Decoding Term Sheets

What Is The Meaning Of A Term Sheet?

A term sheet is a non-binding agreement outlining the essential investing requirements. It can be a starting point for creating more extensive, legally binding papers. An agreement or contract that complies with the term sheet's provisions will be drawn out once the parties concerned have reached an agreement on the details set out in the term sheet. In general, a term sheet should describe the most significant components of a contract without getting into small details or contingencies that would be handled by a formal contract.

It simply lays the framework for ensuring that the parties engaged in a business transaction agree on the most critical parts, reducing the risk of misunderstanding and unnecessary litigation. It also guarantees that significant legal fees for drafting a formal agreement or contract are not incurred prematurely.

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Typical Clauses Included In a Term Sheet

1. Is the Term Sheet Legally Binding?: No, save in the case of legal liability for confidentiality, exclusivity, and costs. The goal is to specify the terms and see if the agreement has enough legs to close between the parties.
2. Assessing the Worth of Your Company: Calculate the value of your firm realistically using comparable companies as a baseline. A high value may look good on paper, but it will also raise the bar for future fundraising if you want to acquire another round.
3. Due Diligence: It's critical for the founder to conduct full due diligence on everybody they'll be doing business with. One of the major concerns raised by venture capital and private equity firms is that the entrepreneur does not conduct their due diligence on their long-term partner. Be specific about how your investors will assist your company in ways other than finance.
4. Financial Instrument: Stocks, which include preferred and ordinary stocks, are the most popular equity. Convertible debt notes are becoming more popular.
5. Partner Participation Rights: There are three categories of partner participation rights, each with a different level of economic upside potential for investors.
   • Non-Participating — The choice that is most owner-friendly. The investor must select between a straight preference for liquidation or a pro-rata share of all proceeds.
   • Capped Participation – Similar to the Full (see below), but the total return from liquidation and participation rights is limited to a certain multiple.
   • Full Participation - This is the most investor-friendly option. The investor gets their liquidation preference first, followed by a pro-rata share of any residual funds. Determine the voting rights of each of the three different sorts of investors.
   • Determine the voting rights of each of the three different sorts of investors.
6. Pro-rata Rights: Pro-rata rights give initial investors the choice (but not the obligation) to invest in subsequent rounds to keep their ownership, which would otherwise be eroded.
7. Liquidation Preference: Liquidation preferences define the payout hierarchy in the case of a corporate liquidation, such as a sale or merger. Liquidation preferences allow investors to specify the initial payout amount and breadth that they will receive.
8. Anti-dilution Provisions: This right protects an investor from equity dilution caused by future stock issues if the stock is sold for less than the original investment price. This also changes relative ownership percentages to prevent new stock investors' stakes from being lowered.
9. Protective Provisions: Protective Provisions give investors veto power that they would otherwise be unable to wield on the board of directors since their percentage share does not equal a majority vote. Examples are forcible discussions, such as a company sale, stock issuing to costs, or hiring sign-offs.
10. Drag Along Rights: This provision permits investors to persuade other stock classes to comply to their voting requests in the event of a liquidation event such as a sale, merger, or dissolution.
11. Right of First Refusal/Right of Co-Sale: Notifies all investors about stocks available for acquisition by other investors and requires board approval of all stock transfers to prevent stock transfers that are done in secret.
12. Guarantees: If the founder is needed to be a guarantee, specify how and when the guarantor will be removed from the note.
13. Vesting Schedule: Vesting is the method through which a company's shares/equity are earned over time (typically four years or fewer.) When a founder with vested stock leaves unexpectedly, the cap table is left with dead-equity. This event may have significant ramifications for the remaining founders and funders.
14. Liquidation Preference: Liquidation preferences allow investors to specify the initial payout amount they will receive.
15. Confidentiality and non-competition protect investors from conflicts of interest that develop when they try to leverage their portfolio by sharing information or investing in competitor enterprises. The duration of this insurance spans from two to twenty years (as seen in oil and gas deals.) In addition, the founder wants the investor to be entirely focused on guaranteeing the success of their company.
16. Mediation/Arbitration/Governing Law and Jurisdiction: Disputes arise that necessitate the intervention of a third party. If this action is required, ensure it is handled in the most convenient jurisdiction for you.

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How Can VCs Protect Their Interests In A Term Sheet?

Four provisions must be included in the term sheet to protect the interests of VCs:

1. Voting Rights: Preferred stock frequently includes Board seats and voting rights. Venture investors have a greater say in the company's operations, management, and direction due to this.
2. Dividends: Dividends are features that distinguish preferred stock from common stock. Dividends boost the overall return for preferred investors while lowering the total return for common stockholders. Dividends are sometimes expressed as a percentage of the preferred stock's initial issuance price.
3. Participation and Liquidation Preferences: Participation and liquidity preferences ensure that the investment is compensated before a liquidity event occurs (when a company is sold, goes public or declares bankruptcy). These considerations are critical if the company is liquidated for less than the amount invested.
4. Anti-Dilution: In the event of a down round, a firm issues equity at a lower valuation than in earlier rounds, the anti-dilution provision protects investors.

The majority of term sheet protections are paid for by common shareholders, who include founders and workers, so it's critical that they're reasonable and equitable. If a VC is overly shielded, it can stifle a company's growth and success by reducing its ability to attract talent and attract new investors in the future.