Of all the challenges you face running your SaaS business, raising capital shouldn’t be one of them. Of course, that’s not always the reality. Whether you’re raising equity or debt, one of the hurdles you’ll face is negotiating a term sheet.
A term sheet is an agreement that lays out the terms of the funding, thereby formalizing how much of your relationship with your investor will work. And while a fair and balanced term sheet will benefit everyone, they’re often written in a way that gives the investor the advantage. If you’re not careful, you could wind up signing a term sheet where you give away more equity than you intended or even lose control over your business.
To ensure that doesn’t happen, there are five pitfalls that you need to consider any time that you negotiate a term sheet. In this post, we’ll take a look at what those pitfalls are and point you to a resource that will help make sure you avoid them.
1. Not considering the impact of share preferences on common shareholders
Some founders and CEOs make the mistake of thinking that if they’ve sold 30 percent of their business to an investor, the investor will simply get 30 percent of the profits when the company is eventually sold. But if the investor has preferred shares, which is often the case, things become more complicated. Preferred shares are when the investor gets its capital back ahead of common shareholders.
This can be catastrophic for common shareholders if the company struggles and is sold for a lower-than-anticipated price. For example, if an investor bought a 30 percent stake in your company for $5 million via preferred shares and the company is later sold for $10 million, the priority return of capital means 50 percent of the purchase price will flow to the investor rather than 30 percent.
2. Using other deal terms to bridge a valuation gap between investor and investee
If an investor believes that the valuation of your company is high, but still wants to complete a deal, it may try to mitigate its risk by incorporating certain provisions into the deal to protect itself in the event of a lower-value exit. That may include requesting cumulative dividends, or double dip preferred shares. An investor may also feel it must be more cautious in its ability to control the company, and request aggressive protective provisions. Such provisions can be used to limit your ability to run your business should the investor lose confidence.
3. Losing the balance of power and protective provisions
Investors may request the right to nominate a majority of the board of directors. Such companies are often founder-run and are not used to their management team being accountable to a board of directors. As such, they may not fully appreciate the implications of board control. The board is legally responsible for overseeing the business. Regardless of the ownership interest of a shareholder, if the shareholder has the right to control the board of directors, it controls the company.
When protective measures are introduced, they might include the right to approve a majority of the board, all future share issuances, all borrowing by the company, and the hiring and firing of senior officers.
4. Overly long due diligence periods
Term sheets are typically signed before the investor undertakes its detailed due diligence. This is why term sheets usually include exclusivity provisions by which the company agrees to refrain from negotiations with any other potential investors or purchasers for a period of time to allow the investor to complete its due diligence.
A reasonable period for due diligence is typically 30 to 45 days. Some investors may, however, request longer periods of 60, 90, or 120 days. Long periods allow the investor to monitor the company’s performance for a period of time before deciding whether to commit, potentially limiting the company’s alternatives in the process.
5. Your investor doesn’t provide the value-add they promised
If your investor has promised to bring in resources and contacts, and to help you raise more money, and then fails to deliver on that promise, it can be a real source of conflict. If you’re looking for this benefit from your investor, you should complete your own due diligence to validate the investor’s ability to provide the promised value-add before you sign a term sheet.
Negotiate your next term sheet with confidence
It’s important to know what you’re getting into and how it can potentially impact your business. Being aware of how the process works and where the potential pitfalls lie is critical. So too is finding an investor who makes the process easy for you and who isn’t motivated to negotiate terms that could ultimately put you at a disadvantage.
That’s one of the many reasons why venture debt is an attractive source of funding. In addition to being non-dilutive, venture debt can provide an important source of capital to enable your company to continue to grow and to engage potential equity partners at the best time for the business and with the confidence necessary to secure the right financing on the right terms. That way you stay in control of your business longer while still securing the capital that you need.
The best way to prevent any problems with term sheets is to ensure that you’re well-informed, and that you understand exactly who you’re partnering with and whether or not they’re a good match for your business. To overcome these challenges and learn how to achieve the best capital injection into your business without the pitfalls, download our new white paper “How to negotiate a successful term sheet.”