???????? Hi friends!

I’m back in London and the sun has been shining which makes coming home from a month in Tuscany a tad easier.

It’s good to be home though and I’m excited for what’s to come in Q4, not least introducing you to some amazing pod guests that we’ve got lined up ????

3 questions I’m answering in this weeks Off Balance:

???? What bad faith actors can harm the ecosystem?
???? How can M&A help founders when times are tough?
???? What are some of the most common economic terms in a term sheet?

I’ve also got some important news about the future of Off Balance and Nothing Ventured ????

Join my free webinar today with SeedLegals:
I’m looking forward to talking to Anthony Rose, CEO of SeedLegals at 2pm BST today about everything CFO related! If you’d like to understand more about the who, what, when and why of getting a CFO involved in your business, sign up here ????????

Also if you have any feedback or if there’s something you’re desperate to see me include, just reply to this mail or ping me online – I’m very open to conversations.

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Now let’s get into it.

Do your research

I remain quite speechless when I see people cropping up on social media with hot takes that really do little more than highlight their own lack of understanding.

There was a recent example of this which I called out in this post on LinkedIn which, to my surprise, got a fair amount of attention.

Essentially someone appeared on Michael Jackson – a pretty well known VC’s – timeline and told him he couldn’t do maths because he had supposedly miscalculated fees based on a standard 2 and 20 structure.

As I have talked about in a previous post, this refers to the fact that VCs take 2% as a management fee and 20% as carried interest (a success fee) once the fund is returned.

I won’t rehash the maths, but the key point was that the 2% is (and this can also vary) taken every year across the life of the fund (or the investment period or higher upfront and then tapering down etc.) which means that a $100m fund generates 2% x 10 x $100m = $20m assuming a 10 year life.

Cue a lot of people (including founders) telling Michael he had screwed up the maths and were essentially doing the equivalent of Nelson from The Simpsons.

Given the amount of information that is out there, it is disappointing to see people coming out with uninformed positions. It doesn’t do the ecosystem any good to have these sorts of bad faith actors in it.

Why, you might ask, am I defending a VC – surely they have a tonne of power already?

Well the truth is I am not defending the VC, I am asking all of us to do better.

The sort of people that came on his timeline and gloated over a supposed error which in reality only showcased their own ignorance, are also more likely the ones to be out there complaining that they were not able to raise any money either.

This is a tough market to be operating in, you have to know everything that may be conceivably of value for you to know. And that includes how different funders operate and are incentivised.

It will only help you get to where you’re trying to go quicker.

And, if in doubt, this newsletter is probably the quickest route to bringing yourself up to speed ????

How can did I add value?

We’re getting to the pointy end of the market right now.

I’ve got a lot of folk in various channels looking at how they can stay default alive.

But sadly for a few this is just not feasible.

And on occasion, as hard a bullet as it might be to bite, it may be time to look for an acquirer.

I’ve had a couple of digital conversations with people recently trying to help them navigate how to think about Mergers and Acquisitions (M&A) when you’re not doing the M&Aing.

Now you might ask me what qualifies me to do this, and I’m definitely no specialist.

But over the course of my time in PNG and here in the UK, I’ve been involved in sourcing, analysing, negotiating and executing deals of various sizes, complexities and outcomes.

And not always from a position of strength.

So, if you have found yourself approaching the end of your runway with no real prospect of raising capital and want the best chance of securing a decent outcome for the business, here are some of the things I would think about.

Get to EBITDA +ve as quickly as you can. If you want (decent) value paid for your business then it needs to be, or close to, generating surpluses. Not only that, but it gives you breathing room.

Your shareholders may prefer no sale. If you have S/EIS investors, they may prefer for the company to wind up so they can get their tax reliefs.

Build out an adjusted income statement. You need to present the business in a way that is attractive to a potential buyer. Re-present your financials for the last 12 months stripping out any one offs or extraordinary items (e.g. redundancy costs) and show them as separate line items after your net profit.

Get a data room ready. Much like a financing round, you will want to have all your documents in order. A buyer isn’t going to want to have to deal with messy cap tables and missing documents. Make sure everything is in place.

Have more than one option. It is always better to have more than one offer on the table. Not only does that give you a range, it allows you to hopefully leverage one offer against the other. But you have to be careful not to annoy either potential acquirer such that they walk away altogether.

Point to your processes. If your startup relies on you to get things done, then it’s less valuable than if you have a bunch of processes mapped out and, preferably, automated.

Acquire or Acquihire. A straight acquisition likely means the business is being bought, an acquihire means someone things your team if the most valuable asset of the business and are buying on that basis. When you’re assessing potential acquirers, make sure you understand what they’re likely to be trying to buy.

Avoid a firesale. This is obvious but a difficult line to tread when you know that the business is out of runway (hence the drive to get to EBITDA +ve a.s.a.p.). But if a potential acquirer smells blood in the water, they will exploit it to extract the best possible outcome for themselves (aka a minimal price). The closer you get to cash out, the more likely you are going to have to sell your business for parts.

Whenever I have these conversations with a founder, my first piece of advice is for them to hire a professional, potentially a broker and certainly a lawyer.

It’s a complex process, with lots of steps and tonnes of moving parts – there’s a whole post about how to even go about identifying potential buyers.

As times remain tough, we are going to see a spate of M&A happening in the ecosystem.

If you’re a founder finding yourself in this situation, I’m rooting for you and if you ever want to bounce anything off of me, just reach out. ????????

Off Balance

Last week we took a deep dive into Valuations, and there is a tonne more I could have written about there. But this week I’ll be taking a look at that most fabled of startup documents – the Term Sheet.

I’ve had to cut myself a little short as there are really two elements to a term sheet that are critical to understand.

Economics and Control. The former deals with the numbers, whilst the latter deals with how the company is run.

One of the reasons we tackled valuations in the previous newsletter was because it’s a critical part of the question of economics.

But all to often founders get fixated on this and this alone.

Founders then get surprised when they are suddenly ousted as CEO or don’t have sufficient voting rights when they need to get things past the board.

And this is why it’s critical to split them out.

So let’s get into the first half of this complicated topic: Term Sheets – Economics.

And you’ll have ‘Term Sheets – Control’ to look forward to learning about soon!

Term Sheets – Economics

You may hear a founders say they’ve received a couple of term sheets and wondered what they were on about.

Equally you may have heard an investor talk about how they have sent a term sheet to a founder and wondered what might be in it.

Whilst there is no ‘standard’ format to a term sheet and two term sheets may even look wildly different from two investors wanting to invest in the same startup, there are some common terms that may be included and some common pitfalls that are worth looking out for lest they catch you out.

With that said, let’s get started with some of the basics.

What is a term sheet anyway?
A term sheet is a non binding statement of the general terms surrounding an investor’s intent to invest in a startup.

Key to this is the fact that it is non binding, i.e. signing a term sheet doesn’t mean that an investor is definitely going to invest, but it’s unlikely an investor would issue one if they didn’t intend to.

Sadly, an investor may pull for a number of reasons:

They don’t actually have the cash to invest (happens more often than you’d think).

Partner that was driving the deal leaves.

Something negative is uncovered during due diligence.

Terms materially change.

Market shifts.

Founder can’t close the rest of the round.

But with a term sheet in hand, this is generally a good sign that things are moving forward in the right direction.

What’s going on when an investor issues a term sheet?
When a term sheet is issued to a startup, it normally starts the clock ticking on a potential investment.

The process is (generally):

Term Sheet >> Due Diligence >> Final terms negotiated and issued >> Share purchase agreement signed >> Monies wired >> Shares issued

Given that lots of things may be uncovered during the due diligence (for example, user numbers may be lower than expected or cash required may be more than anticipated), it is always worth understanding that the final investment may end up on quite different terms than those first set out in the term sheet.

Sometimes people play games on both sides of the table.

Why might an investor issue a term sheet?

An investor may issue a term sheet which they use to lock a startup into an exclusive period (i.e. stopping you from approaching other investors) whilst they do their DD.

There are legitimate reasons to do this, mainly that DD costs time and money. they don’t want to have gone through the pain of DD only to find they’ve been gazumped by another investor.

But there are also slightly less reasonable reasons.

Like they are running down the clock on your round whilst they talk to competitors, or are looking to get intel on the sector and your business because they’ve got ulterior motivations.

This is why it’s critical as a founder to do your own diligence on the investor and their firm.

Check that they do indeed invest in your space, haven’t invested in other startups that may be considered competitive and, if you can, speak to other founders whose startups they have invested in.

Why might a founder issue a term sheet?

Founders sometimes use them to create FOMO.

If an investor is aware that there are other funds keen to invest, it may motivate them to commit earlier, or write a bigger cheque on better terms.

But remember these tactics can fail on either side, and given how much reputation matters in the ecosystem, playing these sorts of games only ends up backfiring in the long run.

Economics vs Control

The terms in a term sheet can be divided into two camps – Economics and Control.

Remember:

Economics = numbers

Control = how the company is run

Many founders focus on the economics and regret it.

But you should absolutely ensure that the economics are acceptable – so that’s where we’re going to focus today.

Key Economic Terms

As I mentioned earlier, there is no such thing as a standard term sheet, however there are some terms that will definitely be included and, others which you’ll want to understand and be aware of.

Firstly, the amount to be invested – this should be a straight forward number stipulating the amount and currency.

Obviously this is the amount that the investor is committing to though they may make reference to the size of the full round.

Second comes the date at which the investment will be made.

This helps give clarity on time lines, obviously if an investor commits to a date 6 months in the future, you may well decline the term sheet.

Next comes valuation.

We covered how a company might be valued in some detail last week, however the term sheet won’t go into any detail on this so you’ll never know how it was derived (unless you ask!)

Instead you’ll get a straight number, but be aware, some will stipulate pre money, others post money and some may not stipulate at all – you have to pay attention and ensure you’re not caught out by these sorts of things.

Sometimes the term sheet won’t include a valuation because the investment is being made under a SAFE or other convertible instrument – be clear if this is the case, there are other terms that come into play here like valuation cap, collar, floor and discount – we’re not going to get into the details here, but I’ll cover them in the future.

Up next we have share class.

Ordinary shares are typically the same class as founders and most early investors.

But VCs (especially in a market like today’s) may ask for preference shares.

With preference shares comes a liquidation preference.

This may be structured as 1x, 2x or Nx where N is the number of times their investment is to be returned IN THE FIRST INSTANCE before other investors are paid out in the event of a sale – this is downside protection.

It will be participating or non participating.

If participating, after having taken the liquidation preference, they are still entitled to further value alongside other investors pro rata to their shareholding.

Think REALLY HARD about what this means to you as a founder.

Quick example:

It is likely that investors will ensure they have pro-rata rights in future rounds, pre-emption rights in case of sale of shares and insolvency and if they feel like really going for it, they may include anti-dilution language (watch out for this one in particular, it’ll mean investors ownership % is protected even if they don’t invest in a future round).

It is likely that VCs will ensure that Tag Along and Drag Along terms are included.

This means that in the event of a shareholder selling their shares, all other shareholders may also sell theirs, or if the VC decides to sell theirs, they can force other shareholders to sell.

This ensures that minority shareholders can’t create circumstances where they can hold up a critical action or outcome that would be in the interests of ‘most’ of the shareholding body.

It would also be quite normal in an institutional round for a VC to ask for an option pool to be carved out of the pre-money capitalisation.

This has the impact of diluting existing shareholders further whilst protecting themselves.

Let’s run through an example:

At incorporation, the founders of FakeCo Ltd (they sell Glucci bags naturally), each own 5 shares of $1 nominal value each.

In preparation for a fundraise, they’re advised to do a subdivision (also called a share split) and their cap table now looks like this:

Note how they still both own 50%, even though they own a lot more shares each now?

At Pre-Seed, they take on some angel investors and their cap table grows to look like this:

Remember that when you’re financing a startup, you don’t sell existing shares, you create new shares and sell those. If you sell existing shares, that would be what we call a secondary financing round and the cash would flow to the existing shareholder not the business.

All pretty simple right?

Well hold your guns cowgirls and cowboys, we’re about to change things up…

At the next round, a VC comes in and says that they’re willing to invest x dollars for 7.41% ownership of the company. Here’s what that would look like ordinarily.

But this VC knows how important it is to incentivise the team in a growing startup and wants to ensure there is an option pool carved out for them.

They say they’d like this to be 10% of the ownership.

But the key is that they’d like it to be 10% of the ownership before they come into the round.

This has the effect of diluting the existing shareholders (founders and angels) whilst the VC manages to retain its 7.41% ownership.

Below you can see the impact of the creation of the 10% option pool if it were to happen before the VC came in, vs directly after them having invested.

Moral of the story?

Every term on a term sheet is there for a reason, make sure you understand why and how it’s going to impact your business.

So there you go, a proper dive into some of the most common economic terms you’ll find in a term sheet.

I know that was a lot to get through so maybe kick back and grab yourself a cold one whilst you digest it all 🙂

Next week, I promise we’ll cover off the other side of Term Sheets when we take a look at everything related to Control.

Hopefully by the end you’ll be well ahead of most folk and prepared to get out there and negotiate your term sheet like a pro ????????

Important Announcement

Don’t adjust your screens guys, but those of you who’ve been following for the last couple of months will know I’d normally be hitting you with The Lowdown right about now.

But in a change to our regular programming, I’ll now be dropping that on Fridays.

On top of that, the entire newsletter will be fully rebranded as Off Balance.

All things podcast related will remain under the Nothing Ventured brand which will go out on LinkedIn, YouTube, Apple and Spotify.

But don’t worry, I’ll still be linking to the pods so you can be sure you’ll never miss a single episode ????

????And that’s a wrap for this edition of Off Balance – I’d appreciate your feedback so just reply to this email if you’ve got something you’d like to say.

???? And if you think someone else might love this, please forward it on to them,

???? Finally, if you’re a fan of the Nothing Ventured podcast, please don’t forget to like, rate and subscribe wherever you get your pods – it really helps us spread the word.

That’s it from me so until next time…

Stay liquid 🙂

Aarish