In this fictitious scenario, London-based Ever Hopeful Limited, has two directors, Roger Branston (the chief executive officer, or CEO) and Donald Trumpton (the chief financial officer, or CFO). Each holds 40 percent of the existing share capital and angel investors hold the rest. The company has decided to take on 1 million pounds of funding from a venture capitalist to further develop its social-gaming platform.
Ever Hopeful has problems, though. A dispute is simmering with a rival software business that claims infringement of its software copyrights, and it's also the subject of an ongoing investigation by the Data Regulator for alleged mishandling of customers' personal data. It's hoping to keep these matters quiet in case they put investors off.
Ruthless Ventures, a renowned venture capitalist with a reputation for backing early-stage businesses, wants to invest and take a 40 percent stake in the equity of the company. This offer values the company at 2.5 million pounds post-funding.
Ruthless presents the two Ever Hopeful directors with a term sheet, which it says is in its standard form and always gets signed containing this wording. The term sheet says that Ruthless will take its shares "with the usual anti-dilution ratchets." Going forward, the directors' shares will be subject to "standard leaver provisions," as will the directors to "standard non-compete provisions."
In addition, the term sheet grants the venture capitalist an exclusivity period of four months following the date of the term sheet so that it has time to do its due diligence. The term sheet is subject to due diligence and "standard warranties."
Issues with the proposal
Did you spot issues with the proposal? Here are several:-
If the venture capitalist takes a 40 percent shareholding, it can block special resolutions that Ever Hopeful may want to pass, which gives the venture capitalist a lot of control.
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When the new shares have been issued to the venture capitalist, Roger and Donald are going to be diluted to below 50 percent ownership of the company overall, and so other shareholders can gang up and out-vote them.
They'll also be powerless to stop special resolutions being passed unless they combine their votes, because they'll each own only 24 percent of the new company. The reason for this: As a result of the new investor coming onboard with 40 percent of the overall shares, Roger and Donald between them now only own 80 percent of the remaining 60 percent of the shares, which comes to 24 percent each. You need more than 25 percent to block a special resolution.
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Four months of exclusivity for the venture capitalist is a long time — during that period, Ever Hopeful is kept out of the market and can't talk to other investors.
Has it got enough cash of its own to keep going without further investment for that period, and for any longer period that may be required if this deal doesn't get completed?
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"Anti-dilution ratchets" mean that on a subsequent investment round Roger and Donald will be further diluted by new investment, but not the venture capitalist.
This puts Ruthless in an even stronger position and may discourage other future investors from coming onboard.
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Roger and Donald need to be very careful about agreeing to "standard leaver provisions," which mean that if either of them leave the company they may have to sell their shares back at a price below market rate.
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The two directors also need to be careful about signing up to "standard warranties" because these have no cap on their potential liability if one of their warranty promises to Ruthless proves to be untrue.
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Given that the deal is subject to due diligence, Rog and Don need to disclose the issues in relation to the potential lawsuit for copyright infringement and the alleged mishandling of personal data.
They should disclose them in a disclosure letter. The two directors are only protected from a warranty claim in relation to these issues if they're disclosed upfront.
