Survive the Term Sheet Negotiation and Investor Due Diligence Part 2
[The following is an edited excerpt from David S Rose’s book The Startup Checklist: 25 Steps to a Scalable, High-Growth Business.]
Changing Forms of Startup Financing
Over the past 20 years, the typical structure for seed/angel deals has shifted from common stock (in the mid-1990s) to convertible notes (late 1990s through early 2000s) to full Series A convertible preferred (mid-2000s) to convertible notes with a cap (late 2000s) to Series Seed convertible preferred or similar (present). This shows the increasing sophistication of investors and founders, the increasing experience and publicity surrounding the advantages/disadvantages of various options, and the increasing availability of model documents and online generators for different choices.
SAFE Funding
In late 2013, Y Combinator, the leading accelerator program, unveiled a type of investment structure called a Simple Agreement for Future Equity (SAFE). SAFEs have some of the good features of convertible notes, but, because they are not actually a form of debt, they avoid some of the problems. Y Combinator has open-sourced the documents and published them at http://ycombinator.com/safe/. In recent years, SAFEs have found a niche in very early investments at low dollar amounts in pure startup companies, particularly in cases where seed investors are willing to wait for an expected future round for their protections. In practice, that has meant chiefly for hot deals (such as those from Y Combinator, where the company can dictate terms because it has more investor interest than it can take) or friends and family rounds (where simplicity is paramount). To date, SAFEs have not been adopted by angel groups or financially focused angels who are proactively leading investment rounds.
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Term Sheets and Closings
All investments in a company are made according to detailed legal documents that specify everything about the relationships between the various parties, the terms of the value exchange, and the rights and responsibilities of everyone involved. The paperwork can range from three to five pages for a simple, non-convertible note to 120 pages or more for a full convertible preferred stock round. Because these are legal documents, both you and the investor(s) have your own lawyers, who work together to develop the actual agreements signed by the principals.
The collection of documents that constitute the investment agreement are summarized in a much shorter document known as the term sheet (anywhere from one to half a dozen pages, depending on the type of investment). Think of the term sheet as a shorthand way of documenting an agreement in principle that takes many pages of legalese to implement. It deals specifically with all of the major points of the relationships, and thus allows both sides to determine quickly whether they want to enter into a deal.
A term sheet is usually (although not always) drafted by the investor and presented to you with a defined date that it needs to be accepted by. If you sign and return it within that period, then the deal is in motion, and the lawyers for each side go back and forth on the documents that will be signed at the closing. Alternatively, you may respond by declining the terms as presented, but indicate that you would be receptive to a deal at a higher valuation, or with a larger investment, or something else. In that case, the ball is back in the court of the investor, who may simply walk away or come back with a revised term sheet.
The period between when an investor presents a signed term sheet to you and the expiration date of the offer is critical for everyone. Since you are not bound by anything in the term sheet until you sign it, you are free to do whatever you want with it, including taking it to other potential investors and saying, in effect, “Look! Here is a signed term sheet that I’ve been given by Tom. Dick, would you be interested in matching or beating it? Just so you know, I’m also speaking with Harry, who has expressed interest as well.”
While it wouldn’t happen in exactly that way, I can guarantee you that the Holy Grail of fund-raising (from a founder’s perspective) is having more than one term sheet from which to choose. And since market competition is one of the main drivers in early stage finance, one term sheet often brings others from potential investors who might have been sitting on the fence.
Because of the possibility (if not likelihood) of their term sheet being shopped around by you to other investors and used as a stalking horse, investors typically try to make the consideration time as short as possible. In most cases, an interested investor will have several conversations with you to figure out the range of terms you are likely to accept. They may also send over an unsigned draft of the sheet that is not binding on them, to get some feedback. After the real term sheet is delivered with a signature, you usually have one to three days to accept or decline the offer.
Once you have signed the term sheet, it is binding—not just legally (for at least some parts of it), but also ethically. If either party backs out of a signed term sheet without a good reason, word will get around, and the action will have long-term repercussions, including a stain on your—or the investor’s—reputation.
After both parties have signed, the lawyers get to work on the full documentation for the round. One lawyer (usually specified in the term sheet) will be responsible for the base drafting, with the other making comments, although in most cases the documents are based on standard industry models. The timing of the actual payment of moneys committed during the investment round depends upon the nature of the round. In friends and family rounds, you may be able to receive funds as they are committed. In a traditional angel round, there will be a targeted range that you are trying to reach, as well as a minimum amount needed to close. Once that minimum is reached, a s closing is held at which the funds are released to the company.
In the past, a closing involved sending paper back and forth for signatures and using overnight delivery services to send checks to the company’s bank. Today, there is a trend toward fully electronic/digital closings, in which the requisite documents are electronically signed by all parties and funds are wired directly into the company’s bank accounts.
Escrow
Depositing funds into an escrow account is often required during a large funding round involving several investors, in cases where investors only want to fund if the company is sure to get all the money it needs to execute its plan. Otherwise, if the money came in as dribs and drabs, the company might get part way down the road, run out of money, and go broke. So investors say, in effect, “Okay, I’ll put the money in escrow with your lawyer (or an online platform), so you know that you’ll have my money. But you can’t get your hands on it until I know that you will be successful in raising the full amount you say you need.”
Another situation in a round like this is that everyone wants to invest simultaneously with everyone else, but logistically the signatures will be coming in at different times; there may be changes in the paperwork until the last minute. So everyone signs the signature pages, and the signatures are held in escrow until everyone gives permission to release, at which time the deal is closed.
The Due Diligence Investigation
On the way to closing your funding round, you will probably be required to provide the investor(s) with significant, detailed information about your business—even more than you gave them during the pitch meetings. “Due diligence” refers to the practice of the investor carefully checking the details of any claims made by the company.
The precise nature of the due diligence process may vary. In an investment round made up of accredited investors, there is no legal requirement for you to provide a prospectus or any specific disclosure schedules. These documents are therefore rarely, if ever, provided for an angel investment round.
Where these schedules and lists do appear, however, is in the due diligence requests from serious investors, which they will provide to you before the closing of the investment deal. Depending on the size of the round and the size and professionalism of the investors (and the budget of their lawyers), the information you’ll be asked to provide will range from nothing more than a business plan and a slide deck (for an informal seed round) up to a voluminous amount of material (for a later stage venture round from a top-tier venture capital fund). A sample comprehensive due diligence request list is included in Appendix B.
The closing documents will then generally include a representations and warranties clause, in which you as the entrepreneur are required to swear on a stack of Bibles (backed up by some severe economic penalties) that everything you have told the investors is true…including such promises as “We own all our code” and “We are operating perfectly legally.” This suggests the first and most important rule for surviving the due diligence process: Tell the truth, the whole truth, and nothing but the truth.
Most investors are well aware of the vital importance of due diligence to the financial success of their undertakings. They take the process seriously, and will expect the same from you as their potential preneurial business partner.
Areas Covered in Due Diligence
The things investors look for during the diligence process generally fall into three main categories:
Market diligence refers to an independent review of the claims that you and your company are making regarding the industry into which you will be entering. Your investor will want to verify the market size, the current competitive players in the market, and the overall industry trends that might affect your company’s planned products and/or services roadmap. The investor will do this by conducting online research, talk to other people knowledgeable in the field, review the reports of analysts, and more.
Business diligence looks into the specific claims that you and your company are making about your business operations. These include your customers, your revenues and expenses, your background, and the background of the other company founders. To check into these claims, your investor will probably want to call some of your customers to verify that they are indeed your customers and that they are happy with your products or services. The investor will also look at your accounting statements, and will at least spot-check some of the details about your career background by speaking to one or more of your previous business associates.
Legal diligence focuses on your company’s structure, documentation, and history, verifying that everything is as claimed. The last thing an investor wants is to find out after the closing that the company’s entire source code is actually owned by some outside programmer because you, the company founder, never effectively acquired ownership of it! Because legal diligence is factual and can be backed up by documents, this is one area where the lawyers on both sides can do much of the heavy lifting.
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This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.