By Patrick Roux is a Senior Corporate Associate at Kemp Little
We often see instances of founders rushing into their first investment round without enough deliberation over the term sheets proposed by potential investors.
A term sheet is the outline agreement between an investor and a company and its founders on the key financial and legal terms of an investment. Whilst it is not a binding agreement (in most respects), it is important for a founder to understand and be comfortable with the contents of a term sheet before signing it. However; a start-up’s need for cash runway can cloud judgements.
The reality is that a lot of VC funds will apply a ‘one size fits all’ approach which doesn’t take into account the stage or size of the individual businesses they invest in. For a founder who may be viewing their first ever term sheet, they may not be able to spot red flags easily and will trust that what they’re seeing is legitimate and standard.
Founders who are encountering this process for the first time can have potentially damaging blind spots, and it can be difficult to understand which terms are normal and appropriate to the investment, and which are unnecessary.
Whilst every situation differs, it’s ultimately about finding the balance of interests for both sides. If a founder is viewing a term sheet for the first time, it’s understandably easy to gloss over certain things, particularly in instances where red flags are more difficult to spot.
85,000 online businesses launched during lockdown in the UK
Key components every founder must understand
What we’re beginning to see in a lot of cases is VCs taking an ‘aggressive’ approach to term sheets for early stage investments, with term sheets that look more suited to larger investments in more mature businesses (perhaps owing to VC standardising their terms across different sizes and stages they make to streamline deal execution).
We often see this play out in VCs insisting on consent rights over actions of the investee company which stray into the operational territory of the business, such as a right to veto hiring and firing of employees without any salary threshold applied to the right. This can hamstring the operations of early-stage businesses just at the time when they most need to be bringing on talent to launch and grow their offering.
We also see VCs being overly-focussed on securing a liquidation preference (essentially the right to receive a multiple of their money back ahead of other shareholders on an exit) on investments into pre-launch companies, where the risk profile of that investment doesn’t necessarily justify it. Asking for justification on these terms is a fair request.
Round Midnight progresses with ‘Tech For Good’ programs
Certainly in the beginning, it bodes well for founders to carry out extensive research on the VC; getting to know the fund and its portfolio can help founders to form a well-rounded opinion on their investors and what they might be like to work with. Asking to be put in touch with founders of the VC’s other portfolio companies should be completely expected – it’s important to question any VC who withholds such information, or is reluctant about sharing it.
Whilst cash flow is king, founders must tap the breaks if they are unsure, and not rush into signing terms
Term sheets aren’t generally binding agreements but, in practice, do make it very difficult to go back on certain ‘agreed’ points, especially where founders have rushed to move quickly on legals.
The lesson here is that it is really important to not rush into anything. Tapping the breaks is a good thing; building a relationship that works for both parties isn’t something that’s achieved overnight, and a good investor will know the value of doing so.
Location tech: the driving force behind the digital economy
If a founder feels as though a VC is insisting on including things on the term sheet that instinctively don’t ‘feel right’, it’s perfectly fine to take some time – and advice – to arrive at a point where they feel comfortable moving forward.
Why founders should consider a range of early stage funding options, including alternatives to VC investment
Whilst VC investment is the necessary direction for many start-ups, a lot are stuck in a traditional mindset which leads them to believe this is the only viable option. Many think that, because going down the VC route is a road taken by many, it’s the natural progression for their business, too.
Instead, a founder should step back and consider: ‘this is what I’ve got on the table, what other options do I have?’. We’re seeing the funding landscape significantly broaden beyond traditional VC funds, in early stage.
Today, founders can get quite far with investments from UK-based angel investors (who are incentivised to put their money into UK start-ups by the EIS/SEIS tax relief schemes) for example. Increasingly, there are more debt options available, too, so it’s almost less about negotiating with a VC than really addressing business requirements and working out which path is most suitable.
Building a network is also one of the most impactful things a founder can do; not only can one brief introduction become an incredibly valued partnership some way down the road, but it can also enlighten founders to all the other options available out there.
Most founders won’t necessarily have well-heeled angel investors in their network, or connections into government-backed debt schemes, but by getting out and networking at sector and investment events, it’s possible to build these networks and expand funding options.