This is the first part of a series of articles on SME Business. In this article, we will discuss some of the key terms that you need to know when negotiating a funding deal for your SME business. If your SME business is in expansion mode and your revenues and/or profits are growing and you need funding to continue your business expansion plans, this article will help you as you negotiate the first part of your funding deal which is term sheet negotiations.
THE STEPS OF A FUNDING DEAL
Term Sheet Stage
- Negotiate a term sheet and sign it with the investor;
Legal Documentation Stage
- Investor does legal/financial/operational due diligence on your company;
- Negotiate and finalise a subscription agreement/shareholders agreement with your investor and arrange for signing;
- Completion of the transaction: Investor pays the money into your Company’s bank account
In relation to the Term Sheet Stage, some of the SME Business owners think that they can skip this step and we note from our experience that business owners that do not negotiate a term sheet usually find it difficult to close a funding transaction (at the legal documentation stage) as their expectations and that of their investors are far apart. If you skip this stage, you may find that your company may incur more legal cost later at the Legal Documentation Stage of the transaction.
MORE ON FUNDING TERM SHEETS
What is a term sheet?
A term sheet works like a memorandum of understanding which aims to crystalise the key commercial terms between the parties before they enter into long form legal documentation. A smart business owner will spend a lot of time negotiating the term sheet to get the best terms and hold the investor to this. This is an important point in deal negotiation and we cannot emphasise this enough.
Why enter into a term sheet between the investee company and the investor?
For the investee company, the owners/shareholders and the investee company want to know the key terms of the investment to decide if they want to spend a few months negotiating and closing this funding deal and doing business with the investor.
When to sign a term sheet between the investee company and the investor?
Once the key commercial terms are agreed, the parties should sign the term sheet as soon as possible. One exception to this is if there are multiple investors pursuing the investee company, then make sure you get a lawyer to vet your term sheets to ensure there is no exclusivity clause binding on the investee company.
Key Terms to negotiate for a funding term sheet from a business owner’s perspective
- Debt or equity or hybrid
Funding can come in many forms as set out below:
Loan – This is the most easily understood. You negotiate a principal amount and interest rate and repayment period with the investor.
Equity- Investors can invest via direct equity subscription, this means that once the investor holds shares, he takes the same commercial risk as the other shareholders for the rise and the fall of the business.
Convertible loans – These are used when the investor assesses that you business is either risky or in between a priced funding round (usually because the investee company and the investor are unable at the current point in time to agree on a valuation for the business but both view that the business is growing and will be worth more in the future so they will wait for a future investor to value the business at a higher priced funding round).
Warrants – Usually a growth private equity firm will invest via a pair of convertible loans and warrants so that it has downside protection from the convertible loan investment and warrants allow it to participate in the upside growth of the firm.
- If equity, what is the valuation of your company and how many percent will the investor get after the transaction
If the investment is an equity investment (i.e. investor gets shares in your company after the funding round), then you need to figure out how to value your company. Note: There is usually a range for valuation for companies so I would suggest you find a friend who is either an investment banker or accountant to help you along to figure what is fair.
Usually the investee company wants the best valuation and the investor wants the worse valuation so the true agreed valuation will be somewhere in between.
A high valuation is a double edged sword. If you have a high valuation and the investor agrees to this, usually the investor may negotiate to adjust his shareholding if the investee company does not hit its target revenue target under an agreed formula. You can study OSIM’s case when they invested into TWG where OSIM raised its stake in TWG Tea to 70% from 53.7%. This area of M&A negotiation is very specialised and we recommend that you get a good corporate lawyer that understands valuation and corporate finance to help you in negotiations so you can plan for both the upside and downside of your business.
- How much funding to be raised and what is the payment schedule for the investor
You would probably need to work with your chief financial officer or finance manager to project cash flow requirements. Then spend some time studying how the investor intends to invest over time. Some investors may assess that they want to invest in 2 to 3 tranches. This means that they can invest the first third and withhold the second and third tranche later if he finds something wrong or not to his liking. Spend time studying this in detail.
- What other important things to note
Some investors may also include conversion formulas into the subscription agreement. This is another complex area of M&A. If you are up against a growth private equity firm, you will need to get an accountant to model the impact of the formulas in a base case, good and bad scenario to see what is the upside and downside of the deal. Many investee company owners usually are just happy to get funding but do not assess their upside and downside risk. The private equity firm is in the business of investing so they will run their own internal risk assessment matrix and price the upside and downside into their conversion formula. There is no reason why you should not figure that part our yourself.
- Exclusivity Period
Most investors (usually the larger ones) will ask for an exclusivity period so that they can focus on closing the funding deal with you. If your investee company has many potential suitors then you would want to hold off signing off on a term sheet with such a clause unless you are serious to turn all other suitors away.
In conclusion, negotiating term sheets is actually a complex matter as you are basically negotiating on the key commercial terms that will be going into your legal documentation for your funding round. Getting external funding from an investor is usually the start of an exciting journey but like marriage choose your investor well. We would suggest that getting good corporate legal counsel early in your funding journey is of paramount importance. A good corporate lawyer will be able to point out the commercial and legal pitfalls of your transaction structure early in your deal which may help you avoid major grief later.
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Click here to speak to a specialist Corporate Law Practitioner today to advise you on your corporate transaction today. The corporate law team has acted for a diversified client base including transactions involving several hundred startups across the startup eco-system in Singapore and for private equity fund deals and is well placed to help you in your corporate transactions.
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