Term sheet
A term sheet, or letter of intent, is a statement of the proposed terms and conditions in connection with a proposed investment. It generally runs about one to five pages in length. In the case of angel investments, the term sheet can be prepared by the start-up or the angels. Most of the terms are non-binding, with the exception of certain confidentiality provisions and, if applicable, exclusivity rights (see below for more details).
Angel vs. venture capital term sheet
At times, you may find little difference between a venture capital term sheet and one from an angel investor. As a general rule, both the investment structures and founder covenants required by angels are less constrained by standardized institutional practice. This can prove a mixed blessing. Certainly, it allows founders and angels to reach stylized arrangements that suit the circumstances, and the terms from an angel can sometimes be easier to “digest.” However, without a default transaction style, start-ups and angels sometime spin their wheels in negotiations. With this in mind, many angel groups have sought to standardize their term sheets in order to streamline the consideration and resolution of some of the key issues (such as corporate governance) that start-ups and their investors face.
Key provisions
Founders should consider the following five key provisions of an angel term sheet:
1. Investment structure
Angel investment structures vary, but angels generally invest in one of three types of securities: common shares, convertible preferred shares, and convertible debt.
Common and preferred shares: Common shares are residual value shares of the same class issued to a start-up’s founders. Convertible preferred shares are shares that include a liquidation preference over common shares (with angel transactions, usually the original investment price), and are convertible into residual value common shares. With common and convertible preferred share transactions, the parties will fix a valuation on the start-up corporation before investment, and this sets the price of the investment.
Convertible debt: Angels often invest through convertible debt. This involves the investors loaning money to the company, with the loan amount being convertible into equity shares of the start-up. The principal advantage of this structure is that the parties can defer fixing a valuation on the enterprise until a future financing round. When the future round is complete, the debt converts into equity shares at the purchase price determined at that time, sometimes subject to a 10% to 25% discount to reward the angel for investing early.
2. Key economic terms
Essentially, the key economic terms consist of:
- quantifying the preferred return of the investment
- quantifying any accruing earnings on the investment
Preferred returns: Preferred returns represent an amount that the start-up must return to the angel before it distributes any assets (payments) to other stakeholders. With angel deals, this amount should generally not exceed the original investment amount, and founders should negotiate any term sheet that proposes a different formula.
Accruing returns: Accruing returns can take the form of accrued dividends on equity shares, or of an accrued interest rate on convertible debt. It is rare in angel deals that such interest would actually be payable in cash. Rather, such amounts accrue and are converted into equity shares at the same time as the principal amount of the loan. The industry has no set standards for accruing return rates, but most commonly the rates vary between 5% and 12%. In negotiating these arrangements regarding convertible debt structures, founders should keep in mind the discount rate (if any) for the future purchase price. Angels typically don’t ask for both a discount rate and accrued returns.
3. Board structure and reporting
While the practice isn’t uniform, angels often require some formal representation on a start-up’s board of directors (either as a board member or appointed “observer”), but they typically don’t want or require control. Some require certain reporting procedures as well (such as monthly sales or product development updates). Generally, founders agree to provide angels with reporting rights proportionate to the nature of their investment, provided that satisfying the obligations do not materially detract from the pursuit of the start-up’s objectives. And if a start-up has found the right kind of angel that might add value to the business, founders will engage those angels willingly.
4. Corporate governance and shareholder agreements
Angel investments almost always require a shareholder agreement among the founder group and the new investors. In reviewing or crafting any proposal, keep these fundamental points uppermost in your mind:
- Most angels are in your corner. If you choose them wisely, most of the legal details that you negotiate will carry little significance. If you stumble, but communicate clearly the reasons for failure and your steps to address them, most angels will stick by you. (They wouldn’t have invested if they didn’t believe in you).
- Look forward to the next transaction. Notwithstanding the basic need to trust one another, founders should understand very clearly what it will take to change the shareholders’ agreement and the share capital structure in the future. Consider carefully the pre-emptive rights provided to investors, or any consent rights over future financing rounds. Ideally, if you have multiple angels, you can create a corporate governance regime that includes an independent evaluation of available alternatives and offers some protection against investor misfeasance or opportunism.
- Regular, honest communication matters. Your conversation with angels (even passive ones) does not end at the closing. Whatever the actual terms of the shareholder agreement, it pays to recognize that the quality of a founder’s personal relationship with his or her investors drives the tone of the company’s governance. Considering all the other challenges a start-up must face, adding unnecessary drama to the decision-making process amounts to bad management practice.
5. Due diligence, exclusivity and closing
The term sheet should define the timeline and process from the date of signing the term sheet to the closing date, as well as the conditions for closing, including due diligence. Most angel term sheets include some basic confidentiality obligations (especially if the proposed investors have not signed a non-disclosure agreement). Less typical are exclusivity covenants that require the start-up to cease investment discussions with anyone else, but some more organized angel syndicates do include such provisions in their standard term sheets. (If so, founders should limit that period to no more than 30 to 60 days.)
For more information on Angel funding look at our sister publication Angels, which is a magazine dedicated to new start business entrepreneurs & high net-worth angel investors. www.theangelmagazine.com
