Chasing investment funding can be an exciting but daunting time for a start-up founder. Once you have delivered a great pitch and attracted the attention of investors, a Term Sheet could be the next step along the capital raising journey. However, it is important for founders and investors to understand those terms because they can have a major impact on the future of the business.
What is a Term Sheet?
A term sheet is a document that includes the important terms and conditions of a deal. This document shall serve as a template for the legal agreement to be drafted. The term sheet itself is non-binding.
Role of the Term Sheet
Even though a term sheet is not legally binding, it is still a very important document because it sets the terms of an investment deal.
The term sheet is usually used by the investor to signal his interest in investing in the company. Depending on the bargaining powers of both parties, the term sheet may be served in the form of a “subject to negotiation” basis or a “take-it-or-leave-it” basis.
The term sheet can be viewed as the skeletal structure that the final agreement (legally binding document) will be based on. Typically, the transaction documents required for a venture capital investment would comprise of a Shareholders’ Agreement and the Venture Capital Investment Model Agreements (“VIMA”).
Types of Term Sheets
There are two types of term sheets:
1. Short-form term sheet
Short-form term sheets are used if parties decide to postpone the discussion of specific terms, until the stage where the subscription agreement and shareholder’s agreement are being drafted.
Generally, the terms used in short-form term sheets are fairly “standard”, “typical” and “customary” in their meaning when read in the context of investment. Therefore, it is important that you are familiar with these terms and their meaning in market practice, or you may be faced with an issue where terms in the term sheet are being disputed.
2. Long-form term sheet
In contrast to short-form term sheets, long-form term sheets require a discussion between the founder and investors, on various key positions and their meaning. This process takes longer than short-form term sheets as both parties have to undergo discussion on various key provisions.
However, one key advantage to using long-form term sheets is that it minimises the risk of facing conflict at the stage where the final document is to be signed since these concepts and positions have already been discussed prior to the signing of the final document. Furthermore, the long-form term sheets imbue investors on concepts and provisions that they would otherwise be unfamiliar with.
Key terms that are used in negotiating the Term Sheet
Term sheets vary depending on who prepares them and according to the preferences and objectives of those involved. The following are examples of key terms that are used in a term sheet. They are not illustrative of the full extent of terms that are to be included in a term sheet.
- Pre-Money Valuation – this refers to the valuation of the start-up/company before the investment takes place.
- Use of proceeds – this term refers to the way the investment amount will be utilised. It can be spelt out explicitly or may refer to a business plan.
- Dividends – this refers to the returns that the investor gets in proportion to his shareholding in the company. This is unlikely to be the focus for investors in the early stages of the investment since most of the company’s cash flow would be channelled towards the development and expansion of the company. Dividends can be fixed or subject to the performance of the company.
- Liquidation preference – this refers to the rights of certain classes of shareholders to be paid ahead of ordinary shareholders in the event of liquidation.
- Conversion – this refers to the conversion of shares from preferential shares to ordinary shares.
- Anti-dilution – this refers to the shareholders’ right to protect their shareholdings from being diluted by virtue of the issuance of additional shares at a lower price than the conversion price of preference shares.
- Employee Share option plan – this refers to the allocation of shares to employees of a start-up to incentivise current and future employees. It can either form part of the pre-money capitalisation (included in the valuation of the start-up) or be deemed to be outstanding (not have the effect of diluting existing shareholdings).
- Voting rights and reserved matter – this refers to the voting rights that are ascribed to the preferential share and may accord more or limited rights to the holder of the preferential share.
- Liability basis – this refers to the requirement that the founder is personally liable for the obligations of the start-up and allows the investor to pursue actions against the founder, in the event that the start-up fails to meet its agreed obligations in the investment agreement.
- Pre-emptive rights – this refers to the right of the investor to subscribe for additional shares (pro rata) if the start-up intends to issue more shares.
- Drag along rights – this refers to the right specific shareholders have to compel other shareholders to sell their shares in the event of an acquisition.
Tips for Evaluating a Term Sheet
When it comes to evaluating term sheets, the priorities and objectives of investors and start-up founders may not always be in alignment, but it is important for both parties to look at the agreement from both perspectives. A term sheet that is unfairly biased towards one party could have serious future consequences. Balance in the agreement is important to ensure mutual success. The following tips provide some guidance for evaluating a term sheet:
- Review the valuation carefully and consider whether it is realistic, especially relative to currently prevailing terms in the market for comparable companies.
- Identify any particularly onerous terms that could create problems in the future or where compliance might be difficult.
- Evaluate what the balance of power and control in the business will be once the agreement is signed.
- Understand that a term sheet is not a guaranteed contract and that there are still steps required before the deal is done.
- Seek expert advice from lawyers, trusted advisors and experienced founders and investors.
- Do some research on the other party (investor or founder) to confirm their history and credentials and ensure you can work with them.
- Always ask questions and clarify any doubts you may have.
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: firstname.lastname@example.org.