Investment readiness and some tips for closing a good term sheet

How much is a startup worth? What is the potential it can express? When will it start generating cash value?

This is what investors ask themselves before investing, with the spasmodic goal of measuring the degree of maturity of a startup, with respect to expectations, innovative character, and market opportunities.

Conceived by Steve Blank in 2014, father of the Lean Startup model, the investor’s thermometer is called the Investment Readiness Level (IRL), and is used to analyze a startup’s investment readiness and the level of growth of the business idea. It is not calibrated in Celsius degrees, but on a scale of values from 1 to 9, which runs through the entire life cycle of a start-up:

IRL 1: identification of the Business Model “Business Model Canvas” (idea);

IRL 2: definition of the market positioning (need);

IRL 3: validation of the product/service (solution);

IRL 4: launch of a Minimum Viable Product “MVP” (validation of the product on the market);

IRL 5: Marketing strategy definition (4P: price, product, promotion, placement);

IRL 6: Validation of the value proposition (external recognition of the value proposition);

IRL 7: MVP effectiveness validation and investment risk mapping of solution technology development;

IRL 8: validation of the operating model (processes, resources, partners);

IRL 9: validation of key metrics for business growth.

Only once a good number of early adopters have been reached, that is when mercury marks “IRL7”, and a significant rise in the temperature of the start-up is registered (far above the values ​​considered “normal”), is it time to turn to investors to attract venture capital, ready to capture this differential value to be acquired, developed and monetized.

In this state of feverish excitement, the entrepreneur is required lucidity, vision, methodology, but above all a competent partner who can accompany him from the beginning, from Day One, during the entire negotiation process between the parties, which is summarized in the various aspects that will constitute the so-called “term sheet” investment: agreement between the founders of the start-up and investors, preliminary and preparatory to the desired “main agreement” (consisting of three main documents: investment contract, shareholders’ agreements, articles of association of the target company).

The Term Sheet is a letter of intent (or memorandum of understanding) with which the parties establish some points on which a general agreement has been reached and regulate how to continue the subsequent negotiations relating to a future investment agreement with one or more investors interested in entering the capital of a company (SRL or SPA), especially for investment operations in start-ups by business angel, venture capital, private equity funds.

The path is “challenging”: it will stimulate the ability to manage stress, highlight communication and interpersonal skills, develop mathematical sensitivity and motivate the deepening of legal concepts.

Put in your pocket the notebook with the check list, in your head the experience gained and the best practices acquired so far, in your heart the desire to do something important for the start-up … and in your wallet the right budget for the advisory that will take you to your destination!

It is fundamental to know the essential elements when drafting the term sheet:

• the term sheet is not binding on the conclusion of the investment transaction, but should nevertheless bind the parties to continue negotiations in good faith;
• the parties are bound to conclude the investment transaction as set out in the term sheet (specific conditions: due diligence, audits, …);
• if one of the parties were to interrupt the negotiation at an advanced stage of negotiation, having generated in the other party the conviction that the operation would be concluded, the pre-contractual responsibility could be configured for the party that has failed to fulfill its commitments (with contextual action against the withdrawn party, to request compensation for economic damages suffered due to sudden interruption).

The term sheet is the point of arrival for the negotiations conducted so far by the founding members of the startup together with potential investors and, at the same time, the starting point for future negotiations aimed at finalizing the investment agreement.

It represents a facilitator of the negotiation with respect to the timing, the complexity of the investment transaction and the type of parties involved. It will work only where correctly prepared, otherwise it risks turning into a double-edged sword for the start-up and its founders.

In order to reach the signing of the investment agreement, it must help the parties to:

• confirm the mutual willingness of the parties to continue negotiations;
• crystallize those points on which there is already an agreement in principle;
• define the structure, method and timing of the transaction and regulate the subsequent stages of negotiation;
• identify the issues subject to further negotiation, governed by different regulations.

By exploring the meanders of the term sheets, let’s try to define a “vademecum” from a technical-legal point of view. Given the purpose of the term sheet, the most important and delicate aspect in drafting such a document is to indicate the BINDING CLAUSES which:

• establish the duration of future negotiations, timeframes and costs of due diligence activities;
• require the parties not to negotiate with third parties for the entire duration of such negotiations;
• affect the completion of certain tasks (e.g., registration of intellectual property rights, incorporation of the company being formed, …) that impact the development of the agreement;
• introduce a time limit on the effectiveness of the term sheet;
• indicate the applicable law and the competent court in the event of a dispute between the parties;
• govern the methods of calculation and payment of the costs that may be incurred by the parties during the negotiations.

Before the start of the evaluation phase relating to the feasibility of the investment, it is advisable to sign an agreement that protects all confidential information, subject to knowledge and exchange between investors and founders, subject to non-disclosure obligations (confidentiality clauses). The clauses benefit both the company and the investors, and are simply a mechanism that the latter use to ensure that the company is legally bound to take care of the protection of intellectual property.

The part of the term sheet relating to the description of the transaction that provides information on the “key financial” values (value, methods and timing of the investment) should not be binding, as it is subject to further analysis and in-depth analysis, before and after the due diligence, according to the discipline of the investment agreement.

In fact, among the main TYPICAL CLAUSES generally used for investment transactions, the economic terms are necessary to define the price of the transaction and, therefore, estimate the expected return on investment for investors in case of a liquidity event (sale of the company, stock exchange listing):

• pre-money valuation: used to indicate the starting point for the determination of the subscription price of the shareholding by the investor during the capital increase.
• post-money valuation: valuation of the company following the completion of the investment, which can be calculated either by adding the amount of new capital injected into the startup, to the pre-money valuation of the same, or by dividing the amount of the new investment by the number of shares received and multiplying the valuation per share, by the total number of shares issued after the investment.

The most commonly applied valuation methods:

• Discounted Cash Flow (DCF): determines the Net Present Value (NPV) of the start-up, and is based on the forecast of the generation of cash flows in the medium to long term, discounted at the weighted average rate of debt and equity dependent on the riskiness of the business and the expected growth.
• Multiples method: comparative method based on indicators that compare the value of the company in relation to variables (multiples) of other companies, such as revenues, ebitda, profit.
• Venture Capital method: determines the current value of the company, based on the terminal value/post-money appreciation (ROI), which the investor is willing to pay in relation to its market potential.
• pay-to-play clauses, to guarantee and protect the valuation activity, whereby the investor loses certain rights in the event of non-participation in the financing rounds subsequent to that of entry into the start-up; this allows the commitment of the investors to be agreed upon in advance, obliging them to continue to participate (pay) proportionately in future financing, so that their preferred shares are not converted into ordinary shares and thus maintain an active role of participation (play) in the company.
• exclusivity clause, which is relevant when the investor binds the partners of the start-up, for the duration of the effectiveness of the term sheet, not to engage in further negotiations with potential third-party investors: in this case, the term sheet should be as short as possible to avoid the start-up founders being able to enter into dialogue with other potential investors for too long a period of time.

Once the negotiation has been completed, and the term sheet has been defined, we will move on to define the contractual agreements: the main agreement will not only include what has already been inserted in the term sheet but it will also define the CONTROL CLAUSES (shareholders’ agreements): investor rights, voting and representation rights, governance rights.

PARTICIPATION RIGHTS:

• Drag Along Pact: the majority shareholder has the right to drag the minority shareholders (even the founders) into the sale, forcing them to sell their shares, regardless of their opinion and will. However, minority shareholders have the right to sell under the same conditions as the majority shareholder (typically for ordinary shares, not for preferred shares).
• Tag Along (or agreement or piggy back): the majority shareholder who wants to sell his shares to third parties must also guarantee the minority shareholders the possibility of selling under the same conditions (right for minority shareholders without, but not obligation to, sell their shares).
• Liquidation preference (or preferential liquidation clauses): clauses aimed at guaranteeing the return on the investment, can be of different types depending on the type of investor, the size and duration of the investment, the pre-money valuation, the type of business and the growth phase in which the start-up is located; determines the modus operandi of the distributions and is based on two main components: effective pre-emption and participation). There are three degrees of participation: full participation, capped participation, and no participation.
• Liquidation preference (or preferential liquidation clauses): clauses aimed at guaranteeing a return on the investment, they can be of different kinds depending on the type of investor, the size and duration of the investment, the pre-money valuation, the type of business and the growth phase in which the start-up is; they determine the modus operandi of the distributions and are based on two main components: effective preemption and participation. There are three degrees of participation: full participation, capped participation and no participation.

The determination of the Liquidation Preference for a start-up starts from the pre-money valuation: in fact, it gives the investor the right to receive, before the other partners, a share of the proceeds from the Exit or from a Liquidation Event which is equal to the investment made or, more often, equal to a multiple thereof and, in the case of a residual amount, provides for a pro-rata distribution with the other partners (type of participatory liquidation).

• Anti-dilution: in the event of a future capital increase, the investor has the right to increase the number of his shares in order to keep his stake in the company unchanged:
• “economic” dilution: after the entry of an investor, the company resolves a capital increase by issuing new shares at a lower price than that paid by the investor on the basis of the previous company valuation;
• “percentage” dilution: decrease in the percentage of the investment due to the issuance of new shares or quotas in favor of third parties for protection, the minority shareholder may subscribe to the option clause, which allows to subscribe to any future capital increases before the shares or quotas are offered to third parties.

RIGHT OF CONTROL, VOTE AND REPRESENTATION:

• Appointment of Directors: right to appoint one or more members (Directors) of the Board of Directors (BoD) to represent the Investor.
• Appointment of Chairman and CEO: right to approve the appointments of Chairman and CEO in order to express a binding opinion on the key figures in the company.
• Appointment of the Board of Statutory Auditors: right to appoint one or more auditors in order to protect the Investor.
• Qualified majority in the shareholders’ meeting: majority votes require the Investor’s favorable vote in order to approve the decisions of the meeting (amendment of the articles of association, distribution of dividends).
• Qualified majority in the Board of Directors: majority votes must be achieved with the affirmative vote of the directors appointed by the investor, regarding decisions of particular importance related to ordinary and extraordinary management, in order to protect the investor (as a minority shareholder), giving him/her the power to influence Governance and participate in the strategic decisions of the company.

GOVERNANCE RIGHTS

• Lock-up for key managers: this consists of a commitment by key managers not to resign and to devote their full time to the management of the company for the duration of the investment contract. The objective of this clause is to ensure continuity of management.
• No competition with founders: Commitment of the other shareholders (but also Board members, employees and collaborators in some cases) not to carry out activities for direct competitors and, if they no longer have a relationship with the company, even in the 2 years following the end of their assignment. This clause is useful because it protects the company from potential leaks of know-how to competitors.
• Management incentives: when objectives related to company growth are achieved, incentives are given to managers either financially or in stock options. In this way, key managers are given the opportunity to be rewarded with variable incentives linked to the company’s market appreciation.
• Disclosure rights: the monitoring of the investment presupposes that the invested company provides information regarding the financial situation and business performance; periodic qualitative and quantitative reports on the economic and financial situation, periodic working meetings and board meetings between investors and company management.

The protection provisions are often hard negotiated even if over time they have become more and more standardized: on the one hand, entrepreneurs would like to reduce them to a minimum; on the other hand, investors would like to ensure a certain degree of control by being able to exercise the right of veto over a series of actions that the company might carry out, especially when they impact the economic position of investors.

But net of the legal aspects and the financial value brought, the entry of the investor must represent an enrichment of skills and knowledge: only in this way can the investment become a real success!

The support activities carried out by an investor can be of a DIRECT nature (provided directly by members of the investor’s team) or INDIRECT (provided indirectly by a specialized network of partners made available by the investor). Some services are provided continuously and others only at specific times in the life cycle of the company; they can be free of charge or at a “favorable price”, in different areas:

• Technological: research and development activities, creation of partnerships for technological development.
• Intellectual Property (IP): development of IP protection strategies, development of new IP.
• Recruiting: definition of contracts and creation of agreements with recruiting companies, activation of the selection process.
• Management: Identification of key executives.
• Business development: opening of new commercial channels, contacts with potential distributors, market analysis.
• Governance and Compliance: attendance at Board meetings, management of relations with auditing firms and other entities, management of risks associated with the company’s activities, compliance with regulatory requirements.
• Planning and Control: financial planning and monitoring with reporting, verification of accounting and financial statements, preparation and updating of business plans.
• Fundraising: access to other funds, direct participation in investment rounds; investors do not fund and invest in one lump-sum at the beginning of the investment, but fund by round, which means that the investment round is made when the startup or company reaches certain goals in terms of growth (rounds series A, B or C).
• Exit: monitoring and selection of exit opportunities, preparation of the process and documents required for exit, negotiation support.

Happy Investing to All!

“Investing is simple, but it’s not easy.” (Warren Buffet)