Term Sheet Overview: Guide to Understanding and Negotiating Term Sheets
Last Updated: 1/5/2022
Term Sheet Overview: What it is and when it is used
As business owners, many of us will have to raise some degree of equity investment. While raising capital, we will have to keep track of the upside risks, as well as keep control over downside risks and try to limit them.
A standard term sheet is mainly designed to document and define the division of upside and downside risks between parties. A term sheet is also a means of assessing investors as well.
The terms set down in a term sheet are the parameters of your financing and you get an idea about what are pressure points for your investors and determine their focus.
The soft skills elements aside, a term sheet will document all terms and conditions of a deal between two or more parties to a transaction. It is a brief of the entire deal and should be a reference point to understand the transaction for an outsider. A term sheet sums up the entire contract’s key points and is usually used to negotiate the finer details of a contract before the legal contracts are made and signed. For instance, if the investment requires payment over some time, the span would be mentioned, what will happen in case of delays would be mentioned (if it is relevant).
A term sheet is negotiated and is meant to safeguard the interests of all parties to a transaction. Both parties must sign it, which indicates consent to the terms specified in the term sheet. The details of the business transaction should be listed in it and ideally in such a manner that there is no ambiguity about anything stated in the term sheet.
The term sheet works as a non-binding document that lists the major terms and conditions of any financial transaction in a business. It works as a base document for the more comprehensive and legally binding documents. When all the parties to the transaction agree to the details specified in the term sheet, a legal agreement or contract that builds upon the terms specified in the term sheet is drawn up. A company’s valuation, capital amount, percentage rate, decision making rights, liquidation levels, non-dissolution provisions, and investor commitment are a few common things that have to be specified in a term sheet.
A term sheet works as an initial framework defining the transaction to come and specifies the major decision points for both investor and business owner. This serves to build a structure of the deal and helps to finalize decision points before the more expensive and legally binding documentation is initiated.
Most Common Clauses
Since term sheets are used in most financing agreements associated with businesses, regardless of the business being established and or a new venture, there is a wide range of clauses and terms that can be placed in a term sheet. Review this sample term sheet by YCombinator to see all standard clauses.
Common clauses that a term sheet would contain are details about the common shares and shares that will be affected by the deal under negotiation.
Most companies issue more shares under financing agreements. This means that there will be clauses about the new shares in the term sheet. For instance, a new “B” category share will be issued and will have higher dividend payouts and fewer voting rights than “A” category shares (the original company shares).
Most term sheets that are used for venture capital transactions would carry a table with share details and profit payments — this is known as a
Capitalization Table
This table gives an overview of the capitalization of the company. It is important to have this documented in a term sheet, particularly if the transaction is going to affect or change the capitalization structure of the business. The capitalization table is a key document for a company, as it details the equity breakup of the company. This table lists the rights and values for all classes of shares and security. It is also designed to report the value for each category of shares and securities.
A good capitalization table should report forms of company ownerships like its convertible securities, employee stock options, dividend warrants, common and preferred stock.
Like most specialized areas of business, the term sheet has some specific terms which apply to certain situations.
Valuation
Some basic terms related to valuation are:
Pre-Money Valuation — Value of the business or its shares before the transaction.
Post-Money Valuation — Valuation of the business or its shares after the transaction
Price per Share — This is a value usually calculated by taking the post-money valuation and dividing it by the new number of shares.
Security types
Many transactions use different forms of securities for investment purposes. These are usually listed in the capitalization table in detail. It is normal for share-related term sheets to list information about the common stocks, preferred stock, and stock options of the business.
A term sheet for a merger or acquisition would usually have details about the initial purchase rate offered, the preferred payment methods, and it would list all the assets that are part of the merger or acquisition transaction. The term sheet of such a deal will also detail what assets, stocks are not a part of the transaction or any items that are seen as key requirements by any party that signs off on the term sheet.
Most Common Mistakes in Term Sheet
Some basic problems to avoid in term sheets are as follows:
The impact of share preferences on common shareholders
Many business owners make the mistake of assuming that if they sell a 20 percent share of their business to a new partner, the partner will just be entitled to 20 percent of the business once when the company is sold.
This may be true if all the shares fall in the common shares category. If the investor gets preferred shares, (which is what usually happens), the profit distribution becomes more complicated. Preferred shares entitle the new partner to gets their returns before common shareholders.
Other deal sweeteners for bridging valuation gaps
When an investor feels that the value of your business is high, but is still interested in making a deal, it tries to mitigate risks. This risk mitigation is usually done by adding some clauses into the term sheet to protect them from lower value transaction ends.
Common clauses used for this purpose are conditions for cumulative dividends, or double-dip preferred shares. Some investors may ask for protective and restrictive provisions that would increase their control over the business’s working. These clauses can impact the owner’s capability to manage the business and can be a deal-breaker if the owner feels strongly about it. the next point is related to these.
Losing the balance of power through the protective provision
At times new investors can ask for the right to place their chosen representatives on the board of directors. Most companies that are adding on new investors are run by their founders and find it difficult to manage their leadership team being held answerable to a board of directors that have been nominated by outsiders. Most management team members find it hard to adapt to more stringent board control.
When such protective clauses are implemented, they can offer the new partners a right to approve members to the board, or a final say on all decisions. This can cover share issuances, future borrowing decisions by the company, and the appointments and placements of senior positions in the business.
Prolonged due diligence periods
Term sheets are usually signed before the investor starts its comprehensive due diligence. It is common for term sheets to have exclusivity provisions. This means that the company agrees not to approach other investors or purchasers for some time. This is meant to allow the investor to complete their assessment and evaluation process. This is known as its due diligence.
A standard time for due diligence is anywhere between 30 to 45 days. Investors at times request for 60, 90, or 120 days. Long periods are usually requested to allow the investor to gauge the company’s performance over some time before finalizing their commitment. This can serve to limit the business’s investment or expansion process since they are bound to wait.
Investor is not contributing
If an investor has committed to bringing in resources or contacts, or to help increase funding, or help the business in any form there should be quantifiable measures. If the investor fails to deliver on the commitment, it can be a permanent reason for conflict. If you have such a commitment on the term sheet, make sure that the terms are clear, measurable, and time-bound. In addition, make sure to do your due diligence about the investor’s capability to fulfill the committed value addition before you sign off on the term sheet.
How to Negotiate a Term Sheet
Commonly Asked Term Sheet Questions
Below are a few questions you have to ask when considering any term sheets for any form of transaction:
Do both parties have sufficient capital to support 6 months delay in the business plan?
An affirmative answer will mean that both parties are not financially desperate and will be able to sustain delays and hiccups. This will make the relationship easier to run and manage funds better.
How quickly can you execute the transaction in light of changing market conditions and depleting funds?
Delays in the execution of the transaction can impact its efficiency and at times means the difference between the first mover and a runner-up in product launches and new ideas.
How soon will the investors get a return on their money and will the returns percentage be ratable?
You must be aware of terms like preference stocks, split rates, redemption ratios, and right ratios, and double dips. Even more importantly, what these terms would signify for the deal and your business is also key to a good transaction.
What will happen if more rounds of financing are needed? Will it be possible to add in a new investor to the company?
For a growing business, adding in new investors is a standard practice, having a reluctant investor or restrictive clauses can make this a long and difficult process.
How interested are the new investors in the board structure and how much control will they have over the decision-making?
How much control new investors have over running the company and appointing new management can make the difference between sound strategy and the difference between an investment and an acquisition.
If the investors want to exit how can they exit their investment and at what rates and terms?
In case there is a need for a split or divestment, who will stand to lose more? Can the new investor pull their financing without flooring your business? And will they be penalized for doing so? An exit may be mutually agreed upon and all such clauses waived then.
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