What Is A Term Sheet?
A term sheet is a document that outlines the key terms and conditions of an investment or exit deal. It serves as a non-binding agreement that provides clarity and scope of negotiation before proceeding to a detailed legal agreement. Term sheets are usually issued by angel investors, VCs, financial institutions or an acquiring company in an M&A deal.
A term sheet is taken as something of a precursor to a legally enforceable document. Term sheets are meant to be discussed and negotiated so that all parties are conceptually aligned.
What Are The Key Components Of A Term Sheet?
Some of the key components of a term sheet are as follows:
- Preamble: It states the major points in a typical term sheet such as the non-binding statement of intent and that it cannot be construed as an offer but an expression of interest.
- Party Details: States the parties involved, generally the investor, the startup and the founders.
- Valuation, Dilution & Securities: This part helps parties analyse and dissect the value, dilution terms and performance.
- Conditions Before & After The Investment: Refers to the prerequisites of the deal that must be met both before and after an investment has been made.
- Economic & Participation Rights: This segment details out the rights to exit, liquidation preferences, downround protection and more.
- Control Rights: These rights ensure protection of investor’s investment.
- Information Rights: Includes financial information such as profit and loss statements, copies of filings made by regulators, and cap table management information.
- Transfer Rights: These are the protocols for the transfer of securities by the shareholders. Transfer rights are split among investors, founders & key management roles and other stakeholders.
- Indemnities & Warranties: These are given by the company to the investors as an affirmation that the information and the documents given to them during due diligence are correct.
- Cap table: Represents the shareholding pattern of the company.
How Is A Term Sheet Different From A Contract?
Simply put, term sheets are non-legally binding documents whereas contracts are legally binding definitive agreements.
A term sheet usually lays the foundation for a contract. It ensures that the parties agree to the terms before entering a definitive agreement to avoid any potential conflict.
What Kind Of Terms Can One Find In A Term Sheet?
Some of the common terms found in investment term sheets are:
Valuation (Pre-Money & Post-Money): Before finalising an investment agreement, investors look at the pre-money valuation (company’s worth before the investment) and post-money valuation (company’s worth including any new investment).
Valuation Cap: A valuation cap is the maximum limit on a startup’s valuation at the time of conversion. This also ensures that investors receive a favourable conversion price even if the company’s valuation increases in a future financing round.
Drag Along Clause: To prevent discord between minority stakeholders with majority stakeholders, investors may request a drag-along clause. This clause mandates that smaller investors follow the lead of larger investors in making important business decisions.
Dividends: Investors often seek clarity regarding their entitlement to net income distributions.
Liquidation Preference: This clause helps investors understand the priority sequence for payouts in the event of a company sale. This information is vital for investors as it helps mitigate risks.
Voting Rights: Investors may want a say in the company’s operations. A term sheet defines the number of votes an investor holds or any restrictions or limitations on their voting rights.
Pro-Rata Rights: Investors may wish to understand their rights for future investment rounds. For instance, based on their current investment, they may be entitled to the right of first offer for future investment opportunities. Conversely, there may be penalties for investors who choose not to participate in future rounds.
No-Shop Agreement: Investors may seek protection against competing investors or subsequent investment rounds. A no-shop agreement sets terms that prevent companies from accepting investment from others at the time of negotiation.
Is The Term Sheet Considered As An Offer?
According to Indian Contract Act 1872, when one person shares with another person his willingness to do or not to do something (abstain) to obtain the assent of such person to such an act or abstinence, he is said to make a proposal or an offer.
However, a term sheet does not fit this definition.
According to Siddarth Pai, founding partner of 3one4 Capital, “Terms sheets are an expression of interest and for it to be considered an offer, which may be subject to litigation, it requires more due diligence than the handful of calls and exchange of information that may have preceded it.”
What Happens After A Term Sheet Is Signed? Can Its Terms Be Modified Afterwards?
Once signed, a term sheet initiates a negotiation process between the founding team and VCs, leading to the creation of a legally binding agreement that outlines the terms of the investment.
It is possible to modify a term sheet when all parties agree to the proposed changes. As a term sheet is not legally enforceable, it tends to offer greater flexibility compared to a definitive agreement, allowing modifications throughout the negotiation stage.
What Are Some Of The Most Common Mistakes One Can Avoid When Negotiating A Term Sheet?
Lack Of Understanding & Implications Of The Terms: This can lead to unfavourable consequences. For example, if a founder fails to anticipate the impact of a liquidation preference, it could result in the founder receiving smaller shares from a successful exit than expected.
Unfamiliarity With Industry Standards: An Investor might request full ratchet anti-dilution protection, but a knowledgeable founder should recognise that it is reasonable and generally acceptable to negotiate for a more balanced approach.
Founders should always educate themselves about term negotiations before signing a term sheet so that they make informed decisions.
According to Ashish Tulsian, the cofounder and CEO of Posist, “There is nothing known as a standard term sheet. If your cofounder, investor or lawyer tells you to forgo negotiating something because it is standard practice, do not listen. When you are building a startup, you are disrupting the standard, so don’t fall for it.”
What To Do If You Don’t Agree With The Terms Outlined In A Term Sheet?
If you don’t agree with the terms outlined in a term sheet, communicate your concerns, propose alternative terms, and engage in negotiations to find a mutually acceptable agreement, or consider walking away if a satisfactory resolution cannot be reached.
What Are Some Of The Best Practices For Drafting A Term Sheet?
- Clear & Concise Language: Use straightforward language to ensure clarity and understanding.
- Define Key Terms: Clearly explain important terms to avoid confusion.
- Specify Parties: Identify the involved parties and provide a brief context for the agreement.
- Outline The Structure: Clearly outline the deal’s structure, including investment type and ownership details.
- Cover Key Terms & Conditions: Include crucial conditions such as valuation, rights, and milestones.
- Be Balanced & Fair: Create a balanced term sheet to protect the interests of all parties.
- Consider Legal & Regulatory Requirements: Ensure compliance with laws and industry standards.
- Flexibility & Contingencies: Allow for adaptability and address unexpected situations.
- Confidentiality & Non-Disclosure: Include provisions to safeguard sensitive information.
- Seek Professional Advice: Consult experienced advisors to navigate complex negotiations and legal aspects.