What startups need to know about term sheets, legal due diligence and employee incentives

What is a term sheet?

Term sheet is just one name for it. Sometimes it’s called a letter of intent, a memorandum of understanding or a non-binding offer. It’s a document that sets out key terms of a transaction and is typically negotiated and signed at the beginning of a transaction.

While only some provisions in the term sheet are legally binding, you should also carefully negotiate the non-binding provisions. They predict how the investment document will look and changing them later is difficult.

Non-binding provisions of a term sheet.

Although non-binding provisions can’t be enforced, you have to be very careful negotiating them. They include:

For M&A transactions.

• Value and purchase price
• Purchase price adjustments, upfront payment, earnouts, milestones
• Payout mechanics (escrow, hold-back)
• How to deal with outstanding instruments (options, convertible loans)
• Employee matters (retain key employees)
• Ancillary agreements

For financing transactions.

• Valuation, share price,
• Shareholder structure post financing
• Board composition
• Board and shareholder matters
• Preference rights on “investor shares”
• Transfer restrictions
• Exit provisions (Tag along and drag along rights and IPO)

Binding provisions of a term sheet.

The binding provisions can be enforced. They include:

• Confidentiality
• Exclusivity
• Costs
• Applicable law and jurisdiction
• Term sheet expiration

Working out all the provisions is usually between the company and the investors. Still, it’s a good idea for the company to involve lawyers because the investors certainly have legal counsel. Let’s look at some non-binding and binding provisions in more detail.

Board governance and shareholder structure.

Term sheets define who governs the board and impose restrictions on the shareholder level. In most cases, investors want veto rights for important board matters. You’ll create a catalog of decisions that require not only the majority of the board’s vote but also an affirmative vote of the so-called investor directors. Investors also want a veto right on the shareholder level for important shareholder matters. How that exactly looks depends on your shareholder structure.

Drag-along and tag-along exit rights.

If everything is successful, what’s the exit strategy? There’s usually a drag-along right in the term sheet that obligates the co-sale for all shareholders in case certain criteria are met.

From a minority perspective, there’s a tag-along right. If the majority of the investors decide to sell part of the share, the minority shareholders have the right to co-sell their shares proportionally.

Provisions relating to IPO.

What happens in case of an IPO may also be fixed in the term sheet. This includes:

• Conversion of preferred shares into common shares
• Registration rights for investors
• Prohibition of selling shares for a certain time after the IPO

Exclusivity.

Investors argue they need the exclusive right to the deal for a certain timeframe because from the moment a term sheet is signed, important transaction costs occur. That’s all kinds of due diligence, lawyers and other advisor fees.

The company is usually reluctant to give exclusivity because they often have several term sheets on the table. If there is an exclusivity provision or not comes down to who has more bargaining power, the investor or the company.

Expenses and costs.

There’s always a provision for expenses and costs. It’s usually on the company to pay the investors’ costs, ranging from CHF 30,000 to 150,000. It is especially high with US investors. If the deal comes through, those fees will be paid out from the investment money. Only if the deal fails it’s a problem because the company shall still reimburse.

Practical advice on negotiating your term sheet.

Big funds always have in-house counsel. They often have standard term sheets based on extensive legal counsel.

The term sheet sets the tone and the timing. The main terms are already fixed.

The best advice Alexander can give to founders is to obtain legal advice when you start discussing important terms with investors, not when it’s in its final form.

What is legal due diligence?

In corporate law, due diligence is the process of conducting an intensive investigation of a corporation as one of the first steps in a pending merger or acquisition or a financing. In a company acquisition, due diligence would include fully understanding the company’s obligations: debts, pending and potential lawsuits, leases, long-term agreements and contracts and so forth. The goal is to identify the company’s current status and potential risks associated with it.

In essence, legal due diligence is a document review resulting in a written report that sets out facts, findings and recommendations, which are then addressed to the investors or buyer. The goal is to ensure that the investor or buyer gets what they expect.

The four key areas of legal due diligence.

• Corporate existence. Is the company existing? Was it duly incorporated?
• Ownership of shares. Are the people indicated in, for example, the term sheet indeed the shareholders? Were shares always correctly transferred?
• Intellectual property. Are key assets actually owned by the company? Are there other material risks that might cause damage in the future?
• Other liabilities. Is there anything else that could cause damage in the future?

The legal due diligence process.

Walder Wyss kicks things off with a document request. The company has to upload all requested documents to a data room. As the requests are usually very extensive, companies should rely on good corporate housekeeping to make the process easier.

Walder Wyss then reviews the documents carefully and might draft some initial reports. In most cases, there will be additional requests to clarify something or deliver even more documentation.

When everything is clarified, Walder Wyss issues a final report. In it, the investor or buyer finds a summary of identified problems with recommendations on how to deal with them.

Implications of findings during legal due diligence.

Something Walder Wyss finds during the legal due diligence might be a deal breaker. But that doesn’t happen often. Usually, both parties are eager to work it out. Certain issues can be fixed simply by signing additional documents.

If it’s not possible to fix a finding, further possibilities to deal with it are the inclusion of warranties and/or special indemnities in the relevant agreement (e.g. share purchase or investment agreement). If a risk realizes itself, the investors or buyers will be compensated. An additional option to address a detected risk is by an amendment of the issue/purchase price.

You’re sharing confidential data.

Be sure to make an NDA before you share your documents. Also, check if you’re allowed to share the documents and in case you’re not allowed or unsure, contact a lawyer to figure out how to get the approval.

Don’t overshare. Only share information that’s important for investors and blackout unnecessary information like personal information on employees. Such information should be anonymized before sending it to your counterparty, their advisor or a data room provider.

Besides the redaction of documents, a good option is, for example, uploading blank model contracts instead of specific employee contracts.

In any case, the target of a transaction should consult with its advisor about whether there is a legal basis that permits disclosure of the information/data and to what extent such information/data can be shared.

At the same time, make sure you don’t hide relevant information. A good lawyer will figure out that something is up, kicking off a time-consuming process of acquiring necessary documentation.

What investors want to know.

Walder Wyss breaks down the investors’ questions with regard to three standard categories of due diligence and gives a list of documents you can provide to answer them.

Who owns the company?

• Cap table
• Share register
• Register of beneficial owners
• Share certificates (if issued) with correct endorsements
• Documents related to earlier capital increases

What IP rights are relevant and who owns them?

• Registrations of patents, trademarks and designs
• Websites
• Transfer clauses that should be included in all agreements
• Transfers and assignments of rights which were not already covered by an agreement

Who works for the company?

• List of employees, positions, salaries and notice periods
• Copies of template employment contracts
• IP transfer clauses
• Non-compete clauses
• Proof of payment of social security obligations

Practical advice on due diligence.

Not only is your company’s current state important but the past, too. Make sure to collect and store all documents from the beginning.

Whenever you deal with legal documents, involve your lawyers early. Have them review your agreements before you enter into several disadvantageous agreements because of a faulty template.

The four types of employee incentives.

Under Swiss laws, employee incentives are grouped into four categories.

Employee shares and employee options both offer genuine participation rights. The difference is that with employee shares the employee directly becomes a shareholder in the company, whereas employee options offer a pre-emption right of participation in the company, and the employees can decide if they want to become shareholders once certain prerequisites are met.

With phantom shares, employees don’t become actual shareholders. It’s only a contractual right to participate in the company’s success. In addition, there are many other bonus programs.

Those can be linked to the performance of the company but also to the performance of the employee.

There is no one-size-fits-all incentive scheme. Companies have to answer the questions:

• Shall the employees become shareholders?
• If yes, at which time?
• Shall the employees have an “investor feeling,” or are individual targets more important?

This article summarizes the 1.5h long event with our partner Walder Wyss Attorneys at Law. Don’t miss key details next time and join our live events here.