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Investment agreement – part 1

Term sheet

The investment of a venture capital fund in a startup requires negotiation and signing of the investment agreement. The elements that obviously must appear in such a contract are the provisions specifying what share package the investor receives, and what value of the investment is declared in return. However, these conditions do not exhaust the list of contractual provisions. This list is much longer, and individual entries have to be determined and clarified. Therefore, the parties sign a so-called “term sheet” – a document that confirms their intention to conclude an investment agreement and defines the essential terms of this transaction. What is important – this document is not a contract or an offer within the meaning of the Civil Code, and therefore does not create any obligation for either party. Its function is to define the essential conditions for a future transaction, which will be elaborated and put in “legal language” in the investment contract.

It is worth emphasizing that not all entries included in the term sheet are non-binding for the parties. The parties declare in a binding manner the confidentiality at all stages of the project implementation, including the phase of negotiating the terms of the contract. Therefore, all information that the founder provides to the fund is protected from the very beginning of the talks and regardless of their final result. The second of the terms that is bindings for the parties may state that the founder will not take any action to obtain another investor for a defined period. In this way, the fund, when carrying out preliminary activities, which incur certain costs (eg legal consultations or performing external analyzes), has grounds to expect that those costs are not borne purposelessly towards the transaction, that will never actually take place.

The purpose of the other clauses of the term sheet can be understood, when we consider the specifics of a venture capital investment, that are significantly different from, for example, a bank loan. The bank lends funds to a company with a certain history of operations, and the repayment is secured, for example, with a mortgage, promissory note or collateral. Venture capital fund doesn’t lend money, but becomes a shareholder of the company, and usually a minority one, and the company has (almost) no history, and there is no collateral. In addition, the fund invests to a certain extent in the business idea, but mostly invests in the team. Deciding to invest, the vc fund believes that the team is competent and motivated. But on the other hand the fund also wants to maintain some control over how funds are spent and how the plans are implemented. Because the fund does not have any guarantees, is investing in a highly risky project at an early stage of development and the success of its investments directly depends on the increase in value of the company, it cannot stick strictly to “passive” investment approach. That is why in the investment contract, the fund tries to include mechanisms that give it the ability to control the implementation of the project, as well as appropriate rights, that can be used when the implementation is not in line with the plan. On the other hand, the investment agreement cannot paralyze the actions of the founding team, nor deprive them of the possibility to flexibly react to the dynamically changing environment. Obtaining this optimal mix of freedom of action and project control requires the creation of a complex investment agreement.

Writing a good contract is a major challenge. Hence, the parties first set their expectations in a business language of the term sheet, and then this document is translated into legal language in the form of an investment agreement.

In our next blog post you will soon find more information on what clauses appear in investment contracts.