We recently received the proposed shareholders’ agreement (SHA) for the new investment rounds of one of our startups. The new round’s lead was going to be an outside institutional investor and the terms were therefore primarily being set by this new investor.
To our surprise, the SHA was quite different than the term sheet which the investor submitted showing their original intent to invest in the company four months ago. In particular, the SHA contained terms which were not in the original term sheet, as well as modifications of existing terms, to the detriment of the company’s founder. In the end, the founder didn’t accept the conditions in the SHA and we completed a smaller internal round.
So why can there be differences between the term sheet which an investor proposes and the final SHA?
The first reason is if, during the course of the due diligence efforts which take place after the term sheet has been signed, the investor discovers material facts that are different from those which they used in arriving at their term sheet offer. Examples of such differences can include misstated historical financial figures, KPI targets which are not hit, or significant changes in the external competitive environment.
Since it’s in an entrepreneur’s interest to minimize changes to the investment conditions after the term sheet has been signed, I encourage entrepreneurs to share as much information as possible with investors prior to signing the term sheet. Due diligence should be reserved to fact check existing information, not uncover new information. While an entrepreneur may not be able to control the external competitive environment, they can share comprehensive and accurate financials and realistic future projections prior to signing the term sheet.
There is also a second reason why the ultimate SHA can be different than what is originally communicated in the term sheet. Specifically, some investors see the term sheet as the beginning, and not the end, of negotiations. They use a term sheet with entrepreneur-friendly conditions to attract the entrepreneur’s attention, and then impose harsher conditions in the final SHA. This can take place even though there are no new material facts which are uncovered, or significant external events which take place during the due diligence process which would justify a change in the term sheet’s conditions. Since the entrepreneur has incurred a significant sunk cost by the time the SHA arrives, certainly in terms of their team’s time and sometimes also by sharing in the costs of due diligence, they can be tempted into accepting conditions which they otherwise wouldn’t have agreed to if they had been proposed in the original term sheet.
The first solution to this problem is to perform research on your potential investors. Ask other entrepreneurs who they have invested in whether there were any significant differences between the term sheets and SHA’s that they received. If this is often the case, you will want to prioritize investors who have a cleaner track record in following through on their term sheet commitments.
The second solution is to lower the negative impact on your business in the event that the SHA is not aligned with the original term sheet. We’ll discuss ways in which you can achieve this in next month’s post.