What is a term sheet?
Term Sheets Defined
A term sheet is a nonbinding document that defines the terms and conditions of a potential investment. This document specifies the general structure of the deal including crucial terms such as the extent of financial contribution, the type of investment, equity protection provisions, and other information.
A term sheet serves as a reference for future contracts and helps ensure the parties understand how parties propose to contribute to a business venture.
Term sheets are primarily used for startups, but they are also commonly included in other business transactions, such as loans, mergers and acquisitions, and those related to real estate.
A term sheet sets the groundwork of an agreement and does not go further into details that could make the document an enforceable contract.
How do they work?
The way a term sheet fits into capital raising is by acting as a non-binding offer that outlines the overall terms of an investment deal and helps parties understand what they are getting into.
The investing process starts when private equity providers identify companies in need of fundraising. Then, investors analyze whether the company has a high potential for profitability, according to their business model.
After this overall research, Venture Capitalists will pitch the most feasible option for finance and negotiate the term sheet with the company owner or representatives.
After both parties agree to move forward, the VC will conduct due diligence, which consists of an in-depth inspection of the financial performance of the business, to decide whether to continue with the investment.
Once the VC are convinced to move forward with the deal, they will make the necessary modifications to the terms sheet to prepare for a binding contract agreement, with the help of a business negotiation attorney.
It is typical for companies to solicit multiple term sheets to compare them across bidders and select the proposal that works at their best convenience.
Purpose of a term sheet:
A term sheet serves as a pre-contractual document that facilitates the investing process by:
- Describing the relationship between the VC and the company that profits from the investment.
- Providing clarity on the extent of the investors’ financial contribution and the implications of the fundraising
- Acting as a basis for further negotiations
- Restricting the target company from accepting funding from other investors
- Providing flexibility to both parties in the event they want to retire from the deal
How are they used?
Term sheets can be used for fundraising purposes across different business transactions, such as:
Startups
Since early-stage companies and startups are in the most need of capital, entrepreneurs use the term sheet to attract investors and find an easy way to fund their companies.
Startups are usually valuated according to their growth rate, location, and strength of the team. Entrepreneurs must ensure their financials are performing satisfactorily and that they can afford to pay back the investment.
Although in most situations investors take a smooth approach and focus on creating a win-win situation to get a good return on capital, entrepreneurs can end up giving more control of their business than they expected.
As an emerging business, it’s likely that you will have to accept the terms offered in the term sheet, but as an established and successful business, you have higher possibilities of a more favorable negotiation.
Generally, a term sheet for startups will outline:
- The valuation of the company and the amount investors will fund
- The percentage of the company investors will own based on their financial contribution
- The rights of investors
- Profit distribution
- The term of the investment, or for how long the investor will stay committed to the company
Mergers and Acquisitions
A term sheet used for an M&A will typically contain information regarding the offered purchase price and the assets or stock included in the transaction.
In a business acquisition, the term sheet takes place before preparing an LOI and a purchase agreement.
In a short bullet list, an M&A term sheet will outline:
- The purchase price
- The earnest money deposit
- Down payment
- Financing terms
- Length of time for due diligence
- Potential deal-breaking terms
Joint Venture
For this type of business transaction, term sheets will usually describe how the joint venture’s matters will be handled regarding:
- Management and decision-making procedures
- Contribution
- Profit sharing
- Ownership structure
- Length of the collaboration
Real Estate
In the context of Real Estate, a term sheet includes details of an investment opportunity or a loan. Some of the common conditions that can be found are:
- The loan purpose
- The amount of the loan
- Payment structure and interest rates
What to Include in a Term Sheet
The elements a term sheet includes vary according to the commercial transaction they are being used for. The following are some terms that are generally used:
- Business Information
Includes the names of the parties involved.
- The business in search of funding
- The potential investor
- Type of security
States what is the type of funding that will be provided and it price per share. It can be in the form of equity, preference shares, or warrants.
- Valuation
One of the foremost elements of the term sheet is valuation since it defines how much the company is worth. This section of the term sheet will determine the price per share for the target company and pre-money and post-money valuations.
- Pre-money valuation: Based on the number of outstanding shares before the investment or the value of the company before receiving funding.
- Post-money valuation: Based on the number of shares after the capital contribution
- Valuation cap: Refers to the maximum limit on the business valuation at the time of conversion.
Amount of Investment
Determines the percentage of financial contribution toward the company. This amount can be represented in a fixed dollar amount, or be subject to certain metrics, such as the LTV (loan-to-value) ratio, which compares the amount of the loan to the value of the asset being used as collateral. Furthermore, the loan amount can be subject to DSCR (debt service coverage ratio) and NOI (net operating income) calculations, which are used to determine the borrower’s ability to repay the loan based on their income and expenses.
Percentage Stake
Identifies how much of the company the investors will own according to their capital contribution. The percentage of stake in the company is proportional to the investor’s ownership of the business.
Dividends
Establishes the distribution of profit, or dividends, which is the amount shareholders receive on a regular basis in proportion to the company’s profits.
Voting Rights
How investors can participate in the decision-making process of the company, in selecting the board members, and have influence over other matters pertaining to the company.
Liquidation Preference
This section details the rights to exit and liquidation preferences. Proportional to the amount invested, liquidation preferences represent how much the founders will receive in the event of the sale or liquidation of the business and state the priority sequence for payouts.
- Straight or non-participating preferred: Stockholders are entitled to receive their investment back (including dividends) and an additional multiple of their original investment amount before any proceeds are distributed. The amount is chosen by the stockholders and can be 2X,3X, or another multiple of their investment.
- Participating preferred (double dip): With this type of preferred stock, stockholders can receive their entire investment back (including dividends) before any proceeds are distributed to common stockholders. However, the preferred stockholders also have the ability to share in the remaining proceeds on an equal basis with the common stockholders, effectively being paid twice.
- Capped (or partially) participating preferred: They have the rights as participating preferred, however, their aggregate return is capped, for they cannot share the remaining proceeds common stockholders.
Time frame
Establishes the term in which investors must review the term sheet and decide whether to accept the offer or withdraw from it.
Common Clauses in Term Sheets
There are specific clauses you must pay attention to whenever you handle a term sheet. Some of them are meant to protect investors but can also have a negative impact on your company. Review each of the following clauses before entering into an enforceable contract:
- Anti-dilution rights: Protect investors from facing a decrease in their ownership stake of the business when new shares are issued.
- Non-binding provision: This provision ensures parties are not yet legally obligated to carry out their terms.
- No-shop provision: Acting as an exclusivity agreement, this clause states the target business cannot accept offers from other investors at the time of negotiation
- Confidentiality terms: This non-disclosure clause prohibits both parties from sharing any sensitive information that is revealed during the informal discussions.
- Drag-along and tag-along clauses: A drag-along clause allows a majority shareholder to require a minority shareholder to sell their shares in the event of an acquisition. With a tag-along clause, a shareholder may have to sell their shares to a buyer under the same conditions as a majority stakeholder.
- Pro-rata rights: Based on their current capital contribution, investors may be entitled in the future to buy more shares of the business.
- Right of refusal (ROFR) and approval of sale: With this clause, shareholders must be notified whenever there is a transfer of stock which allows them to buy shares from an investor who is selling.
Red Flags in Term Sheets
A term sheet, although not enforceable, is key in a negotiation because it will be the precedent of a favorable deal for both parties. The following are indicators that your deal may present some irregularities;
- Excessive equity: If investors are asking for a large share of your company, they can end up having too much control over your business and even replace you as the sole owner.
- Unrealistic valuation: While it’s common for business valuation perspectives to differ, ensure the investor’s saying on the worth of your company is not so farfetched from its actual value.
- Fundraising restrictions: You should be careful when VCs try to restrict your company from receiving future capital contributions
- Short-time investments: If the investor plans to vest on your company for a short period, this may indicate that they’re not serious about their investment and may retire without warning.
- Absorbing voting rights: Ensure there are not too many investors on the Board of Directors or that they do not possess an excessive voting right capacity.
Frequently Asked Questions
Who should write term sheets?
The party who is interested in investing must provide a term sheet to the owners of the company. This could be venture capital investors, angel investors, or other capital raisers. For Mergers and Acquisitions, the term sheet should be provided by the business buyer.
Even when a term sheet is not a binding document, it is highly recommended that a business attorney has a significant collaboration in the drafting of the term sheet. An M&A lawyer will ensure the term sheet contains fair and feasible terms and that it does not have elements that could make it an enforceable contract.
What are the term sheet’s key points?
Generally speaking, the term sheet’s essential point could be reduced to:
- The amount of the investment or purchase price
- The company valuation, that states the worth of the company prior to the investment and after it is made.
- The assets or percentage stakes that are involved in the transaction
- Voting rights, which determine the decision-making power of investors.
- Anti-dilutive provisions, which protect the investors’ company ownership when new shares are issued.
- Liquidation preference, or the order the payment from the realization of assets must follow in the event of liquidation
What is the difference between a term sheet and a contract?
While a term sheet is a non-binding document that sets expectations of a possible investment, a contract describes an agreement between two parties that can have legal consequences if responsibilities are not fulfilled.
What is the difference between a term sheet and an LOI?
While both are nonbinding documents, a letter of intent is used with more frequency in the context of Mergers and Acquisitions, while term sheets are more prevalent in private-equity investments.
Additionally, the format between the two differs. Term sheets are structured in an outline format, with bullet points, while LOIs are prepared in the form of a letter.
