WHAT IS A TERM SHEET?
A term sheet is an agreement that is not binding in nature and serves the purpose of outlining basic terms and conditions to be established upon proposed investment or transaction. It, therefore, works as a sort of pre-negotiating proposition between the parties interested and forms a basis for a more elaborate document that has the semblance of a contract, for example, a shareholders’ agreement or a purchase agreement.
Use of Term Sheet:
It offers a summary of key terms of a deal that gives room to discuss financial terms, ownership structures, and the rights of the parties.
It gives a clear framework for agreeing on what needs to be agreed by both parties before proceeding with the transaction.
Saves time and disagreements later with what has been left out from the main discussion.
Common Uses
Venture capital (VC) deals: Where the investors seek to invest in either startups or early-stage companies.
Mergers and Acquisitions (M&A): When one company acquires another or two companies merge together.
Partnership Agreement: Typically represents two businesses wanting to cooperate with each other, working together in conjunction with accepted terms.
UNDERSTANDING THE KEY COMPONENTS OF THE TERM SHEET
A term sheet is a non-binding agreement outlining the key terms and conditions under which an investment will be made. It forms a framework of negotiations and will form a foundation for a definitive agreement. The main elements of a term sheet are described below:
1. Valuation
Pre-money valuation is the value of the company before the investment.
Post-money valuation: It is the company value after putting in the investment made. It applies when determining the equity stake of the investor.
2. Investment Amount
This is the amount the investor will invest in the company-it is quite essential when determining the equity stake of the investor.
3. Equity Structure
The equity structure encompasses:
Types of shares: That is, whether the investor is receiving common stock or preferred stock.
Convertible instruments: Sometimes, the investment is made as convertible debt, which is convertible into equity at a later stage.
4. Liquidation Preference
It helps to indicate the order of payout in case of a liquidation or sale of the company. Normally, preferred shareholders get their investment amount back first with some additional multiples sometimes (e.g. 1x, 2x liquidation preference).
5. Voting Rights
States the extent to which shareholders would be able to control corporate decisions on the part of investors. Preferred shareholders may have added rights and privileges, including veto authority on certain matters (e.g., mergers, amendment to the articles of incorporation).
6. Anti-Dilution Provisions
Protection from dilution of stockholders in case and when the company later issues shares at some lower price. There are two common measures: full ratchet or weighted average anti-dilution.
7. Board Composition
Specifies who will sit on the company’s board of directors and how many seats the investor can appoint, thus influence on key decisions.
8. Dividends
Identifies if investors have a right to dividends and if it is either cumulative-the ones not paid accumulate-or non-cumulative-forfeited if not paid.
9. Vesting Schedule
Frequently issued to founders or key employees to incentivize them to stay with the company for a specific period. The shares vest with a cliff, implying that there will be no vesting until a certain period usually one year
10. Exit Provisions
These words give mechanisms for exiting the investment, such as liquidation by offering shares to sell, becoming public, or even selling the business venture. Other rights may be drag-along or tag-along rights in which the investor is assured of participation in the sale.
11. Right of First Refusal
This is a right accorded to the investor, which grants them right of first refusal to buying of additional shares before selling to other third parties. This preserves the percentage ownership held by the investors.
12. Exclusivity and Confidentiality
Thus, this deal guarantees that the corporation will negotiate only with the investor during the proposed timeline and both of them maintain confidentiality of the deal.
13. Conditions to Close
There are conditions that need to be satisfied before closing the deal, including legal due diligence, board approvals, or regulatory requirements.
The term sheet is essentially a tool that aligns the expectations of the company and the investor before accepting a formal agreement. Even though it is not binding in nature, some sections may still carry legal weight.
CONCLUSION
The term sheets are important documents in structuring investment or transaction agreements as they state the main terms the parties are proposing. Even though not binding, it presents a basis from which negotiations would be advanced by both parties upon which to converge in anticipation of the drafting of the definitive and binding contract.
Certain key constituents consist of valuation, amount invested, equity structure, and liquidation preferences where the financial and ownership implications are clearly made both to investors and the company. Provisions related to voting rights, board compositions, and anti-dilution protect investor interest while encouraging business growth.
Provisions consist of exclusivity and confidentiality clauses to ensure trust and privacy of the process. Finally, a term sheet reduces the potential for misunderstanding and makes way for a transparent path to closing a deal. No doubt it remains a very important tool both in venture capital and in mergers and acquisitions as well as in other business agreements.