Building a startup is a tough challenge. The Founder must possess incredible perseverance and grit, able to hire and rally his tribe of followers, and be well equipped with knowledge to execute with day-to-day business affairs.
But that’s not all. As a startup begins to grow, fundraising becomes a critical aspect. If you are successful, a potential investor will pass you a term sheet and ask you to sign it before a shareholders agreement can be firmed up.
As you stress yourself out over the legalese, you wished you had a lawyer on hand, but the amount raised isn’t much to justify the cost of hiring one. Anyway, it is just a small fundraise of US$100k, what impact is there signing this first term sheet?
The lack of knowledge leads to potential economic losses and management control over your startup
In more established ecosystems like Silicon Valley, clauses in fundraising agreements have been applied consistently.
However, in South-East Asia, standards in investment agreements have many variations, mainly because of higher-risks and unfamiliarity among the investment community. The humble Y-combinator SAFE agreement, initially meant to make documents simple and easy to process, had become quite unsafe to the entrepreneur. Here in Singapore, SAFE agreements tend to have added clauses that at times may contradict each other.
The TRIVE team have advised many early-stage startups via its NEXT50.sg pro-bono mentorship. And it astounds the team on how lopped-sided some investment agreements have been designed to significantly put most risk on the founder, while the investor has significant management control and rights over the company.
So what fundraising documents should a founder need to know before starting to enter into agreements? And when should such documents be used during fundraising?
Here are the 4 main fundraising documents you are likely to face in an investment, explained in a nutshell:
1. The Term Sheet
Investopedia explains that a term sheet is, “a non-binding agreement setting forth the basic terms and conditions under which an investment will be made. A term sheet serves as a template to develop more detailed legal documents. Once the parties involved reach an agreement on the details laid out in the term sheet, a binding agreement or contract that conforms to the term sheet details is then drawn up.”
How it is used: A term sheet is best used during an equity fundraising round, when a startup founder has found the lead investor to lead the round. While it is non-binding, it is the ‘no-shopping’ period where the founder is not able to seek out proposals from other investors. This is to respect the effort of the lead investor to processing the deal.
Upon signing the term sheet, the startup is free to use the term sheet as reference to solicit other co-investors who wish to join in the investment round. A note of caution is that no terms and conditions should be removed or added by co-investors, unless agreed by the lead investor.
2. A Shareholder Agreement
It is an agreement, which uses the term sheet as reference, that outlines the shareholders’ rights and obligations. This is a crucial document that contains clauses that governs shareholders’ privileges. It also provides protection for the investor(s) and lays out important details on what should take place in a case of events such as the issuance of new shares.
How it is used: The shareholders agreement is binding, which reflects clauses drawn from the term sheet. This agreement will likely include clauses like the valuation, purchase amount of shares, type of share purchased and description of rights if it is a preference share, reverse vesting of founder shares, restrictive convenants, shareholder and board reserve matters, and jusridiction of the agreement.
All existing shareholders and new shareholders have to sign the agreement, unless a clause was invoked in previous agreements like drag-along rights.
This is one agreement which is highly recommended to be vetted by a lawyer.
3. Convertible Notes Agreement
It is a type of equity-financing that incurs interest.
The investor invests money in your startup and receives discounted shares when you issue shares at a later date. The convertible note sets out the conversion event which triggers the loan to convert to equity. If the conversion event is not reached upon the maturity date, the loan will have to be repaid (with interest) or it will automatically be converted to equity at the pre-determined rate (with interest included).
How it is used:Convertible notes and SAFE agreements (in the next point) are used to simplify fundraising. They are both usually used during bridge rounds, where for reasons an equity fundraising round was unnecessary.
Convertible notes are still used by investors in this region due to the familiarity.
4. SAFE (Simple Agreement for Future Equity) Agreement
SAFE was created by Y-combinator with the basic aim of making investment simple and quick to process, as compared to a shareholder’s agreement. Similar to convertible notes, it is meant to save the trouble of deciding important clauses or having rights and privileges bestowed on the investors that an equity fundraising round will have.
But unlike a convertible note, it is an equity and not a debt instrument, thus no interest is payable. There is also no expiry date, which effectively saves the founder from negotiating a new agreement which the convertible note faces.
How it is used: You can refer back to the Convertible notes on the usage of SAFE as they are quite similar.
The SAFE agreement, if it followed similar terms by Y-combinator, would be reasonably be an effective fundraising agreement. It is unfortunate that SAFE agreements which we have seen in Singapore, many unnecessary clauses were added which makes the agreement so toxic, it becomes very hard for VCs to do a follow-on investment. One might use the original SAFE agreement to compare and identify the added clauses.
The above provides just a quick glimpse of the various documents that you may find yourself fussing over in the midst of an investment agreement. Navigating through complex terms and clauses within these documents can often cause new entrepreneurs to worry and stress, especially when the company does not have the financial ability to hire a legal advisor.
If you are an entrepreneur having initial conversations with potential investors, it is crucial that you go armed with the knowledge of such fundraising skills. Invest the time and resources you will need to seek out the information you will need to protect your company, this will certainly pay off in the future through business transparency and greater clarity with your investors.
This is part of the Startup Advisory series. This article serves as an informational piece and does not constitute as legal advice. Readers should consult their own legal advice before entering into any agreements.