yet. The two main rights you get with preference shares are liquidation preferences and anti-dilution.

Liquidation preferences and anti-dilution

A liquidation preference gives the holder priority over the proceeds of a startup. If the company winds up or is sold, investors with liquidation preferences get their money back before the ordinary shareholders get paid.

A liquidation preference might also have a ‘multiple’ attached. A two times (or ‘2x’) multiple, for example, means that an investor is entitled to returns of twice the amount they had invested. The higher the multiple, the more an investor is entitled to if the company shuts down.

Anti-dilution protects shareholders from being diluted by new funding rounds. The most common anti-dilution provisions come into play if the company raises at a lower valuation during their next funding round – this is called a ‘down round’. Investors generally don’t like having their stake in the company reduced by new share issuances, especially if the new investors pay a lower price per share than they did. When a company does a down round, the value of an existing investor’s shareholding drops drastically. Not only does their shareholding percentage in the company decrease, the value of each share they hold falls. The anti-dilution clause tops up the existing shareholder’s equity stake by compelling the company to issue additional shares to them.

3. Pre-emption rights

At every funding round, shareholders are diluted because new shares have to be issued to give to new investors. This reduces the shareholder’s overall shareholding percentage.

Pre-emption rights protect shareholders by giving them first dibs on new shares when the company carries out a fundraising round. The new shares have to be offered to shareholders with pre-emption rights before they can be sold to new investors. This gives the shareholders a chance to ensure that their shareholding percentage in the company does not fall.

4. Drag, tag & co-sale rights

These rights come into play when selling the company becomes a possibility. They are designed to protect majority and minority shareholders respectively and to represent the potentially competing interests of both groups.

Usually in early-stage companies, the investors are minority shareholders and the founders still own most of the equity as majority shareholders.

Drag-along rights

Drag-along rights give majority shareholders the power to ‘drag-along’ minority shareholders when an offer is made to buy the company.

The drag-along prevents the shareholders from being held hostage by a few shareholders who refuse to sell their shares. If a certain percentage of shareholders want to go ahead with the sale, then all shareholders will be forced to sell at the same price.

It might sound like an aggressive measure, but the drag-along provision sets out precise conditions in which the majority shareholder can force the sale:

The percentage of shareholders who have to agree to the sale to invoke the drag-along – usually 75%.

The majority shareholder has to identify a buyer who will purchase a sufficiently large number of shares – usually over 50% to transfer company control over to the buyer.

Tag-along rights (AKA co-sale rights)

Tag-along rights protect minority shareholders in the event of an exit share sale by a majority shareholder. The tag-along extends the sales right to other shareholders, so that they can also sell their shares at the same price as the majority shareholder if they want.

Let’s break down an example of a tag-along provision. A shareholder holds 20% of the shares and finds a buyer for their entire shareholding. The rest of the shareholders (the ‘Tagging Shareholders’) are entitled to collectively sell another 20% of the remaining 80% of the shares – that is, a quarter of the remaining shares. The amount of shares a Tagging Shareholder can sell depends on the size of their shareholding. A 20% shareholder is entitled to sell up to one quarter of their shares, which translates to 5% of the shares in the company.

Tag-along rights allow investors to reap the rewards of their initial investment by riding on the coattails of their fellow investors. They are especially useful for investors who hold a relatively small number of shares and who might have difficulty finding a buyer for them – since buyers tend to prefer purchasing a sizable chunk of a company.

As a founder, however, you should be aware that tag-along rights might make it more difficult to find a buyer as the majority shareholder. This is because you’ll need to find someone who is willing to purchase more than just your shares.

5. Investor consent

While investors are typically happy to let the founders get on with managing and growing the company, few investors are willing to grant founders completely free rein.

It’s common, especially when a venture capitalist is involved, for investors to protect their investments by insisting on having veto rights over certain important decisions. These decisions include company payments and loans over a certain amount – but exactly what your investor wants a veto right over will depend on your company and your investor.

While it’s difficult to avoid granting consent rights entirely, as a founder you should make sure that you’re not agreeing to anything too restrictive.

For example, it might be sensible for investors to require that the company gets consent before taking on more than $250,000 of debt a year if it has an annual revenue of $1m. But this restriction  makes much less sense if the company has an annual revenue of $10m.

6. Board seats

Investors who have a significant shareholding (usually 15% or more) will often ask for a board seat, known as an Investor Director position.

You might think that having an external party on the board would get in the way of your ability as a founder to manage your business, but there could be advantages to appointing an Investor Director. If your investor is a reputable venture capitalist, there’s a good chance that their board representative has valuable experience and insights that can help you scale your business.

On the other hand, remember that investors also have their own agenda and stakeholders. While all directors owe an overarching duty to the company, the reality is that having an outsider on the board can increase the odds of friction. Don’t be too quick to give away board seats in exchange for an investment because a difficult board can be a real impediment for a growing company.

7. Warranties: liability caps

Investors commit money based on promises about the health and viability of the company – for example, that the cap table is correct, the company isn’t being sued and that it owns its intellectual property. In most cases, these promises – or warranties – are not spelled out in detail at the Term Sheet stage. Instead, there’s a general understanding that ‘customary’ warranties have been made by the company and/or the founders.

There can be severe financial consequences if a founder fails to disclose something that might affect an investor’s willingness to invest.

A warranties liability cap protects founders by limiting the amount of liability you would have to pay if there was a breach. It’s usual to set a cap per founder that outlines how much they would personally be liable for. It’s customary to cap the liability of the founders to an amount equal to their annual salary – though if the founder isn’t being paid anything yet, then you could set a fixed figure.

Be aware, however, that investors might request that the liability cap does not apply to certain ‘fundamental’ warranties. These relate to critical aspects of the company – for example, that the founders and the company have not been indicted for fraud or that a winding-up application has not been made against the company. Investors will typically expect that there’s no cap on the liability resulting from the breach of fundamental warranties.

Fundraise faster with SeedLegals

That’s our round-up of the Term Sheet jargon you need to know. We hope it helps you negotiate the right terms for your deal and close your round quickly and efficiently.

If you have any questions, or still not sure on the best way to go, we’re here to help. Get in touch with our team who will guide you and help you get started. 

*Disclaimer: The information contained in this article does not constitute and should not be treated as legal, tax, accounting, or financial advice.