THE TERM SHEET: ARE ANGEL INVESTORS BEGINNING TO LOOK LIKE VENTURE CAPITALISTS? Joseph R. Bell, University of Arkansas at Little Rock 2801 South University Avenue, Little Rock, AR 72204 501-683-7207; jrbell@ualr.edu ABSTRACT The objective of this assessment is to examine the provisions of an Angel Investor term sheet. The term sheet is the initial letter of intent between an Angel Investor and the founders of a company. Not only will we attempt to clarify some of the legalese contained in the document but each section will also include an interpretation as to why it’s included and the potential impact on the parties to the agreement. EXECUTIVE SUMMARY Angel investors have been hurt over the years not only by the dot bust but even when deals are “successful” the Angels have been diluted by large, subsequent rounds of financing. Today, Angel Investor Term Sheets have taken on the look and feel of Venture Capitalists investments. This paper assesses the terms of a specific Angel Term Sheet and compares it to recommended Venture Capital provisions. The paper goes on to identify if the Angel terms are more or less favorable to the entrepreneur. SO WHAT Angel investors have changed the way they invest. The consequences can have a very harsh impact on entrepreneurs. Many entrepreneurs are unaware of the effects of the Term Sheet until specific provisions kick-in and the entrepreneur’s ownership position within the company is severely negatively impacted. INTRODUCTION A sample term sheet which served as the basis for this discussion is contained in the appendix. Terms sheets will vary based upon many factors including the desires of the parties, economic times, industry, etc. While much of the literature focuses upon Venture Capital stage term sheets, the conclusion will recognize differences/similarities of the Venture Capital versus Angel term sheet and if the terms favor the Investor or the Company/Founders. Please be advised that this is only a guide and legal advice should be sought for any company or investor utilizing a term sheet. A term sheet outlines the terms for a deal; it serves as a letter of intent given to a company seeking investment by a venture firm in order to outline the proposed terms for an investment transaction between two parties. “A non-binding agreement setting forth the basic terms and conditions under which an investment will be made” (www.investopedia.com/terms/t/termsheet). A term sheet has two important functions; it summarizes all the important financial and legal
terms related to the transaction; and it quantifies, in both numbers and qualified terms, the value of the transaction or the Venture Capital [Angel] financing. The term sheet will serve as the basis for the legally binding documents which follow, a Purchase and Sale Agreement, and frequently, a revised Certificate of Incorporation. (Wilmerding, 2005) Arthur Lipper III in his “The Guide for Venture Investing Angels”, states, “Although the term sheet may take a variety of forms, from a cursory and informal letter to a more detailed and formal memorandum, it is intended to accomplish the following purposes: (Lipper III, 1998, pp.341-342) • To reflect the agreed upon valuation of the business and to quantify the proposed allocation of the value between the entrepreneurs and investors; • To summarize key financial and legal terms of the transaction which will serve as the basis for preparing definitive legal documents; and • On, occasion, to impose enforceable legal obligations upon the parties, such as requiring payment of expenses in the event the investment does not close or prohibiting negotiations with other parties pending the completion of the transaction. Most view term sheets as a vehicle solely within the purview of the Venture Capital community. Wilmerding states, “It is entirely plausible that one Angel or several could work together to provide an entrepreneur a pool of capital and in so doing require that their capital be treated differently from that of the entrepreneur who would hold common stock. In this instance, the Angel Investor or Investors would probably provide a term sheet but given the early stage of the company, the framework of the term sheet would likely be quite simple.” (Lipper III, 1998, p.16) Our premise is that with the ramp up of deals during the dot com era, and an increase in both the sophistication level of individual Angel Investors and the appearance of Angel syndicates, the document has gained a strong foothold at the Angel stage. Wilmerding discusses five basic forms and styles of term sheets, each referring to the term sheet adopted by five leading venture capital law firms. (Wilmerding, 2005) We differ in that the term sheet discussed here was developed by an Angel Investor, reflects a significant degree of sophistication in both its legal and financial terms, and tracks closely the provisions of sample venture capital term sheets. The content of a term sheet can vary widely based upon the negotiated terms of the parties, the needs of the venture, the signs of the times (with the downturn of the economy in the early 2000’s term sheets became more investor friendly and less favorable to founders), etc. Over the years, the terms have begun to favor the Investor more and more. Many of the provisions, as you will see, are an attempt to protect the rights and financial position of the Investor. It reflects true that “Cash is King”. An agreement is reached after the parties negotiate terms that both can live with. There are hundreds of sources online for an investor to find sample term sheets. Every term sheet is different. Every business has its own unique situation which calls for a unique term sheet (www.angelstartegies.com/as/termsheet). Lipper states, “Despite standardization of much of the venture capital process, it remains fundamentally highly idiosyncratic, with each transaction reflecting the particular chemistry between entrepreneur and investor. Accordingly, there exists no such thing as the perfect model of legal documentation for the investment transaction. Each set of documents needs to be tailored to reflect the unique combination of styles and interests involved.” (Lipper III, 1998, p.341)
CONCLUSION The detail of the Angel term sheet is very indicative of how far Angel Investors have come in regard to defining the terms and conditions of their investments. This particular term sheet tracks very closely to what Wilmerding has laid out as the provisions for a Venture Capitalist approach to a term sheet. Many of the protective provisions alluded to in the VC term sheet are also present in the Angel one. Interestingly, in Appendix 2, where the provisions of the Angel term sheet are compared to the Wilmerding Evaluation Criteria either favoring the Investor or the Issuer, the Angel term sheet, for the most part, would be defined as rather Investor favorable. This may be due to the difficulties Angel Investors faced once larger subsequent rounds of financing were infused into the venture. These monies were generally in the form of Venture Capital dollars and the end result was significant dilution and a loss of control by the Angel. It then begs the question, was this far more restrictive Angel term sheet a direct result of the Angel and Venture Capitalist experience or has it been a natural progression to “protect” early stage investment? A consequence, as mentioned earlier, of these more restrictive provisions is their ability to inhibit future rounds of funding. So how does the Angel go about protecting themselves from downrounds, redemption issues, liquidation preferences, etc. without inhibiting future rounds of funding? The conclusion here might be there is a fine line between trying to protect that early funding position and attracting future investment. All provisions of the term sheet are negotiable and both parties need to keep in mind what effect these terms have not only on future funding rounds but the true chilling effect it might have on the parties themselves. REFERENCES www.investopedia.com/terms/t/termsheet. Wilmerding, Alex, Term Sheets and Valuations, Aspatore, Inc. Fourth Printing 2005. Lipper III, Arthur, The Guide for Venture Investing Angels, Missouri Innovation Center Publications, Columbia, Missouri 1998. www.angelstartegies.com/as/termsheet, Angel Strategies, An Angel Capital Firm, 2004.