How to decode termsheets
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High Level understanding of key clauses that typically go in a termsheet
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How to decode termsheets
- 1. ©PSA 2019 PSA Legal Counselors How to Decode Termsheets IFCCI – February 1, 2019 Dhruv Suri Partner PSA
- 2. 2 ©PSA 2019 PSA Legal Counselors What is a Termsheet? Binding provisions in a Termsheet: •Exclusivity period •Confidentiality clause •Dispute resolution G E N T L E M A N ’ S H A N D S H A K E
- 3. 3 ©PSA 2019 PSA Legal Counselors Negotiating the rights • Valuation • Anti- dilution • Types of shares • Management rights • Liquidation preference • Representations and Indemnities • Transfer restrictions and exit rights
- 4. 4 ©PSA 2019 PSA Legal Counselors Valuation Pre-Money Valuation Post-Money Valuation
- 5. 5 ©PSA 2019 PSA Legal Counselors We will invest 2 crore for a 10% stake. 18 Cr. 20Cr. 2 Cr. Post Money ValuationPre-Money Valuation Investment Pre Money Valuation + New Investment = Post Money Valuation
- 8. 8 ©PSA 2019 PSA Legal Counselors Anti Dilution Full Ratchet Weighted Average The conversion price of the shares outstanding prior to such financing is reduced to a price equal to the price per share paid in the dilutive financing. The price is adjusted by a weighted average of existing price, number of outstanding shares, number of shares to be issued in the proposed investment, and the aggregate consideration received. Becomes relevant if there is ever a “down round”
- 9. ©PSA 2019 PSA Legal Counselors Promoters owns 10,000 shares in the company for 100% stake Seed investor, X, agrees to invest Rs 1,00,00,000 at a pre-money valuation of Rs 2,50,00,000 Pre-money valuation of the Company : Rs 2,50,00,000 New Investment : Rs 1,00,00,000 Post-money valuation of the Company : Rs 3,50,00,000 Per Share price : 2,50,00,000/10,000 Rs 2,500 % shareholding of X : 1crore/3.5crore * 100 28.57% Promoters shareholding drops to: : 71.43% Number of shares allotted to X : 4,000 New investor, Y, agrees to invest Rs 1,00,00,000 at a pre-money valuation of Rs. 2,00,00,000 Price per share : 2,00,00,000/14,000 Rs. 1428.57 Anti dilution protection to X : 1,00,00,000/1428.47 7,000 shares (instead of 4,000) 9
- 10. 10 ©PSA 2019 PSA Legal Counselors Impact on Shareholding Shareholder Number of Shares % Shareholdi ng Promoters 10000 47.60 X 4000 19.04 Y 7000 33.33 Shareholder Number of Shares % Shareholdi ng Promoter 10000 33.34* X 7000 33.33 Y 7000 33.33 *on a fully diluted basis
- 11. 11 ©PSA 2019 PSA Legal Counselors Weighted Average Anti-Dilution ProtectionWeighted Average Anti-Dilution Protection Formula CP 2 = CP1 * (A+B) / (A+C) Where, CP2 New Conversion Price CP1 Existing Conversion Price A Number of shares outstanding before the new issue including equity shares resulting from conversion of convertibles and exercise of options; but it excludes any equity shares entitlement of the new investor B Number of shares that the company should have issued to the new investor for the aggregate consideration received factoring CP1, that is Total consideration received from second investor/CP1 C Number of shares to be issued in the proposed investment
- 12. 12 ©PSA 2019 PSA Legal Counselors Applying Weighted Average method: CP1 Rs. 2,500 per share A 14,000 shares (10,000+4,000) B 4,000 (1,00,00,000/2,500) C 7,000 shares to be issued to Mr. Y CP2 2500*(14,000+4,000)/14,000+7,000)= 2,142.85 New Conversion Price Rs. 2,142.85/share Therefore, Mr. X will be issued 467 shares 1,00,00,000/2,023 = 4,666.68 shares on a FDB New shareholding- Promoters (44.45%), X (22.22%) and Y (33.33%)
- 13. 13 ©PSA 2019 PSA Legal Counselors Lesson? Remember… Over-negotiating this for an early stage/seed round can also dampen investor confidence
- 14. 14 ©PSA 2019 PSA Legal Counselors Types of instruments •Equity Shares •Preference Shares •CCPS •Debentures •Convertible Notes
- 15. 15 ©PSA 2019 PSA Legal Counselors Management Rights •Board seat •Voting rights – Reserved Matters •Information rights •Observer rights
- 16. 16 ©PSA 2019 PSA Legal Counselors Reps and Indemnities •Company information •Directors, their interests and conflicts, if any •Accounts •Regulatory compliances •Licenses, permits, approvals •Material contracts •Intellectual property •Employment related issues •Litigation/Notices •Taxation •Insurance •Real estate Indemnity by Promoter or Company or both? Disclosure schedule? Cap on liability? Overarching reps “standard”?
- 17. 17 ©PSA 2019 PSA Legal Counselors Liquidation preference Liquidation Event is defined to broadly include winding up, consolidation, merger, sale of asset of company, change in control, IPO etc. 1X, 1.5X, 1.7X, 2X, 3X…….
- 18. 18 ©PSA 2019 PSA Legal Counselors Liquidation Preference Participating liquidation preference Non- participating liquidation preference The right holder will be entitled to receive his predetermined returns but shall not be entitled to receive any portion of the surplus proceeds. The right holder will be entitled to receive his pre- determined returns as well as all shall also participate in the distribution of the surplus proceeds.
- 19. 19 ©PSA 2054 PSA Legal Counselors Transfer and Exit rights •Promoter vesting and lock-in •Preemptive rights •ROFR and ROFO •Put and call option •Tag along and drag along rights •Redemption rights •Buy back •Third party sale arranged through promoters •IPO Commit EXIT in a reasonable time. Funds often link it with their fund cycle. 5-7 years reasonable
- 20. 20 ©PSA 2019 PSA Legal Counselors Lastly, “Risk comes from not knowing what you are doing.”: Warren Buffett
- 21. 21 ©PSA 2019 PSA Legal Counselors What could go wrong? Firing of a founder: Dodging the bullet -Shareholding percentage -Get everything in writing -Collaborate and inform -Select investors/ board of directors wisely
- 22. 22 ©PSA 2019 PSA Legal Counselors What could go wrong? Employee Stock Option Plan •Equity v. Option of equity •What is being allotted: The specifics •Expiry of ESOP: Fixed period or on termination
- 23. 23 ©PSA 2019 PSA Legal Counselors What could go wrong? Angel Investors •Problem of plenty: Fragmented shareholding and demands •Driving seat issue: Founders v. Angel investors •Smart money vs. Dumb Money
- 24. 24 ©PSA 2019 PSA Legal Counselors Concluding thought… My overreaching philosophy about terms in a seed round termsheet is that make sure you are protected when things go exceedingly well for the company. Please do not focus on terms that are protective when things go bad. If we are entering at a 5-10cr valuation and things go bad, the residual value is not much for an investor to care. In fact, an entrepreneur who takes a view that he/she needs to be protected on the downside in a seed round is actually a big red flag for us. The ambition should be to build a business that is 100 times the size! - Karthik Reddy, Blume Ventures
- 25. 25 ©PSA 2015 PSA Legal Counselors Thank you NEW DELHI CHENNAI 14A&B, Hansalaya Building 3B, Jamals Musfira Chambers 15, Barakhamba Road 2/17, Jagannathan Road, Nungambakkam New Delhi – 110 001 Chennai – 600 034, Tamil Nadu Tel: +91 11 4350.0500 Tel: +91 44 4900.1450 Fax: +91 11 4350.0502 Fax: +91 44 4900.1455 E-mail: contact@psalegal.com E-mail: contactchennai@psalegal.com