What exactly are term sheets? Here's a step-by-step guide

By Payaswini Upadhyay

Online blog site Tumblr went from a startup in 2007 to a billion dollar valuation in 2013. The yet-to-turna- profit company is estimated to have earned $13 million last year-why thendid Yahoo! value it so high? Bet you want the same for your startup.

There are a few common valuation methods that most investors use- Discounted Cash Flow (DCF), asset valuation and market comparables.

DCF entails estimating future revenues and profits and arriving at a discounted present value of those profits.

Asset valuation involves estimating the cost of recreating the startup. The valuation arrived at by this method also takes into account current revenues, customer contracts if any and market comparables. As the name suggests, it is comparing your company with the valuation of similar businesses. PwC’s Neeraj Garg says that often a combination of these methods is used when it comes to valuing a startup.

“We do detailed analysis of the business plan in terms of what the company proposes to do. Sometimes, we try the top-down approach…in the sense that this is the market which the company proposes to address…this is the kind of market share the company can get after’n’ number of years, and this is the kind of profitability that it can generate,” says Garg.

“We try to do some sort of benchmark analysis with the company’s business plan vis–vis the information that is available in the public domain. But given the fact that there is always a cash flow projection bias in terms of DCF projections, we always try to look at some sortof guideline transactions.”

Qualitative factors
Besides the quantitative aspects, factors like quality of management, scalability ofbusiness, the underlying business itself, control versus minority interest also get captured in the valuation. “At the end of the day, valuation is an art. Recently, Warburg Pincus agreed to invest Rs 3,500 crore into Delonex started by Rahul Dhir, erstwhile CEO of Cairn India. I think this was because of his experience in Cairn India and that he understandsthe oil exploration industry despite the fact that this company does not have a track record. These become qualitative factors and get considered for estimation of discount rate when we really work out the cash flow computations.”

The valuation is manifested in the price of the security sold by the startup. This security could be ordinary equity shares, preference shares, warrants or convertible debt instruments. The question it raises is if there is a first among equals here? Darshika Kothari, Partner at AZB says that it depends on the objectives sought to be achieved by the investor as well as the entrepreneur.

“It is fairly safe to assume that any investor will want equity shares because that’s what is going to give him the voting rights. Often investors and entrepreneurs may also offer or choose to invest in either mandatorily convertible preference shares, convertible debentures, optionally convertible debentures or preference shares. This could be toachieve certain objectives which could be in the nature of say a mismatch of valuations,” she says.

Kothari explains with an example. “Suppose the perception of the investor is that the valuation of the company or the enterprise value should be 100 and the promoter’s perception is that it should be a 120. Now if it turns out at a certain point in time that the investor’s valuation was indeed right and the investor made the investment based on the valuation that was proposed by the promoter, then the investor should get a larger number of shares. How is that really achievable? That is achievable when you have convertible instruments and these convertible instruments have a formula that sets out the parametersbased on which you can either get a higher or a lower number of shares,” she says.

[caption id=“attachment_77294” align=“alignleft” width=“380”] Neeraj Garg, PwC and Darshika Kothari, partner, AZB. Image: Entrepreneur India[/caption]

Be careful
“I think like most entrepreneurs I was focused completely on valuation. I did not understand if anything else in the term sheet really mattered. As I am older and wiser now, I tell entrepreneurs that valuation in the isolation of the nature of the security-specifically what is the liquidation preference on the securities- is not relevant,” says Avnish Bajaj,an entrepreneur turned venture capitalist, cautioning startup-pers.

Bajaj gives an example. “Say an entrepreneur has raised Rs 20 crore and has given away 40 percent of his company and then another venture capital (VC) gives him Rs 20 crore and asks for 50 percent of his company. Let’s say the first VC wants a Participating Preferred Stock, which means they get their money back and a return on top of that and the second one gives a straight deal, which is just their ownership,” he says.

“If the company sells for Rs 100 crore, believe it or not, the guy who gave the first better valuation is the guy who will make more money and the entrepreneur will make less money. So, they will first get their money back and then participate in the proceeds out of that.”

And that is because participating preferred stock gives the investor the right to claim profit in case the company is sold; against this is a common stock holder who is lower in hierarchy both in good times and bad. When the company distributes dividends, preferred stock holders have the first claim and when the company liquidates, the preferred stock holders are paid out first.

Investor rights
Valuation is one tough negotiation but not the only one! Your investor is going to want several rights as protection before he signs that cheque. The first among those is right to information, which includes right to inspect the books of accounts and opportunity to visitthe companies facilities. Ideally, these should fall away if the VC’s shareholding falls below a certain predetermined threshold. More importantly, your VC will insist on what are called Reps and Warranties meaning a statement of facts on the company underwritten by you,the entrepreneur.

Kothari says to address this concern Investor objectives: Darshika Kothari what promoters can consider doing is to disclose as much as they can to the incoming investor. “If you have disclosed all the good and bad things-may be you don’t have a license, may be you havebreached a material lease, you don’t have an environmental consent-you can say I am not going to indemnify you for what I have already disclosed to you.”

All money comes with strings attached. Your investor may want board representation too, the right to approve important business decisions such as a big expansion plan or even a small one and the right to veto them as well. Affirmative and negative rights are often also referred to as minority protection rights.

Right to veto
Bajaj says a VC looks for two things. “One, minority protection of the economic interest. So if you go and do a dilutive round of fund raising, the company shouldn’t be able to change my rights without my approval. There are a bunch of rights around governance and operations of the company. So my view on minority protection rights is it is not even worth debating and negotiating over. It is a nonstarter on negotiation; the VC will wonder what the intent of the entrepreneur is.”

But that doesn’t mean an entrepreneur’s hands are completely tied says Bajaj. “What I put in generally is that I will have a veto right over the annual operating budget of the company. But once I have agreed on it, if there is CAPEX, debt in the operating budget, the entrepreneur has to come back to me for everything. What I put in is that even if there are material deviations, you have to come to me only,” he says.

“So what I would advise entrepreneurs to do is, if somebody says CAPEX, I would say any CAPEX outside of operating budget above Rs x lakh. So that way you are getting enough operating freedom as an entrepreneur; yet the VC is getting enough protection.”

There is also the Right of First Refusal or ROFR. A ROFR binds the entrepreneur to offer his shares to the investor first before offering them to a new shareholder.

Bajaj says that the right compromise on these is the Right of First Offer. “What we tell the entrepreneur is we will let you first take our shares and inform you that we want to sell. You make us a fair offer. If we like the offer, go ahead and buy our shares and typicallythen there is a safeguard that I cannot sell to somebody else at a price lower than what you had offered.”

Your investor would also want to protect his investment by putting in a Liquidation Preference clause. This clause specifies which investors get paid first and how much if the company is sold.

The VC may try to over-optimize by putting in a liquidation preference where they will first get either their capital back or some multiple of their capital back and then participate in the proceeds. Such onerous instruments are called Participating Preferred Stock.

The middle path, says Bajaj, lies in straight preferred. If the company is being sold below the capital invested or close to the capital invested, the VCs should get their money back. If it is being sold at a high enough price, then the VCs should be able to participate asa common stock holder…they shouldn’t get both."

Drag, tag, call, put.
If the VC decides to sell his interest in your company, he can drag you to do the same. The investor may also ask for a Tag if you decide to sell your stake. A Call option gives you the right to purchase your investor stake. A Put gives him the right to make you buy it.“The founder seeking to sell-I think what the investor will want is to piggyback or tag along and sell a certain stake.I think where there is room for negotiation is that should the investor tag along for its entire investment or should the investor tag along for a pro-rated portion of his investment.”

“So, if the promoter is selling 10 percent of his stake in the company, shouldn’t it be a fairer proposition or probably the entrepreneur can argue that yes, the investor has a tag along right but only for an equivalent proportion or he can also sell 10 percent of hisinvestment,” adds Kothari.

Payaswini Upadhyay is Correspondent, CNBC-TV18

This article first appeared in Entrepreneur India magazine.