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

By 13.01.2023January 24th, 2024All, Features

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

Conducting legal due diligence and preparing and negotiating term sheets for M&A or financing transactions can be difficult. But a well-planned and carefully crafted strategy and focus on key terms can save you a lot of headaches.

Three speakers from Walder Wyss Attorneys at Law told us what startups need to know about term sheets and legal due diligence in M&A or financing transactions as well as employee incentives.

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Our guests from Walder Wyss Attorneys at Law

Alexander Gutmans

Dr. iur., LL.M., Attorney at Law and Notary Partner

Alexander Gutmans advises national and international clients in commercial and corporate law, mergers & acquisitions, private equity, venture capital and financings, as well as healthcare and life sciences in contractual and regulatory matters.
He studied at the University of Basel (lic. iur. 1990; Dr. iur. 1995) and Lausanne and received a master’s degree from Yale Law School (LL.M. 1996). In 1993, he was admitted as an attorney at law and in 2002 as a notary. He started his professional career as legal counsel at Sandoz AG. After an assignment as a foreign associate with an American law firm in New York, he worked for 15 years as a lawyer for a leading Swiss law firm with offices in Basel, Bern and Zurich during the last 11 years as a partner.

Karina Tschon

MLaw, Attorney at Law Associate

Karina Tschon advises clients on matters of commercial and corporate law. She studied at the University of Basel (BLaw 2014, MLaw 2016). Before joining Walder Wyss as an Attorney at Law, she worked as a trainee lawyer at the Civil District Court Basel-Landschaft East, the Criminal Court of Basel-Stadt, in a law firm in Basel and the legal department of a pharmaceutical company in Basel. Karina Tschon was admitted to the bar in 2019 in the canton of Basel-Stadt.

Michelle Bruni

Attorney at Law, Certified Tax Expert Senior Associate

Michelle Bruni specializes in all aspects of domestic and international tax matters, both corporate entities and individuals. Furthermore, she advises clients on matters of commercial and corporate law.
She was educated at the Universities of Berne and Helsinki (BLaw 2009, MLaw 2012). She was admitted to the bar in 2014 after working as a trainee lawyer for a large bank in Zurich and a commercial law firm in Basel. She graduated as a certified tax expert in 2020. Before joining Walder Wyss, Michelle Bruni worked as an Attorney at Law and a Certified Tax Expert for an international commercial law firm in Basel (2015-2020).

The five steps of M&A or financing transactions

Walder Wyss looks at the mergers and acquisitions (M&A) or financing transaction process in five steps.

  1. Roadshow/Scientific, IP due diligence/valuation discussion and negotiations.
  2. Term sheet.
  3. Legal due diligence.
  4. Investment agreement and shareholder’s agreement/share purchase agreement.
  5. Signing and closing.

The two most important steps are the term sheet and legal due diligence.

Everything startups need to know about term sheets

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

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.

When founders negotiate on their own, there’s a gap in experience and level of sophistication between founders and investors. This gap has to be bridged by founders by getting lawyers involved at an earlier stage.

Alexander GutmansPartner at Walder Wyss

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.

Everything startups need to know about legal due diligence

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.

Everything startups need to know about employee incentives

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.

Frequently asked questions about term sheets and legal due diligence

What do you have to look for when negotiating your first term sheet, so it doesn’t affect future financing or M&A?

There’s a new term sheet in every round. The term sheets and investment documents of the seed round don’t have as significant an impact as, for example, a licensing agreement.

What’s the best way to structure the virtual data room?

It’s best to structure your data room the way the document request is structured. If you upload documents for other types of due diligence, it makes sense to store your legal-relevant data in separate folders as well.

Should I set up a data room for each investor, or can they all have access to the same data room?

You can use one data room. In most cases, investors won’t be able to see who accessed the files anyway.

Who pays the legal fees for writing up term sheets?

Investors often have their own in-house counsels. The founders or company have to pay the fees as part of the overall transaction costs.

How does equity ownership of a university change the view of potential investors?

Whether universities have real shares or phantom shares, investors usually don’t mind.

How much money should startups estimate to spend on the legal due diligence process?

To prepare a data room, get the necessary support and pay legal fees, startups should calculate roughly CHF 7’500.–

How can problems with IP discovered during legal due diligence be fixed?

Often, new agreements are concluded. If the current employment agreement doesn’t cover IP rights, you can enter into an amendment agreement. If an agreement with the service providers doesn’t foresee a clause that they transfer the IP rights afterward, you can make a separate transfer declaration. Severe issues have to be clarified with a patent lawyer.

Are there any warranties on IP ownership required by the investors?

Yes, that’s very often requested by investors.

Can a VC require that a startup works with a specific lawyer?

No. They can recommend a firm, but they can’t force you to work with them.

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