If you sell shares in your idea or business, you'll need to agree terms and conditions with your investor. A 'term sheet' will give you a summary of the main terms and conditions.
Term sheets aren't legal documents. But they can become part of the legal contract you make with an investor.
Agreeing terms and conditions
You'll need to agree the terms and conditions with your investor. It's normal that you'll need to negotiate these over a period of time.
It's important you understand any terms and conditions you agree to and how they might affect your idea or business. To help you with this, you should get advice from a:
- corporate finance advisor
Checking your term sheet
Term sheets will contain different kinds of terms and conditions. However, there are common things you can look out for, including:
1. Valuation and dilution
A term sheet will show a valuation of your business.
The valuation determines what percentage of the business you're selling. For example, if you want to raise £20,000 and your business is valued at £200,000 you'd be looking to sell 10% of your business.
The valuation also determines how much any existing shares are 'diluted' (reduced). For example, if you own 100% of your business and issued another equal share to an investor, your share will be diluted to 50%.
You need to agree this valuation with your investor.
Different investors might make different valuations of your business. If you're choosing between investors, the valuation isn't the only thing to consider.
For example, a low valuation from an investor who understands your business might be better than a high valuation from an investor who doesn't.
2. What your investor gets for their money
Your term sheet will say what your investor will get in return for their investment. This usually takes the form of:
- ordinary shares
- preference shares
- convertible loans
'Ordinary shares' give investors the right to vote at shareholder meetings. This includes voting on things like the:
- amount of dividends proposed
- salary packages of board members
'Preference shares' give investors rights, for example to:
- buy shares at a lower price during future fundraising
- higher dividends
'Convertible loans' are where an investor lends you money. They can then either choose to convert this loan into shares later, or have you repay it at a fixed rate.
3. Board structure
Your term sheet will also show if an investor wants someone to represent them on your board.
An investor might want to appoint a someone to oversee the running of your business. You should discuss the responsibilities this person will take on with your investor.
4. Drag along and tag along rights
It's common for term sheets to refer to 'drag along' or 'tag along' rights. Drag along and tag along rights protect investors.
Drag along rights give rights to majority shareholders. They give them the right to force other shareholders to sell their shares to the same buyer, on the same terms.
Tag along rights give rights to minority shareholders. They give them the right to sell their shares on the same terms and conditions as a majority shareholder.
You should think about what your shareholders priorities are when agreeing drag or tag along rights.
5. Anti-dilution protection
Your term sheet will give details of any 'anti-dilution protection'. Anti-dilution protection protects the price of an investor's existing shares. This is if further shares are issued at a lower valuation than their original investment.
Anti-dilution protection is sometimes known as 'ratchet clauses'.
The amount of protection an investor seeks will depend on:
- the original valuation
- whether they expect there to be a need for further investment
6. How money will be divided if your business is sold or liquidated
Your term sheet will normally say how money will be divided if your business is sold or liquidated.
Before agreeing this, work out how much you'd expect each shareholder to get in different scenarios. For example, if your business sells for a high amount of monmey or if your business is liquidated.
7. Conditions to close
'Conditions to close' are any terms or conditions you need to meet before an investor will give you any money.
This usually includes passing due diligence. It could also involve clearing any existing debts you have.
It's important you feel the conditions are achievable. It's also important you have a realistic timeline to meet them.
Help and advice
Before agreeing to any terms or conditions, you should get advice from:
- a lawyer
- an accountant
- a corporate finance advisor (corporate financier)
They can make sure terms of the investment work out well for both you and your investor.