The best outcomes can come from counter-intuitive impulses. Spend less but better structured time and achieve more – check. Sleep longer and do more in fewer waking hours – check.
And here’s another one. Do a Term Sheet and finish your investment round better and faster. Counter-intuitive but right on the money.
Yes, a Term Sheet is a legal document (even if it is not binding). Yes, it will take time to negotiate and prepare. And, yes, it may even cost you money. But it is the single best cost-saving, time-saving, result-enhancing tool I know when negotiating an investment round.
Want to know if an Investor is serious? Show him your Term Sheet. Want to know if an Investor is sincere? Show him your Term Sheet (or check out his changes). Want to know if the deal points scrawled on the back of your napkin are understood all round the same way? Put them in your Term Sheet. And when it’s signed, then your Term Sheet is GPS for lawyers. The task of putting together contract documents is more implementation, less point-scoring.
So here are my thoughts on questions I am frequently asked about Term Sheets:
1. What is a Term Sheet?
A Term Sheet is a summary of the business, finance and legal terms that will apply to an investment round. Most of the provisions are not legally binding.
2. Why is a Term Sheet a good idea?
The Term Sheet is probably the single most cost saving process in negotiating an investment round.
The Term Sheet is an excellent tool to support negotiation. The attempt to agree a Term Sheet will show at a much earlier stage whether it will be possible to agree terms.
A well-drafted Term Sheet provides clarity and certainty on key deal points, and narrows the issues to be agreed in long form documents. The Term Sheet is a roadmap for documenting the deal, and a drafting instruction sheet for the lawyers doing that job. Negotiating and agreeing a four page Term Sheet, is much easier than doing so when working with long form documents, some of which can be 40 or 50 pages in length.
3. Who prepares the Term Sheet?
Founders should take the lead and prepare the Term Sheet. It can improve the deal terms. It demonstrates confidence and assertiveness in the management of the investor relationship and the deal process. This is more likely if there is no Lead Investor or in early seed stage investments.
However, if a Lead Investor is involved in the investment round, counsel to the Lead Investor will typically prepare the draft Term Sheet and the Founders will negotiate changes to that draft. This gives the Lead Investor more control over the terms and the negotiation.
4. Are there steps I should take to prepare before starting to discuss a Term Sheet?
The most important step is education. Founders need to grasp the technical meaning of the terms, and where the market range is for negotiation of those terms. The critical points to cover are corporate governance, capital structure and rights, dilution, and exit processes.
Founders should prepare for investor due diligence by having documents and information prepared, organised and available once the Term Sheet is signed.
Founders also need to understand the process. It occupies more time and takes longer than Founders think.
5. What are the typical non-binding provisions in a Term Sheet?
Typical provisions will include:
(a) Offering terms: This will set out the pre-money valuation and its method of calculation, the subscription amount and price per share, the post-subscription capital structure, and the timing for completion of the round. Investors may require warranties about the state of the business of the Company. Founders should insist that warranties are only given by the Company, are set out specifically in the Term Sheet, and have a limit on liability imposed.
(b) Share class rights: Investors will want special preferred rights attached to their shares. These include liquidation preference, preference on a liquidity event (such as a trade sale, asset sale or IPO), rights to convert to ordinary shares, rights to have their shares redeemed, voting rights, and (unusually) rights to preferential dividends. These are technical terms that need to be carefully considered. The wrong outcome will leave Founders with significantly less than they may expect on an exit.
(c) Governance and information rights: Investors may seek to have one or more persons appointed to the Board of Directors, and then to regulate the frequency, content and administration of matters considered by the Board. Also, Investors will seek rights to a range of financial and business information, and visit and inspection rights.
(d) Reserved matters: The Term Sheet will set out a list of matters that require special consents or approvals. Some matters may be reserved for decision by the Board, but require the positive approval of the director(s) appointed by Investors. Other matters may be reserved for the special consent of Investors holding a threshold percentage of the preferred share class (held by Investors). From a Founder’s perspective, the list of matters should be as limited as possible.
(e) Anti-dilution: The Term Sheet will grant Investors a first right of refusal on the issuance of new shares, and also protection against dilution of the value of their holding if a down round occurs. Founder’s should ensure that anti-dilution protection on a down round should be on a broadly based weight average calculation, and not by full ratchet.
(f) Share transfers: The Term Sheet will specify that shareholders wishing to transfer shares must first offer them rateably to other shareholders (or sometimes, only the Investors). Investors will also seek the right to sell shares along with an exiting shareholder (sometimes called a ‘tagalong right’), and may permit Founders to require Investors to sell if a threshold financial outcome and minimum approval is reached (sometimes called a ‘dragalong right’). Certain related party transfer are exempted from restrictions. A lock up prohibition on any transfer may be imposed.
(g) ESOP: The intended terms of a share option plan will often be set out in the Term Sheet, together with a timeline for its completion. Founders should assess the effect of an ESOP on Founder dilution.
6. What are the typical binding provisions in a Term Sheet?
The common binding provisions in a Term Sheet are:
(a) Confidentiality: This will impose an obligation on the Founder and the Investor to keep the negotiations, due diligence and process confidential.
(b) Costs: This will designate which party is responsible for legal costs. Usually all parties bear their own costs. Sometimes, Investors may request the Company to pay for its costs. At minimum, this cost contribution should be capped, and at best, deleted.
Other binding terms occasionally seen in Term Sheets are:
(i) Exclusivity: This imposes an obligation on the Company to deal and negotiate only with the Investor for the period of exclusivity in respect of any subscription for shares in the Company. It is highly restrictive, and not Founder-friendly.
(ii) Most favoured nation: This provision permits the Company to deal with other potential Investors, but requires the Company to offer any better terms secured by those other Investors.
(iii)Break clause: This provision requires a party withdrawing from completing the investment on the basis of the Term Sheet to pay a fee to the other party. The amount of the fee should approximate the costs incurred by that party.
7. Is a Term Sheet always non-binding?
A Term Sheet will be non-binding if it clearly states the parties do not intend the document to be legally binding. Otherwise, it could be binding. Sometimes, Investors may want the Term Sheet to be binding, and may draft it as such. Watch out for this; it may not be in Founder’s interests.
8. Can I change the agreed terms in a Term Sheet in long form documents?
Yes. Though in practice, changing terms demonstrates a lack of good faith and could put the investment in jeopardy. Changing the agreed terms in a Term Sheet usually only happens if there has been a change in circumstances – either to the business or the trading environment – after the Term Sheet was signed.
9. Can I introduce new terms into long form documents that were not in the Term Sheet?
In practice, new terms are introduced if they are consistent with, clarify or expand the agreed deal points in the Term Sheet. Also, new terms are included if they are not material but are needed to complete well-drafted long form documents. Occasionally, an issue will need to be addressed that was not discussed or agreed at the Term Sheet stage, and this can result in new terms being added. Otherwise, new terms could be a sign of bad faith and put the investment in jeopardy.
10. Can I walk away from a Term Sheet, if I change my mind or better terms are offered to me?
Yes, but there should be a compelling reason to walk away. The risk is that a Founder who walks away from a deal agreed in principle will acquire a reputation in the investor community, and may find it more difficult to raise capital in future.
11. What are the common mistakes that Founders make when negotiating a Term Sheet?
Two common mistakes are:
(a) not fully or deeply understanding the meaning and effect of the terms in the Term Sheet. For instance, a failure to understand or model the outcome of a liquidation preference, can result in a Founder receiving significantly smaller share of exit proceeds than he may appreciate.
(b) not knowing or understanding the range in the market on particular terms. For instance, an Investor may ask for full ratchet anti-dilution protection. A Founder should know it is reasonable (and generally acceptable) to negotiate for this to be broadly based weighted average anti-dilution protection.
Sometimes, a Founder may not realise that these mistakes have occurred until an exit or dilutive event has occurred, well after the investment round has completed. This comes back to the point of education. A Founder should not sign a document he does not understand, and he should arm himself with knowledge, insight and understanding before negotiating a Term Sheet.
12. What are the common oversights of Founders when reviewing a Term Sheet?
Common points to be alive to include:
(a) What authority or approval rights do Investors have? Is this appropriate? This is particularly the case in respect of reserved matters, where the reserved decisions should be limited to maintaining the capital structure, not second guessing business management decisions.
(b) Are obligations placed on Founders, as opposed to the Company? This can occur in particular where Founders are requested to give warranties on the business of the Company personally, and in addition to the Company.
(c) Are investor rights appropriate for the stage of development of the Company? For example, redemption rights exercisable by the Investor can have a profound impact on the cash flow of a business, and its viability. A right such as this should not be given in early investment rounds.
(d) Will the terms result in too much bureaucracy and administration? For instance, obligations to convene frequent board meetings, or onerous reporting obligations, can distract Founders from getting on with the business.
(e) Should there be more detail on some points? For instance, there are no “customary” reserved matters or warranties. These should be spelled out.
(f) Are some provisions simply irrelevant? To take an example, registration rights are irrelevant, if a listing in the US is not contemplated.
Ultimately, the devil is in the detail. Particular care should be taken where the Investor presents the Term Sheet.
13. Do I need a lawyer to prepare a Term Sheet?
A lawyer should, at minimum, review the Term Sheet before it is signed. He can then advise you on the meaning of the terms and whether the terms are unfavourable or unusual compared to market practice. He can also give you options so you can negotiate improved terms. Ideally, a lawyer should draft the Term Sheet. It will ensure clarity and proper use of technical legal terms in the Term Sheet.
14. How much does a Term Sheet cost?
Costs will vary according to the degree a lawyer is involved in both drafting and negotiating. Typically, in early stage investments, the lawyer’s role will be limited to drafting or reviewing the Term Sheet, and will not include direct negotiation or extensive advice. It should be possible for the Founder to negotiate a fixed fee for an agreed work scope to draft or review the Term Sheet.
15. Is a Term Sheet only used in investment rounds?
Term Sheets are used in many business scenarios. Its main purpose it to help parties to distil and agree deal points. This makes a Term Sheet useful for any complex situation where it makes sense to agree core principles up front. Term Sheets are also commonly used in mergers & acquisitions, financing arrangements, joint ventures, and franchising transactions.
Padraig Walsh is a Partner at Tanner DeWitt specialising in Corporate & Commercial, Financial Services Regulation, Notarial Services. Thank you for reading. Find out more about what I do here.
This article is provided for general information only. It does not contain legal advice, is not intended to provide legal advice, and none of its content should be relied upon as legal advice. You should not act or refrain from acting on any content in this article without seeking appropriate legal or other professional advice on your particular circumstances.