Angel Fundamentals: Understanding Equity Deal Terms - Introduction

Note: This article is the first in an ongoing series on Early-Stage Deal Terms. To learn more about navigating term sheets and investment documents, download this free eBook today Understanding Early-Stage Deal Terms or purchase our books at Amazon.com.

Angel investing deal termsActive angels work with term sheets regularly, but not every investor fully understands the sometimes arcane language in these highly-specialized documents. What are term sheets, what do they signify, and why are they so important?

If you will walk through this short series on deal terms with us, we can explain. Although it is a fairly complex subject, we have a relatively simple framework we can use to help all angels understand term sheets better and retain and apply that understanding in real life deals.

Non-Binding; Summary Instructions

As we noted in A Guide To Angel Investing Documents, most angel investments start with or are accompanied by a “term sheet” (or sometimes a “memorandum of understanding”) summarizing the terms of the deal. Unless a term sheet expressly states that it contains legally binding sections, early stage investment term sheets are not legally binding agreements. Instead, term sheets can be thought of more like a set of notes outlining the principal elements of the deal as agreed by the negotiating parties. They serve as a basis for soliciting interest from prospective investors as well as a guide for use by counsel drafting up the definitive binding documents.

Many Topics

The problem is that they can be dense and complex. Term sheets can cover literally dozens of subjects. They are written in very jargon-heavy shorthand so they can be quite intimidating for less-experienced investors. You will see provisions on everything from price, size of round, composition of the board to liquidation preferences, drag-along rights, and anti-dilution protection.

Framework: Four Key Areas of Concern for Investors

But these documents do not need to be overwhelming because all term sheet issues can be grouped into four basic areas. Within those areas, the individual provisions can be thought of as a group of tools representing a negotiated balancing or risk allocation between the concerns of the founders and the concerns of the investors in that basic area.

So what are those four key areas?

  1. Deal Economics - Investors want to make sure they get a big enough slice of the pie to make the investment worthwhile on a risk-adjusted basis. They want to make sure they get paid back first. They want to put a time-clock on the founders. And they want to make sure employee options don’t dilute them inappropriately.
  2. Investor Rights / Protection - Investors want to make sure no future financing deals contain terms which unduly diminish the value of their investment or lead to someone moving into a superior liquidity position (without paying appropriately for that right).
  3. Governance, Management & Control - Investors want to know what’s going on in the company, have a say in critical decisions, and they want to protect against founder behavior that could be damaging to the company.
  4. Exit/Liquidity - Investors want to make sure they maximize the chances to get their money back in all possible exit scenarios (positive or negative), even if they have to force such a situation to occur.

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Fair, All Things Considered

Those goals may strike an observer as greedy or at least aggressive, but they are not really when you consider how equity investment deals work. Unlike lenders, who have a legally-enforceable right to be repaid (often further secured by collateral or guarantees), investors purchase equity on no-recourse terms. If a company fails, the equity is worthless. Absent fraud or misdeed, equity investors have absolutely no right to be repaid. Thus investors are fully assuming the risk of failure of the venture, proportional to the amount of money they put into it. The only way they get their money back is for two things to happen in sequence:

  1. the company to make progress and become more valuable and
  2. an opportunity arises in which investors can sell their stock in the company to a third party for more than their original purchase price.

In that sense, equity investment can be thought of as a loan that the ultimate acquirer of the company is expected to repay.

Hard-Learned Lessons

Once looked at through this lens, the many provisions of a term sheet begin to make more sense and seem more reasonable. They provide protections for the many company development potholes and speedbumps experience has taught investors to expect. Whether a given term sheet represents a perfectly fair compromise is a function of the market and investing dynamics around a particular company at a particular time. Nevertheless, the term sheet negotiation process is always a constructive way to air and address the tension between investors’ concerns and founders’ concerns.

Founders’ Concerns

That was a quick overview of the investors’ concerns, but while negotiating, founders have their own set of concerns and are worrying about a different set of issues.

  • They do not want to lose control of the company, either by selling too great a percentage of their company or by agreeing to overly powerful contractual control provisions.
  • They do not want to be economically washed out by selling too much of their holdings too cheaply.
  • They do not want to lose ownership of their shares if they are fired or resign.
  • They do not want their company to run out of money and shut down.
  • They do not want to give personal guarantees or put up their home or other assets as collateral; and
  • They worry about the fit with and value-add from their investors.

The Value In The Term Sheet Process

So when investor concerns meet founder concerns, you clearly have the potential for strong tension between positions. One important role the term sheet formation process plays is to identify all the key issues and allocate the various risks between the parties. If you are successful, you will come to, and record, a negotiated middle ground on the various issues. Stay with this deal terms series to learn how the various individual provisions work in doing exactly that.

To learn more about navigating term sheets and investment documents, download this free eBook today Understanding Early-Stage Deal Terms or purchase our books at Amazon.com.