A term sheet, also known as a memorandum of understanding (MOU), is a non-binding agreement that represents the basic terms of an investment. A term sheet is a basic template and framework for creating more complex and enforceable contracts.
If the parties agree to the terms and conditions stated on the term sheet and comply with due diligence, a binding agreement will be created, such as: SPA (Share Purchase Agreement) and IRA (Investor Rights Agreement). The agreement complies with the terms and conditions stated on the term sheet. The term sheet mainly includes fundraising, corporate management, and liquidation.
The most important aspects of term sheets are:
- The amount of money that investors have committed
- Company valuation
- Percentage of equity that investors are entitled to
- Liquidation preferences
Mistakes to Avoid
- Lack of Clarity and Accuracy
One of the most important aspects of creating a term sheet is to make sure it is clear and accurate. Ambiguity can cause misunderstandings across the board and lead to conflicts and legal issues.
Why is it important:
- Avoid misunderstandings: Clear language helps prevent misunderstandings between the parties.
- Streamlined negotiations: Precise terms allow for smoother negotiations by reducing confusion.
- Protect from legal disputes: Clear definitions minimize the risk of future legal disputes.
How to work around this error:
- Use simple language without technical terms unless absolutely necessary.
- Explicitly define important terms in the document.
- Make sure all parties understand all terms before proceeding.
- Important Terms for Non-Violation
A comprehensive term sheet should cover all important aspects of the transaction, including valuation, investor rights, governance structure, and exit strategies.
Why is it important:
- Covers all the basics: Including all important terms ensures that nothing critical is overlooked.
- Sets expectations: Both parties know exactly what to commit to from day one.
How to work around this error:
- List all key components, including equity, voting rights, board composition, and more.
- Ensure that milestones or power metrics are clearly defined if they affect funding or control structures.
- Insufficient Risk Allocation
Risk allocation relates to how debt and liability are split between investors and founders if something goes wrong (e.g., financial losses or regulatory issues).
Why is it important:
- Protecting founders’ interests: Proper risk allocation ensures that founders are not unfairly burdened with debts beyond their control.
How to work around this error:
- Clearly construct liability clauses so that all parties understand their obligations within various scenarios (e.g., indemnification agreements).
- Ignore Legal Proceedings
Legal compliance is extremely important when developing business contracts. Ignoring the procedure can lead to invalid contracts and legal complications later.
Why is it important:
- Safety nets: Proper documentation ensures that contracts hold up in court in the event of a dispute.
How to work around this error:
- Consult with a corporate lawyer early in the investment process, especially for startups.
- Ensure local laws related to contract formation are followed (e.g., required signatures).
- Not Seeking Legal Counsel Early On
Engaging attorneys early provides invaluable guidance to ensure the legality and fairness of the contract. Legal counsel protects both parties and avoids expensive mistakes during negotiations.
Why is it important:
- Expert advice: Minimize the risks and improve the quality of contract terms with professional legal assistance.
How to avoid this error:
- Work with lawyers specializing in startup investments who can provide feedback during the negotiation and drafting stages. Regularly test assumptions, and proactively address unclear provisions before signing any agreement.
- Copying Templates Without Adjustment
Using a general template without tailoring it to your specific needs can result in a document that doesn’t fully meet the requirements of your situation.
Why is it important:
- Customization: Each startup has different priorities. Adjustments are needed to reflect these differences accurately.
How to work around this error:
- Review existing templates but modify them to suit your business’s specific needs, such as size, scope, and business model.
- Work with consultants who understand your business model and can help identify necessary adjustments.
- Overlooking Red Flags on the Term Sheet
Certain clauses may strongly favor investors at the expense of the founders.
Why is it important:
- Protects founders’ rights: Ensures fair trading structures and prevents investors from gaining unfair advantages.
How to avoid this error:
- Carefully review all clauses, especially those related to ownership controls, exit events such as mergers, acquisitions, and IPOs.
- Negotiate disadvantageous terms and seek expert advice when necessary.
- Don’t Understand the Concept of Valuation
Valuation methods vary depending on factors such as market conditions and growth prospects. It’s essential to understand these concepts when negotiating the term sheet.
Why is it important:
- Informed negotiations: Founders can make strategic decisions when they understand valuation methods and market conditions.
How to avoid this error:
- Learn the basics of valuation methods (e.g., Discounted Cash Flow, Venture Capital Method, Post-Money Valuation).
- Seek advice from experienced financial advisors or entrepreneurs familiar with valuation processes.
- Ignoring the Conflict Resolution Mechanism
Including a mechanism for resolving conflicts efficiently prevents prolonged and costly litigation that could harm the business’s reputation in the long run.
Why is it important:
- Save resources and time: A conflict resolution clause saves time, money, and preserves business relationships.
How to avoid this error:
- Include an arbitration clause that outlines how disputes will be handled.
- Use neutral third-party mediators when possible to ensure fair and impartial resolution.
- Investor Management is Too Limited
Investors need certain oversight, but founders must ensure that investors don’t overstep their boundaries and that they maintain adequate decision-making authority to keep the company’s strategic direction aligned with its original vision and values.
Why is it important:
- Protecting founders’ autonomy: Ensures that founders retain control over core decisions and the company’s growth trajectory.
How to avoid this error:
- Set clear limits on investor involvement in governance structures.
- Negotiate protective provisions that safeguard key decisions, ensuring the company remains founder-led.
References
- 10 Common Mistakes to Avoid When Drafting Contracts, Carbon Law Group
- 5 Term Sheet Mistakes to Avoid, Digify
- Shana Lebowitz, A Comprehensive Guide to Venture-Capital Term Sheets, Business Insider
- Understanding Term Sheets, Startup Movers
- Ten Things You Should Do Before You Sign a Term Sheet, Inceptiv L.
This article has been written by Isha Gupta. For any other queries, reach out to us at: queries.ylcc@gmail.com
