This week in our series on key term sheet provisions, we’re taking a look at conditions precedent to financing. In order to understand conditions precedent to financing, you have to remember that the term sheet itself is non-binding. The conditions precedent to financing detail events that have to occur before the term sheet will become binding.
What Are Typical Conditions Precedent to Financing?
There is typically a clause that states the funding is conditioned on the investors completing due diligence, and being happy with what they find. This condition gives the investors the right to walk away from the deal even after the term sheet has been signed, if they find something out about the company that makes them no longer want to invest. Investors are able to negotiate for this right to walk away because they don’t want to invest in a company without first thoroughly investigating it, and they don’t want to pay to thoroughly investigate it until they know what the terms of the deal would be.
Another condition precedent is the completion of the necessary legal documents. Often the clause will require that the legal documents are completed to the satisfaction of the investors. Other common conditions precedent are the delivery of a detailed budget, and delviery of a management rights letter to investors.
What Should Founders Lookout For?
- No shop clauses: no shop clauses prevent founders from seeking alternative financing sources. The best leverage a company can have in negotiating with investors is that other investors are lined up ready to offer more favorable terms. Once a no shop agreement is effective, founders lose their leverage.
- Employment terms: details on employment agreements will sometimes be left to the conditions precedent section of the financing documents. For example a condition precedent may provide that employment agreements must be signed by the founders on terms that are acceptable to the investors. However, founders are much better off if they negotiate for their employment rights in the term sheet. Once founders have signed the term sheet they lose most of their bargaining power, since the conditions precedent tend to be investor friendly.
- Founders should be wary of conditions precedent that indicate the investors have not yet received approval from their organization. Ideally founders would only sign term sheets that have the approval of the investors’ organization.
- Legal fees: some conditions precedent require companies to pay the legal fees of the investors regardless of whether the deal closes. Founders should not agree to such terms, or else they may end up with no funding and an obligation to pay for their lawyers and the lawyers of the investors who did not invest in them.
Conditions precedent are part of every funding agreement, and are often overlooked. Founders should remember that the term sheet is non-binding and should pay close attention to the language detailing the conditions precedent.