A term sheet is a non-binding agreement setting forth the basic terms and conditions under which an investment will be made. It is the first step of the investment transaction between the Investor and Investee. It acts as a base for the parties to draft more detailed definitive Agreements as it has all the important and key points of the Investment Contracts.
Importance of the Term Sheet
A Term Sheet is a basis for an investment contract, because of the following points it is essential:
• It brings the focus of the Parties at an early stage on essential commercial issues in the transaction;
• It enables them to respond to incomprehension and confusion;
• It allows the parties to develop key legal principles that allow them that frame the transaction’s definitive documents;
• Advises the parties of conditions precedent to be fulfilled before the final papers are signed
• It defines the due diligence process;
What does the Term Sheet Include?
The term sheet, when it comes to startup investment will include the following;
• Business info, existing shareholders and existing managers
• Company’s assessment and the money the company aims to raise
• Certain rights to continue as directors for particular promoters or investors
• That investors have ‘reserved rights’ concerning some big company decisions
• Information on the use of the funds invested
• Any limits on founders’ activities
• A description of the stock issue and ownership rights and what happens when the company is sold or wound up
• Liquidation Preference
• Anti-dilution controls
• Investors’ exit rights
• Pool option.
• Access to details and inspection rights
• Clause of arbitration
• Article of Controlling Authority
• Other requirements and regulations
What are the Most Important Provisions in the Term Sheet
1. Drag along rights – A controlling shareholder will compel a minority shareholder and a partial shareholder to sell their stock.
It means ‘you have to sell it if I sell.’
2. Tag Along with Rights – A tag along provision enables the minority shareholder to sell their stake in case the majority shareholder is selling theirs. The minority shareholders are entitled to sell their stake at the same terms and conditions as the majority shareholder/s.
It means “I have the right to sell with you if you sell.”
3. Option Pool – Also known as an “Employee stock option pool,” it is an option given to the employees which gives such employees the right to purchase or subscribe to the securities offered by the company at a predetermined price on a future date.
4. Affirmative Rights –This clause lists the events in respect of which the investor’s consent has to be taken. Examples include:
• Amending corporate records
• Changing company equity, including issuing new shares, creating new classes/series of shares, issuing ESOPs, etc.
• Pay dividends
• Issuance of any new shares or other instruments
• Any merger, asset transfer, takeover, control process adjustment, etc.
• Company liquidation or breakup
• Other important occurrences
5. Liquidation preference– This provision provides for the pay-out order in case of liquidation by the firm. The creditors or preferred stockholders of the company will usually get their money first instead of other stockholders or debt holders if they are liquidated.
6. Anti-dilution protection – It prevents the interest of existing shareholders if the company further issues equity at lower valuation as compared to a previous round is known as price-based anti-dilution protection.
7. Exit Rights – Under this provision, details on the investor’s safe exit from the company are described. Some standard inclusions are:
• Preferred Exit
• IPO, Next Funding Round
• Drag Along
• Tag Along
Term Sheet acts as a base document and the parties must be clear whether or not they want the agreement to be binding. As a founder, you need to be cautious about contracts that limit your ability to work too long with other investors and to be even more careful with an investor who wants to place a penalty on you if the terms of the agreement are violated for any reason.
If they do not accurately represent what has been negotiated or fail to discuss key issues, term sheets can be problematic documents to use because any ambiguity can create confusion about the exact nature of the relationship between the parties. Too much detail can lead to delays and costs because you will discuss and negotiate upon the same contract twice. Very little can mean that none of the key business problems have been dealt with, and then you can find out that you never had an agreement. You can save time and money by having a good term sheet, but a bad one would do the opposite.