A term sheet is a non-binding agreement setting forth the basic terms and conditions under which an investment will be made. It is a letter of intent prepared by an investor to summarize important financial and legal terms related to the transaction. Once the parties involved reach an agreement on the details laid out in the term sheet, a binding agreement or contract that conforms to the term sheet details is then drawn up
Founders seeking investors must be conversant with the content of a term sheet in order to make safe and informed decisions. The following are some of the important contents of a term sheets;
- New Securities Offered
This clause generally indicates the type of securities offered. The shares offered to investors can be preferred or ordinary shares. Preferred shares give a more senior position in the company’s capital structure, which means it usually has some rights attached to it that give it preference over common shares and usually generates powers that common shareholders do not hold. On the other hand, common shares usually hold no special powers, it’s just ordinary shares with one vote exercisable per share in the event a shareholder vote is called.
- Post- Financing Capitalization
The purpose of this section is to summarize what the capital structure of the company will look like after the proposed new financing. The information in this section allows the reader to determine the pre-money and post-money valuations of the company. Pre-money valuation refers to the agreed value of the company before the new investment and as the name implies while post-money valuation is the mathematical value of the company after the investment has been made.
A dividend is a sum of money paid regularly (quarterly or yearly) by a company to its shareholders out of its profits. Dividend provisions are one of the critical tools that allow investors to protect their investment and to get out of an investment with at least some prospect of a return in the event of liquidation of the company.
In the case of startups, rather than paying regular dividends, the dividend is allowed to accumulate overtime by growing the preferred equity of the investor in size over time. At the end of the investment, the preferred equity would have increased overtime and the investor will benefit from the fixed return.
- Liquidation Preference
The liquidation preference clause is a tool that enables favorable treatment for preferred shareholders in the event of liquidation.
The liquidation preference sets out who gets paid first and how much they get in the event of a liquidation, bankruptcy or a sale. Venture firms include liquidation preferences to protect their investments from downside risks, by making sure that they get their investment back before any other shareholders.
- Option pool
An option pool is a strategy used to attract talent to a company by sharing equity with employees. Investors are aware of this and often insist on the creation of an option pool before their investment. The creation of an option pool will also prevent dilution of the investor’s shareholding.
- Anti-Dilution Rights
A very important consideration when raising funds is anticipating how, as a company grows, new rounds of financing will affect the value of the shares of company’s existing shareholders. This clause is a very important tool for investors who want to ensure that any subsequent financing will not dilute the value of their investments below the price they paid in a prior round.
- Voting Rights
Voting rights are the rights of a shareholder to vote on matters of corporate policy. This clause points out how voting rights are divided and for which corporate action a voting majority is required.
- Board Composition
A board of directors is a group of individuals chosen to represent the interests of the shareholders in the company. Its mandate is to establish policies for corporate management and oversight and make decisions on major corporate decisions. Investors will propose a board composition that will give them a bit more control and ensure an effective change in the influence, balance, and role of the board.
- Information Rights
Information rights define the extent to which investors are given access to information in a company. Investors require the ability to examine almost any document, audited or unaudited, financial or otherwise, that may exist in a company’s files or accounting software.
- Right of First Refusal
The Right of First Refusal is a clause that investors include to ensure that an investor is able to have influence over the sale of any shares, be they preferred or common, and to retain the ability to either purchase those shares, restrict their sale or refuse a sale.
- Pre-emptive or pro-rata rights
Pro-rata or pre-emptive rights give investors the right to maintain their level of ownership throughout subsequent financing rounds. This is done by allowing the holder of the rights to participate proportionally (pro-rata) in any future issue of common stock prior to non-holders.
- No-shop clause
The no-shop clause prevents the company from seeking investment proposals from other investors. This gives the investor leverage because it prevents founders from looking around for better investment terms. It is important to pay attention to the timing to avoid an unduly long no-shop clause, as it could allow the investor to take a long time for her due diligence and to potentially drop out at the last moment.
- Drag along and Tag along rights
In the event of a sale, the acquiring company typically wants to acquire all shares. While the majority shareholder can decide to completely sell the shares and the company, the minority shareholders cannot be forced to do the same without a specific clause or a lengthy legal process. Drag along rights prevents situations in which a minority shareholder can block the sale of a company that was approved by the majority shareholder or by a collective representing a majority.
In order to protect the minority shareholders, there are also tag-along rights. These rights give the minority shareholder the right to join in any action with the majority shareholder. This is because majority holders are often more capable of finding favourable deals from which the minority shareholder would be excluded without this provision.
- Redemption rights
This clause ensures that investors have a right to demand redemption of their stock within a specific window of time. This is essential for a structured venture fund, as they have a set time to return the funds to their limited partners.
The clause also stipulates how much time the company has once the event has happened to complete the redemption and if it relates to a fraction or the complete investment.
- Conditions Precedent
The Conditions Precedent section presents a road map to the completion of the financing that is proposed by the term sheet. It details the due diligence that must be completed once the term sheet has been agreed upon and highlights the necessary steps that must be taken in order to complete the transaction.
Understanding the terminologies employed in a term sheet and their implications would help founders make informed decisions, ultimately enabling them to take actions favorable to the company. Term sheets must be properly understood before proceeding to the closing of the investment and creating legally binding terms for the investment.
It is essential that founders employ the services of lawyers in reviewing term sheets offered to them by investors and to negotiate terms that would favour the company.