Term-sheets and Sh*t-terms; Chapter 3: Investor Rights

All right, so this is the final banter for this series on Term sheets and Sh*t terms and it's actually a pretty interesting one.

So I'm guessing y'all remember Rahul - the AI startup bro who got a term sheet from Bad Capital.

In case you're new to this newsletter, you can go back and read the previous banters right here, it'll provide you with more context.

In the last two chapters, we covered everything from valuations to founder obligations and in this one we're going to cover the final part of the term sheet - Investor Rights

PS: As I started writing this, I realized that there is a lot of context required to explain these terms, however, I'm trying my best to keep it short and simple :)

As Rahul moved forward into the term sheet, he started reading words he'd probably never heard before. This included terms such as Tag along right, Drag right, Liquidation preference, Reserved matters etc

Now Rahul was confused as to what these rights meant.

Additionally, he wanted to understand which rights the Lead Investor (Bad Capital) should have and which rights the minor investors (BFFs and family) should have.

So let's look at these one at a time!

Board Seat:

The right for an investor to hold a position on the company's board of directors.

Sh*t term: Everyone is on the board - the more the number of people Rahul has on the board, the less control he has over the company. Now if Bad Capital appoints 2 people on the Board and Rahul is the third person on it - it's outnumbering him on a 2:1 ratio in the beginning itself.

BFF Tip: Ideally, the Board seat should only be offered to your lead investor, additionally think of fall away thresholds limits, say for e.g.10% - if an investor holds less than this, they don't get a board seat (right falls away).

Lead investor: ✅

Minor investors: ❌

Reserved matters or Affirmative vote matters:

To be honest, this is the most important part of the entire transaction. Reserved matters is a list of business-related decisions where the founders/company will need to get prior approval from Bad Capital.

Now this list isn't mentioned in the term sheet and is covered in the SHA, however, to still give you an idea, this includes things such as

• Raising your next round
• Availing of debt over a certain limit
• Business contracts over a certain limit
• Related party transactions
• Creating subsidiaries or entering into joint ventures
• Hiring or firing people above a certain pay scale

PS: If you want to get a little ahead, we've crafted an entire module on how you can navigate transaction documents here

BFF Tip: Spend time on these with your investors and ensure that these aren't too minute that even for your day-to-day operations, you need approvals

Lead investor: ✅

Minor investors: ❌

Drag Along Right:

It basically means that if Rahul can't provide an exit to Bad Capital in 5 years, Bad Capital can force the sale of all shares to get an exit.

Remember the Exit obligation that we spoke about in the last chapter - this is solely linked to that.

Sh*t term: Say the exit obligation was 3 years instead of 5 - that would mean that Bad Capital can enforce the Drag right in 3 years.

BFF Tip: Make sure your Exit clause is at least 5 year so that your lead investor cannot enforce the Drag right before that

Lead investor: ✅

Minor investors: ❌

Pre-emptive Right:

Also referred to as ‘pro-rata’, this means that investors can invest in a future round to maintain their shareholding from the current round.

For example, in this case, Bad Capital holds 28% after the current round but when the company goes out to raise a next round, Bad Capital will be diluted as the company issues new shares to incoming investors.

In that case, Bad Capital is entitled to buy enough shares to keep their shareholding at 28%.

So you see how even if Rahul was to raise its next round from Good Capital, how Bad Capitals' large holding can play a big part?

BFF Tip: It's natural for your lead investor to have this right, however, with regards to your minor investors, try and offer this right to those who you think can add long-term value

Lead investor: ✅

Minor investors: ✅

Anti-dilution:

Investors often negotiate for anti-dilution provisions. Now, these provisions aim to maintain the value of the investor's stake in the company if there is a down round (investment at a lower valuation)

Now let's plug this into Rahuls' situation here given that the business is in serious need of capital and hasn’t shown great progress and new investors are required but they want to come at a lower price ;

Let’s say the existing investors (Bad Capital and BFFs) purchased shares at a price of USD 100 per share. Now, the company raises the next round at the price of USD 75 per share.

If Bad Capital didn't have the Anti-Dilution provision, they would've been issued the diluted number of shares at the new price.

However, because Bad Capital has an anti-dilution provision and given that they earlier paid a higher price, they would be compensated for the down round by getting additional shares.

BFF Tip: The market standard is to provide the Anti Dilution provision to all investors. So make sure you always raise at the right price and build the business in a manner that a down round isn't required :)

Lead investor: ✅

Minor investors: ✅

Information rights

Bad Capitals' entitlement to receive regular updates on the company's performance and financials, along with priority benefits in case of a company sale or liquidation.

This tbh, is pretty standard, however, you can define what standard information you'd like to share with your investors and at what cadence.

BFF Tip: You can offer this to your minor investors as well. This way, you'd be keeping all your investors in the loop with the progress of the company and additionally you never know which investors of yours can help out when!

Lead investor: ✅

Minor investors: ✅

Liquidation preference:

It is the order in which shareholders get their money back if the company is liquidated. Investors want their money back before the founders.

The standard for this is 1x liq-pref and all investors (Major and minor) in a round are treated at the same level.

Sh*t term: 1.5x of the investment amount as liquidation preference

BFF Tip: Don't sign a side letter with any of your investors for a different liquidation preference

Lead investor: ✅

Minor investors: ✅

Tag along right:

Tag along gives investors the right to sell their shares too, if a Founder is selling his shares.

BFF Tip: Ensure that your carve-out doesn't include any tag restrictions

Lead investor: ✅

Minor investors: ✅

Other BFF Banter;

1. Navigating Transaction Documents
2. India's Rooftop Solar Mission

Hiring;

A bunch of our portfolio companies are hiring at the moment, so in case you're looking for a switch, feel free to drop a message!

If you can't describe what you are doing as a process, you don't know what you're doing.

W. Edwards Deming