What is Term Sheet?
Term Sheet is a brief, non-binding document that outlines the basic terms and conditions required for making an investment, bridging the gap between the initial discussion agreement and the final binding deals.
It acts as a blueprint for the final agreement deal and ensures that the parties involved in the business transaction generally the startups and the investor get a clear and transparent understanding of the structure, financial aspects and the mutual expectations.
Basic elements like parties involved in the transaction, valuation, properties involved, initial purchase price, time period, amount of investment, percentage stake, voting rights, liquidation preference and any other element that is considered to be relevant should be included in the term sheet. Term sheet is a crucial document for any startup, it lays the foundation and is a daunting task as the interest of both the parties should be aligned.
WHAT EVERY FOUNDER NEEDS TO KNOW?
Every founder must be aware of the important sections and the key term used in the term sheet. Below is the breakdown of its each section:
1. Economics & Control
This section explains the ownership percentage of the company new investors will get, the full aspect of the company’s valuation as well as the sum of the capital. These ownership percentages, of course, are critical for equity allocation and the resultant potential returns upon exit.
Pre-Money Valuation: The valuation of the start-up just before attracting the venture capital investment. It is a basis for the new share value given to the incoming investor.
Post-Money Valuation: The value of the whole start-up after the acquisition, including the original valuation before the investment and the new capital.
Liquidation Preference: It states the sequence and the amount of payment to the investors in times of the company’s sale. Therefore, it gives preference to the investors by providing that the investors are paid out prior to the common shareholders when a liquidation or an exit occurs.
Conversion Rights: Are contractual rights allowing investors to: a) Vary the price of shares to match that on an equity market; b) Sell to a private equity firm instead of the public market; or c) Purchase shares at a future date.
Employee Stock Option Pool (ESOP): It is a piece of a company’s stock that is made available to employees, usually as a result of the founders’ shares and taking into account a certain percentage of the post-money valuation. A good ESOP may be used to attract top talent who are motivated to have this stake in the company.
Dividends: Money that the shareholders receive from the company’s profits. The dividends can be either cumulative, i.e., they are the sum of unpaid dividends for the previous years and the current year, or non-cumulative, meaning they are not accumulated when unpaid in the present period.
2. Investor Rights & Protections
Most investors attach some specific clauses to the term sheets so as to protect themselves during difficult times, like down rounds.
Anti-Dilution Rights: Shielding preferred shareholders in case of a down round the company executes where the further funding round at a valuation less than that of the first becomes necessary.
Pro-Rata Rights: These rights allow investors to keep their ownership stake by participating in future funding rounds. Typically, this right is granted to larger investors, although they may choose not to exercise it.
Right of First Refusal (ROFR): This gives existing shareholders the chance to buy shares from an investor looking to sell, ensuring that shares aren’t transferred to a competitor without their awareness.
No-Shop Clause: The founder agrees not to pursue other investment offers while negotiations are in progress, and the investor promises to conclude the deal within a reasonable timeframe.
3. Governance, Management & Control
This section explains who can make decisions on the start-up and control between investors and founders.
Voting Rights: The rights of shareholders to vote on important company matters, such as making board appointments or general business decisions.
Protective Rights: Empower investors with the right to prevent or veto certain actions, for example, issuing new shares or absorbing tremendous debt.
Board Rights: Define what constitutes the Board of Directors so that the interest of the shareholders is represented properly. Typically, a board should be a balanced mix of investor representatives and founders.
Information Rights: Ensure that a start-up regularly gives the financial updates of a company to investors; this helps create a factor of transparency along with decision-making.
4. Exits & Liquidity
This section spells the conditions and rights concerning the selling or exit of the company, ensuring that all the shareholders understand what is expected of them as well as rights when such an event occurs.
Drag Along Rights: It enables the majority shareholders to compel the minority shareholders to accompany them in selling the company as one unit and prevent small stakeholders from blocking the sale when it has been approved by the majority.
Tag-Along Rights: Minority shareholders are protected and involved in a sale if the majority shareholder wishes to sell his shares.
Redemption Rights: Investors have the right to demand that the company buy back their shares at some point after the period of time provided, thus having an exit in case the company does not go through any liquidity events such as the IPO or acquisition.
CONCLUSION
Term sheets are critical for both the founders and investors in establishing the economics, rights, and governance structures of a venture capital deal. It provides a clear framework for navigating investment negotiations, protecting interests, and planning for future growth or exits. Understanding these terms helps ensure that agreements are fair and mutually beneficial, laying the groundwork for a successful partnership.