Rockstart Law School: General elements of an equity term sheet
Setting up and running a startup requires knowledge of the industry that you are in. It also requires knowledge about finance, marketing, customer service, management, and legal matters. There is no way of knowing everything you need to know, which is why the network that supports you becomes a valuable tool and asset.
Rockstart Law School is a combination of blog posts by outside contributors and vlog posts by Rockstart’s very own legal counsels Els Metten and Lisette Schuilwerve. They will show the roadmap to the legal side of starting and running a startup company. Rockstart Law School focuses on the Dutch law system and is meant as a resource and gives you lessons learned and suggestions, but is not meant to be used in the place of legal advice. Always consult your lawyer, but we hope these series of posts will give you a greater understanding of the legal needs and points of attention that you may encounter during your startup journey.
When your startup company is growing, you will need to focus on raising funds to meet the financial needs of the growing business sooner rather than later. Basically, there are two types of funding available to small businesses: debt financing and equity financing. In this blog post, I will focus only on the latter, more particularly on the key document in any equity financing round, being the equity term sheet. It kicks off a series of blog posts on the main topics of an equity term sheet. So, let me start with the basics and explain some general elements of the equity term sheet below.
In short, the equity term sheet is a preliminary, mostly non-binding document, which sets out a summary of the principal terms of an intended investment in the company by one or more investors against the issuance of shares in its capital. It lays the foundation for the more elaborate terms of the financing round, which will, upon reaching agreement on the term sheet, be recorded in the long-form transaction documentation. However, this does not imply that all applicable terms need to be addressed in the equity term sheet. It typically only outlines the most fundamental terms, which are, among others, about valuation, milestones, anti-dilution, liquidation preference, representations & warranties, reserved matters, tag and drag along, reserved matters, right of first refusal, pre-emptive rights, vesting, and non-competition. These topics will be addressed in more detail in the subsequent blogs.
Despite its mostly non-binding (mostly, because a few binding provisions are often included on costs, exclusivity, confidentiality and governing law) and summary nature, the equity term sheet is a key document and one should not underestimate its significance. The contents of the equity term sheet will determine the parameters of the final agreements on the financing round. “The equity term sheet is critical. What’s in it usually determines the final deal structure. Think of it as a blueprint for your future relationship with your investor.”(1)
The prior means that the contents of an equity term sheet should be carefully considered, not only in view of maintaining an appropriate negotiation position and avoiding unpleasant surprises at a later stage, but also to direct attention to the important business aspects/issues of the intended investment and create a sense of momentum between the parties. Poorly considered equity term sheets too often result in difficult discussions or even deal-breaking issues while drawing up the final agreements—especially if certain fundamental terms were lacking or if one of the parties did not properly understand the actual impact of certain terms included in the term sheet. Whereas well-considered equity term sheets have a major advantage in that fundamental issues have already been identified and tackled at an early stage, thereby increasing the likelihood of closing the investment on terms that are satisfactory to all parties. This, in turn, reduces the effort, time, and costs necessary to negotiate and draw up the final agreements at a later stage.
The significance of negotiating and drawing up a sound equity term sheet is often underestimated by entrepreneurs (and even some investors). One can easily step into the pitfall of focusing too much on costs. In fact, most benefits are primarily gained during the negotiation on the equity term sheet, which many people don’t invest enough time or effort into, sometimes even forgoing the involvement of a lawyer at this stage altogether. When it comes down to negotiating, entrepreneurs often have experience and/or knowledge disadvantages compared to seasoned investors and thereby run the risk of of focusing on the wrong (non-material) aspects and even harming the future relationship with the investor(s). As Brad Feld and Jason Mendelson, writers of Venture Deals (a must-read for every entrepreneur facing fundraising), put it: “For the entrepreneur, an experienced lawyer who understands VC financings is invaluable. VC’s make investments all the time. Entrepreneurs raise money occasionally. In addition to helping negotiate, a great lawyer can help focus the entrepreneur on what really matters.” (2)
Patrick Munk is a Partner / Attorney of VESPER Attorneys. He specializes in business law and regularly advises entrepreneurs, start/scale-ups and VC firms on funding transactions involving equity and (convertible) debt instruments. He distinguishes himself as a casual, constructive and pragmatic lawyer with a strong focus on adding value to negotiations by creating win-win situations.
T: +31 (0)6 50 51 24 47 / E: email@example.com
VESPER Attorneys is a forward-thinking law firm based in Amsterdam, the Netherlands, specialized in (venture capital) financing transactions, M&A, employment law, financial supervision and litigation. Its lawyers are committed to providing high quality legal services at a competitive and reasonable cost. Their clients include VCs, investors, securities-issuing companies, asset managers, emerging companies and entrepreneurs.
2 Venture Deals by Brad Feld & Jason Mendelson, 2011, p.11
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