Raising Funds? Be Sure to Scrub Down the Term Sheet
When preparing for any equity or debt fund raise – be sure to have your CPA evaluate the financial implications of the terms & conditions.
According to Bruce Gibney (formerly with famed VC firm, Founders Fund) “Venture financing turns on three things: Money, power and ignorance.” He went on to note “These variables converge most violently in the term sheet, which proposes the basic relationship between the venture capitalist and the company. Term sheets have a set of short, formalized components, which in combination quickly become exceedingly tangled and opaque.”
In essence the term sheet acts as the initial road map for an investment agreement, setting out the broad parameters of a potential investment typically in terms of five key elements: The stock purchase agreement, the investor’s rights agreement, the certificate of incorporation, right-of-first refusal & co-sale agreement and voting agreement.
When it comes to term sheets it is important for founders, entrepreneurs and their business partners to have a qualified CPA evaluate their term sheet closely before they are signed. One should clearly understand how the specific terms will apply to them personally, on a financial basis. This careful examination of the terms will allow you to clearly understand the potential financial, tax liability and legal impact of various provisions in the document.
This exercise may show that for founders (and the company at large) that some funding is not worth taking, and taking money based on terms that are unfavorable to your company may reduce its overall value in the long-term. You need to look beyond the “boilerplate terms” that are often included to facilitate a funding transaction by lawyers, venture capitalists and private equity firms.
In particular, the following should be given close consideration when it comes to creating and reviewing the term sheet:
- Stock Restriction Agreements: Are there limitations on transfer of shares? If you are the owner, can you sell your shares? Who can you sell them to, and when?
It may be possible to negotiate terms that are more favorable to founders, like being able to sell their shares at a premium over their cost-basis. This is a good thing in the event the company grows, becoming prosperous, and the company’s share value appreciates as a result.
Vesting schedules are another favorable term to consider for founders. The most common founder schedule vests an equal percentage of stock (25%) every year for four years on a monthly basis. It may be appropriate for a one year “cliff” (i.e. the founders don’t get their initial 25% share vestment unless they stay with the firm for at least 12 months) especially if the founders don’t have a history of working together.
And is there enough cash available for potential buyout options? If one founder decides to leave the business and the other founders want to buy them out, will there be enough cash available to facilitate this transaction? Are there insurance policies that might facilitate this buyout?
- Onerous Liquidation Preferences: They can effect the distribution of the fund raising “waterfall,” including return of capital, different rates of return, and different participation parameters. Founders and early seed investors can get short-changed as a firm moves forward in its fund raising efforts.
Unfavorable liquidation preferences can dictate that later investors (example: Series A vs. Seed round) reap the majority of the economic benefit when a company exits through a sale or M&A activity. This can leave founders and early angel or seed round investors holding the short-end of the economic stick so to speak.
So make sure you understand the terms of subsequent fund raising rounds, decide that you really need the money now, and it’s “worth it” at this point in the life-cycle of your business.
- Terms of Debt Covenants: These terms are a promise in an indenture, or any other formal debt agreement, that certain activities will or will not be carried out. When expressed in unfavorable terms, they can render an emerging growth company vulnerable.
You should work with your CPA and lawyers to avoid unfavorable repayment requirements, based for example on maintaining a certain EBITDA level, restrictions on business expansions or acquisitions. This can cause a problem because it might require you to pay back a loan before you are ready (or able) to pay it back. It pays to drill down on the details here, like exactly how the lender is going to make the EBITDA calculations.
- Tax Deductibility of Interest Payments: Tax deduction losses, and therefore a higher tax bill, can occur due to applicable tax laws.
The first example is “Payments-in-Kind” (PIKs) where a company pays its loan interest expense in the form of additional bonds, shares of preferred stock, or some other service offered in kind -in lieu of paying in cash. These types of interest payments to lenders are not always tax deductible.
Another pitfall to avoid is known as “Applicable High Yield Discount Obligations” (AHYDO). An example of this is a loan interest rate that is five points higher than the applicable federal benchmark rate. In this case you may not be able to get a tax deduction on the interest expense because the interest rate is considered by tax authorities to be too high.
In this case tax authorities are guarding against excessive interest expense tax deductions – that might be used to fund acquisitions, a vestige from the days of leveraged buyouts.
- Options and Warrants: It’s important to know how the options and warrants will be treated – as these contractual instruments allow the holder special rights to buy securities at a fixed price (exercise price) until they expire.
For example an employee or consultant will typically receive stock options. An investor in a convertible note and warrant round typically receives stock warrants.
A compensatory option will look different from a contractual standpoint compared to an investment warrant. Options are usually granted under an equity compensation incentive plan, have a vesting period and repurchase rights on termination of service. A warrant will not be granted under an equity incentive plan, and usually does not come with a vesting requirement.
In addition, the tax liability differences between compensatory stock options and investment warrants are dramatically different. Be sure you know how these terms are stated in your terms, and check with your CPA on the different potential tax liability consequences of what’s being offered.
So these are the many types of issues you need to consider when raising money. Careful analysis with your CPA can help to determine if makes fiscal sense to take investment money or loans, or not.
We strongly recommend that you have a qualified CPA review your term sheet to identify both potentially favorable and unfavorable terms. Then if possible you should work to negotiate better terms that will deliver positive financial outcomes in the long run.
This material has been prepared for general informational and educational purposes only and is not intended, and should not be relied upon, as accounting, tax or other professional advice. Please refer to your advisors for specific advice.