Chasing investment funding can be a thrilling yet challenging experience for a start-up founder. You’ve delivered a compelling pitch and caught the eye of potential investors. Now, the next step in your capital-raising journey might be presenting a Term Sheet. It’s crucial for both founders and investors to grasp the terms within this document, as they can significantly shape the future of the business.
What is a Term Sheet?
A Term Sheet is a document that outlines the key terms and conditions of a potential deal. Think of it as a blueprint for the final legal agreement. While the Term Sheet itself is non-binding, it sets the stage for the formal, binding contract to be drafted later. Understanding its contents is essential to ensure that both parties are on the same page before moving forward.
Role of the Term Sheet
Even though a Term Sheet is not legally binding, it plays a crucial role in the investment process as it sets the foundational terms of the deal.
- Signaling Investor Interest: The Term Sheet is typically used by investors to express their intent to invest in the company. It indicates serious interest and commitment from the investor.
- Negotiation Basis: Depending on the bargaining power of both parties, the Term Sheet may be presented as either a “subject to negotiation” document or a “take-it-or-leave-it” offer. This flexibility allows for initial adjustments and discussions before finalizing the terms.
- Blueprint for Final Agreement: Think of the Term Sheet as the skeleton for the final, legally binding agreement. It provides a structure upon which the detailed legal documents will be built.
- Components of Final Transaction Documents: Typically, the transaction documents required for a venture capital investment include a Shareholders’ Agreement and the Venture Capital Investment Model Agreements (VIMA). The Term Sheet helps ensure that all critical points are addressed and agreed upon before these detailed documents are drafted.
Types of Term Sheets
Term sheets can be categorised into two main types based on their depth and level of detail:
1. Short-form term sheet
Short-form term sheets are utilised when parties agree to defer detailed discussions on specific terms until the drafting stage of the subscription agreement and shareholder’s agreement.
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- Standard Terms: Typically, short-form term sheets use terms that are considered “standard,” “typical,” or “customary” within the investment context. It is crucial to be familiar with these terms and their industry meaning to avoid potential disputes during negotiations.
2. Long-form term sheet
Key terms that are used in negotiating the Term Sheet
Term sheets serve as preliminary agreements outlining key terms before finalising a binding contract. While they can vary based on the parties involved and their specific goals, here are essential terms commonly negotiated:
- Valuation: The pre-money valuation of the company and how much the investor will pay for a stake.
- Investment Amount: The total amount of investment and how it will be disbursed (e.g., in tranches).
- Ownership Stake: The percentage of equity the investor will receive in exchange for their investment.
- Dividends: Whether and how dividends will be distributed to shareholders.
- Liquidation Preference: Priority for repayment in case of liquidation or exit.
- Anti-Dilution Provisions: Protections for investors in case of future rounds of funding at lower valuations.
- Voting Rights: Rights related to decision-making and governance.
- Board of Directors: Composition and rights of board seats.
- Founder Vesting: Conditions under which founders’ shares vest over time.
- Exit Strategy: Terms related to how and when investors can expect to realise their investment (e.g., through IPO or acquisition).
- Governance: Rights and responsibilities regarding major business decisions.
- Confidentiality and Non-Compete: Obligations regarding confidentiality and restrictions on competing activities.
- Due Diligence: Process and timeline for conducting due diligence on the company.
- Conditions Precedent: Conditions that must be met before the investment is finalised.
- Governing Law and Dispute Resolution: Jurisdiction and method for resolving disputes.
These terms are foundational and can significantly impact the rights, obligations, and future trajectory of both the investor and the company. It’s essential for both parties to thoroughly negotiate and understand each term to ensure alignment and mitigate potential conflicts in the future.
Tips for Evaluating a Term Sheet
When evaluating term sheets, investors and start-up founders may not always align in their priorities and objectives. However, both parties must consider the agreement from each perspective to ensure fairness and mutual success. Here are key tips for evaluating a term sheet:
- Carefully review the valuation and assess its realism relative to current market terms for comparable companies.
- Identify any overly burdensome terms that could pose future challenges or compliance issues.
- Evaluate the balance of power and control within the business post-agreement.
- Understand that a term sheet is not a binding contract and that further steps are required before finalizing the deal.
- Seek expert advice from lawyers, trusted advisors, and experienced founders or investors.
- Conduct research on the other party (investor or founder) to verify their history, credentials, and compatibility for collaboration.
- Always ask questions and clarify any uncertainties you may have before proceeding.
Taking these proactive steps will help ensure that the term sheet negotiation process is thorough and beneficial for both parties involved.
Please note that this article does not constitute express or implied legal advice, whether in whole or in part. If you require legal advice, please contact us at: info@silvesterlegal.com.
