Seed-stage investing is on the up across the world, now accounting for 67 per cent of all venture capital (VC) funds in North America. Seed deals in Europe have increased 19-fold over the last four years. And in Africa, funding availability is also on the rise.
It is still nowhere near the level that it needs to be at, but there are signs that the age of African VC is arriving. Last year’s VC4Africa Venture Finance for Africa Report said total capital investment in African startups more than doubled to US$26.9 million in 2014. This, however, is only a drop in the ocean, as the figures only apply to those startups listed on the VC4Africa platform.
The true figure is probably around US$500 million or perhaps higher, considering the amounts taken home by the likes of Takealot, Jumia and Konga, while 2015 has also started well, with the likes of Ubongo, M-KOPA Solar and Parcelninja among a number of startups to have obtained funding. Mobile operators, such as Millicom and Safaricom through its US$1 million investment fund, are also pumping in cash.
The importance of term sheets
With this growth in available funding in mind, African startup founders need to be well versed in how to negotiate a term sheet that is satisfactory to both them and the investor, protecting both their interests. The negotiation of a satisfactory term sheet is one of the most critical parts of the process of equity investment. If we think of the relationship between the two as a marriage, the term sheet is the ideal moment to agree on a mutually beneficial arrangement rather than putting on paper a more adversarial prenuptial agreement.
The term sheet is the starting point for negotiations between startups and possible investors. Founders must remember that they are always likely to benefit the investor, and will be based on that investor’s prior experience of putting money into businesses. They are also likely to have more legal support. But by following some basic rules, many of which are laid out below, startups can sign a term sheet that lays the groundwork for a long and profitable relationship.
Keep them simple
Term sheets designed specifically for angels and startups are becoming more common, compared to just a few years ago where VC term sheet templates were commonly used by angels. Typically, angels and startups have wanted to simplify the process, reducing the number of terms and legalese, and cutting down on legal fees.
As a result, angel term sheets such as this is the United States and the recent equivalent launched in South Africa are useful tools for founders, and more specifically aimed at early-stage funding rounds. Common terms are simplified, and the makeup fits the requirements of angels and startups. Another template term sheet created by angel investor Dan Rosen – the nine-page Model Angel Term Sheet – removes terms unnecessary for most angel deals, and offers comments explaining terms. Term sheets like this are around half the size of a VC term sheet.
Key terms in angel term sheets include, pricing and valuation, board and information rights, participation rights, liquidation preference, and redemption rights. For more on these, read further.
Understand the terms, they matter
Terms such as those mentioned above are vital, and therefore you need to understand them. Every entrepreneur needs to know about liquidation preferences, participation,and ratchets. If you don’t know, read up. These terms are generally the creation of investors, and they will generally have been created because they have learned they are valuable ways of recovering their investment if all goes badly or increasing their return if all goes well. You need to be guarded against this.
That said, terms are not bad. They are there to protect you and your startup as well, and are part of the standard investment procedure. But if you don’t understand the terms, you can’t complain afterwards if they are damaging to your. Swot up, and make sure you’re as prepared as the investor when negotiating the term sheet. Here’s a bit of help on the big ones.
- Liquidation Preference: One term that could have the greatest impact on you. Liquidation preferences refer to how proceeds will be divided between various shareholders in the event of the sale of the company. This is separate from equity ownership, and if negotiated in a certain way can allow a shareholder with a preference to be able to receive a multiple of their original investment back before any other shareholders can take any proceeds. This needs to be watched, generally the lower the liquidation preference the better it is for the entrepreneur.
- Participation and non-participation: Often used in combination with liquidation preference, participation means the investor can participate in all proceeds – after the liquidation preference – based on their equity in your startup. For non-participation, investors either get their liquidation preference or can convert their preferred shares to common shares and participate with all other investors. Again, can be important when it comes to an exit, and need to be watched.
- Founder vesting: Generally in early stage investments, founders are most likely to be considered vital to the ongoing success of the startup. Investors are therefore likely to need you to re-vest your equity over a period of time. The term sheet is the time when you can get ahead of this discussion, by establishing a vesting schedule, and addressing what happens in the event of you leaving the company for whatever reason. Understand the term, protect your stake.
- Board structure and composition: Vital to understand. You might think percentage of ownership is the true indication of control, but in a venture-backed company control really lies with the management team and the board of directors. Be aware of this and have it in mind when negotiating your term sheet, as board structure, the list of decisions that require board approval, and voting thresholds for certain actions, will all have a large impact on the extent of your actual control of your startup after you have received funding. In general, smaller boards are better than larger boards.
Think carefully about the valuation
Another term that barely needs defining is valuation, what the investor will pay for a certain amount of your company. This is crucial, and takes up a lot of the entrepreneur’s time when it comes to negotiating a term sheet. Clearly, a higher price for a certain stock share is better than a lower one. But you need to have it in mind that not all offers per share are equal, given aspects such as liquidation preferences, and you will need to think carefully about accepting a high price.
There are circumstances where you would be better off accepting a lower price, especially if it can allow you to negotiate more flexible terms elsewhere. Also take care to make sure a Stock Option Pool for future employees is included in the “pre-money” price, or at least established once the money has been received. It is also important to consider how the valuation this time will affect your next funding round. Kopo Kopo have some interesting thoughts on this here. If all goes well, you’ll probably raise funds several times, and high valuations the first time round can cause problems later if that valuation is ahead of your business fundamentals.
So yes, valuation is important. But a number of investors argue that many first-time entrepreneurs tend to overemphasise its importance. This puts at risk a startup’s ability to obtain funding from its preferred investor, possibly losing the value these more long-term investors could add. Generally, funds or angels that compete on valuation alone are essentially saying they cannot add much in terms of value to your startup.
Create a “waterfall”
Before agreeing to any term sheet, you need to create a “waterfall” spreadsheet clearly laying out what you and any investors gain in the event of an exit, be that low, medium and high. This will help you understand what the future holds in the event of you selling a stake in your startup, and you should not do so without knowing the future possibilities either way.
This links back to the need not to be totally consumed with the valuation. In the willingness to trade terms for a bigger valuation, entrepreneurs run the risk of losing out in the long-run. Before agreeing to anything, create a waterfall and find out what the outcomes are likely to be given a number of different scenarios. This will help you properly understand what tradeoffs are being made and what impact they will have in the future.
It is important to remember that venture capital is not free money, but debt. If there are too many preferences stacked up, it can cause problems down the line, meaning investors could put it in the term sheet that their money is guaranteed to be paid back first out of any sale proceeds. This risk can multiply the more money you raise.
This is your startup, whereas the investor probably has a number of other options. What happens in the future inevitably matters more to you than to them. Make sure the terms protect you and your future equity, while also proving attractive to worthwhile investors. There is little point in signing a big deal but regretting it down the line when it is too late. Understand what you are doing, and negotiate in order to protect yourself and your startup.