INTRODUCTION
Entrepreneurs and start-up founders are not the kind of people who would be extremely adept with paperwork and are often clueless about the documentation required at the time of seeking investment for their stunning business idea. A term sheet happens to be the preliminary document that a start-up founder has to encounter at the beginning of any investment transaction. In simple terms, a term sheet is like a marriage proposal where the company and the investor meet to negotiate the terms of their investment.
Basically, a term sheet is a legal document that sets out the parameters to be adhered to by parties in a business agreement. It is a document that marks the start of an investment transaction.
WHAT IS A TERM SHEET AND WHY YOU NEED IT?
A term sheet is the first document of understanding that is entered into between the investor and the founders of the company. The terms in the term sheet outline the “conditions” for an investment and sets the tone for future negotiations and documents. The conditions would involve terms like the pre-valuation of the company, the price per share which is to be issued or purchased, the post valuation, details regarding the control and the money which is to be received at the time of the exit of the investor.
Term sheet are important because they act as a roadmap for lawyers to prepare the transactional documents. Drafting of transactional document is an extremely cumbersome process. Once a transactional document is entered into, then there is no going back. This is where terms sheet come in. They are a pre-transactional document, the terms of which can be debated and negotiated upon. One term sheet can be used as a basis for many transactional documents. Hence, saving time and effort required for negotiating various documents individually. This is why it becomes extremely important to have a term sheet that is comprehensive and unambiguous.
IS TERM SHEET MANDATORY?
No, it is not mandatory to prepare a term sheet before the final investment agreement. But most founders prefer having a term sheet because it gives a clear picture of the major terms and conditions of an investment on which the investors and the founders can agree upon thereby reducing the chances of a misunderstanding and subsequent dispute.
ESSENTIAL CLAUSE IN TERM SHEET
A term sheet is an important document. It forms the basis on which the transactional document formed. The term sheet contains some important clauses which are also put into the transactional documents as it is since the parties have already discussed, negotiated and agreed upon most of them. It is for this reason that these clauses should be minutely observed. The following are the clauses which should be well understood by parties;
- INVESTMENT AMOUNT
The amount that is being invested in the company. this clause is important because the purpose of seeking investment from the company’s perspective is to raise capital.
- PRE-MONEY VALUATION
Companies are valued by the investors, business gurus and experts to see how a company is doing. The primary aim of any investor who values a company is to see how much it is worth right now and how much it will be worth after the investment.
Investors see the value of a company pre-investment. Then they assess the value of the company post an investment infusion in the company. This is how they make a choice as to whether they will invest or not.
- CONVERSION RIGHT
A conversion right is the right to convert preference shares or debt into equity shares. These can be optional or mandatory. Investors at early stages either invest through convertible notes (a loan which is then converted into equity) or convertible debentures (debentures which are later converted into equity). This is quite a favorable option for early investors whose ultimate objective is usually to gain equity control in the company.
- OPTION POOL
An option pool is a set of stock set apart by the company to give it to the employees who stay with the company for a long time. This is used by the companies to attract employees with expertise. Option pool are part of pre-money valuation and are mostly taken out of the stock of the founders. Hence, this assessment will be valuable for investors in order for them to understand how their stakes will get affected.
- LIQUIDATION PREFRENCE
The liquidation preference clause (LP clause) sets out who gets paid first and how much they get in the event of an IPO, winding up or the investor wants to strategically exit the company. in case of shareholders, the investors would want to get paid first. Hence, these clauses are often referred to as ‘downside protection’ clauses and are meant to protect the investors from the adverse consequences of downside events.
- DRAG ALONG
Drag along rights means that a majority shareholder will be able to ‘drag’ a minority shareholder ‘along’ in case the majority shareholder wants to sell but the minority shareholder does not. This clause is beneficial to the buyer because it helps him get the most control of a company with a deal.
- WARRANTS
Warrants are security that allows the holder to buy a company stock at a predetermined price. A warrant clause in a term sheet focuses on the terms of the issue of such warrants. This clause is usually put with a warrant-purchase agreement clause, with the latter focusing on what the agreement will contain.
- DIVINDENDS
The dividend is a periodic payment done by the company to its shareholders from its net profits. In a term-sheet, this clause assumes the highest importance because investors would want to invest in the companies ‘equity only when they know that they are going to receive dividends out of it.
- ANTI-DILUTION CLAUSE
Investors always have an apprehension that their own shareholding in the company may get diluted in case the company goes ahead and issues new shares. For these purposes, the investors insist on an ‘Anti-dilution clause’. This anti-dilution is usually achieved by having an adjustment formula through which the investor’s original shareholding is arrived at.
- DURATION OF THE STAKE
In this clause, the investor will ensure that he will keep his investment in the company and he will not revoke it. Up to a certain number of years.
- TAG-ALONG RIGHTS
This clause is put in the interest of minority shareholders. It enables the minority shareholders to ‘tag along’ the majority shareholders in case the majority of shareholder are selling their stake in the company.
- EXIT-RIGHTS
This clause in a term sheet lists out, in brief, the different exit rights that an investor wishes to have in the investment.
- CONFIDENTIALITY
This clause is beneficial to both the investor and the company. It makes negotiating the deal without the fear of secrets getting divulged, easier, and hence, facilitates the agreement.
CAN I AMEND THE TERM SHEET LATER?
An amendment is a necessary part of any legal document. The term sheets are no exception to that rule. Hence, most term sheets come with an amendment clause that states how a term sheet will be amended. Terms set out in a term sheet may be modified at any time prior to signing the final funding agreement however, once a term sheet is signed, it is not considered appropriate to go back. This is because sometimes, the parties start drafting financial documents on the basis of this term sheet and going back again only results in wasting of time and resources.
CONCLUSION
Term sheet is very important document for a transaction document. The major terms of an investment agreed between the investor and the company are laid out in the form of this document. Term sheet are supposed to give the major points to both the investor and the investee to agree upon and based on these, go further with the transactional documents. It is famously said that a “signed term sheet” is more of a gentleman’s handshake than a legally binding document.
YLCC would like to thank Nikita Jain for her valuable contribution in this article.
