What Entrepreneurs Need to Know About...

February / March 06 By: Eric Billingsley Volume 4 Number 1

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This is the fourth in a series on helping the entrepreneur put his or her best foot forward during the process of securing funding. The articles are researched and written by Eric Billingsley.

After shopping your business idea around to many potential investors, you finally receive a term sheet from a venture capital firm. The document lays out the financial and logistical framework for that investor to provide you and your company with equity capital. In essence, the term sheet seeks to protect the financial interests of the investor(s) while also providing a structure that will help grow your company.

This is a monumental step indeed. But before signing on the dotted line, it's important to understand how to protect your interests in the deal-making process. Here are a few points to consider when making "The Deal."

Hire Expert Counsel
No matter how much you think you know your business, hiring a lawyer adept in early stage financing and your particular industry niche is critical before signing off on a term sheet or any other investment proposal. Lawyers can help you understand all of the language and ramifications of a proposal, organize the company's legal documents, and act as a go-between for you and the investment firm. It is also advisable to seek counsel from other entrepreneurs, CEOs and the like who have successfully raised capital.

Know the Investor
Perform your own due diligence on any investor who is expressing interest in your company. The fact is there are great investment firms out there and lousy ones. Some questions may include: the number of companies the firm has financed and how successful the companies were; whether or not the firm is experienced in financing startups in your industry; and references from other CEOs who've used the firm. Remember that once you accept equity capital, an investor is an active partner in your business. They should be able to provide not only capital but the expertise that will help your company achieve success.

Review the Term SheetLine by Line
An initial term sheet is not a legally binding contract but rather a reference point for both parties to move forward in the financing process. However, it's important to review the document line by line with legal counsel to determine whether or not the language and terms are acceptable and appropriate for your particular capital needs. Once agreed upon and signed, the term sheet acts as a road map for the creation of future legal documents. A few biggies in the term sheet include:
—€ Purchase price per share. The monetary worth or valuation of your company prior to receiving financing.
—€ Post financing capitalization. A description of the capital structure of the company after receiving financing. It shows the equity stake, or ownership, the investor has in your company.
—€ Corporate governance. This outlines how much control over decisions the investment firm will have in the company.
—€ Liquidation preference. This is a description of how money will be divvied up to investors when a company is sold or liquidated.

Heed Red Flags
There are a few red flags to look out for when reviewing an investment proposal. Under-financing of your company can result in not having enough money to accomplish the lofty goals of investors. Exclusivity or "no shop" agreements limit your ability to attract other investment options though they are a common part of many final term sheets. Make sure milestones set up by the investors are reasonable. And clarify terms and/or sections in the term sheet that are awkward or confusing. Your lawyer and expert counsel will help you determine which parts of the proposal are worth fretting over.

Negotiate Before Signing
Sticking points in a term sheet need to be addressed prior to signing-off. It's very difficult to back-pedal once an investment firm begins the extensive due diligence process that will eventually lead to committing funds. There is no guarantee the investor will agree to your revised terms and conditions. This may indicate that the deal is not right for your company or that the term sheet needs to be reviewed again by you and your legal counsel. Reassess all of the pros and cons of the proposal, as well as other financing options, before tossing it out altogether or signing on too hastily.

Prepare for Due Diligence
Once a term sheet has been signed, the investment firm will significantly increase the level of due diligence it performs on your company prior to committing funds. It can take anywhere from one to six months to complete the transaction. Business due diligence involves a thorough review of the product, revenue projections, management team and more. Legal due diligence may include providing key contracts for the business; employment agreements, minutes and consents of board of directors and shareholders; confidentiality and invention assignment agreements with employees; corporate charter and bylaws; litigation related documents; patents and copyrights and other intellectual property related documents.

A signed term sheet does not guarantee financing. Many problems with your company can surface during the due diligence phase. This is the intent of the process though it does not always result in an investment offer being withdrawn. So it is advisable to be up front with the investors about possible glitches that may surface, not oversell yourself and the company's capabilities and continue running your company in the same fashion you did prior to receiving the offer.

The negotiation is yet another opportunity to make a good impression. In other words, go into the negotiation thoroughly knowledgeable, confident and realistic, rather than trying to wing it. The latter approach will cost you and the investor money, time and embarrassment. At worst, unprofessional behavior may lead the investor to question your credibility and back out of the deal altogether. At best, continually impressing investors can have the affect of building a sense of trust and partnership, and pave the way for future financing.

Sources:
Deal Terms: The Finer Points of Venture Capital Deal Structures, Valuations, Terms Sheets, Stock Options and Getting Deals Done, by Alex Wilmerding
Term Sheets & Valuations: An Inside Look at the Intricacies of Terms Sheets and Valuations, by Alex Wilmerding
Feld Thoughts: www.feld.com/blog/archives/term_sheet; www.allbusiness.com.