by Robert Wenzel
If you are trying to either start a new business or raise money for an existing company, one way to gain new funds is by having investors. When you decide to accept capital, one of the first things that you need to do is create a Memorandum of Terms, which is often referred to as a “term sheet”. Oftentimes, deciding what to include in the Memorandum of Terms can be a difficult process.
There are several different theories as to what should be included in the term sheet. One idea is to initially add the most important terms of the agreement and then negotiate most of the details after the document has been drafted and given to all parties.
This method allows both sides to know up front what the most important points of the partnership are. At the same time, all the parties can determine what they feel may be important and add these aspects to the agreement once the basic framework is in place. In addition, there may be some issues that one (or both) sides did not think of during the initial negotiations. Having an open-ended memorandum can provide the added flexibility to make changes when needed.
Another ideology is to begin the process with a very detailed term sheet. Beginning the process with most, if not all, of the terms in place makes all parties aware of what is to be expected during the entire process. However, a more detailed memorandum may not provide the flexibility that is needed if an issue arises or if one of the sides needs to change the agreement down the road.
Additionally, a third method is to negotiate the terms of the primary financing up-front and have them in the memorandum of terms. This can help both sides, since they will be able to confront one of the key issues from the beginning-how the financing will work. The company will know at the start how much money they will be working with. Conversely, the investor will know how much capital they need to provide and what to expect in return on their money.
It can also be helpful to describe what kind of financing will be included in the memorandum of terms. Some of the different types of investment options are:
1) Staged financing. This is where investors will provide money over a defined period if the company reaches certain goals. It can allow the party to assess the situation at hand and only continue to provide capital if the business is successful. If the company is not doing well, the investor can keep any potential losses to a minimum.
2) Priority liquidation preferences. When a business is in a field with a large number of liquidations, the investor will be able to recoup their money if the company folds.
3) Participation in liquidation distributions. If the company does go out of business, then the investor will be able to regain a certain amount above their original purchase price.
4) Cumulative dividends: If the business fails or merges with another company, then the investor will be able to receive a certain percentage of the dividends from their original investment.
5) Full-ratchet antidilution provisions: This can be implemented when the two sides do not agree on the amount of return. The investor will still receive money back, but it may be adjusted in the form of a dividend or split.
It is always best to evaluate your situation and determine what financing needs meet your organizational goals. This will help to determine what kind of term sheet to draft and what kind of options to include for the investor.