A term sheet is a critical document in business transactions, particularly in investments and acquisitions. It outlines the fundamental terms and conditions agreed upon by the parties before finalizing a formal agreement. However, beneath its seemingly straightforward appearance lie key legal terms that require close attention. Understanding these terms is vital to ensuring a fair and beneficial agreement. Here’s a breakdown of the essential components of a term sheet and what to watch for in each.
Valuation
The valuation of a company is often the starting point in a term sheet. It determines the worth of the business and directly impacts the equity stake that investors will receive. Watch for whether the valuation is presented as pre-money (value before investment) or post-money (value after investment). A misunderstanding here can lead to unexpected dilution of ownership. Ensure the valuation aligns with the company’s financial health and market position.
Equity Allocation
Equity allocation specifies the percentage of ownership that founders, investors, and employees will hold after the transaction. Pay attention to the proposed cap table, which outlines the equity distribution. Consider how this will affect voting power and control of the company. If employee stock options are included, verify their size and how they impact overall dilution.
Liquidation Preferences
Liquidation preference determines how proceeds are distributed if the company is sold, merged, or liquidated. This term protects investors by guaranteeing a certain return on their investment before other shareholders are paid. Look for whether it’s a 1x liquidation preference (returning the original investment) or a higher multiplier, and whether it’s participating (investors also share in residual proceeds) or non-participating. This can significantly affect the founders’ and employees’ returns.
Voting Rights
Voting rights outline who has decision-making power on major corporate actions. Investors may request specific rights to approve key decisions like issuing new shares, selling the company, or amending bylaws. Scrutinize the balance of voting power to ensure it doesn’t overly favor one party, leading to a loss of control over strategic decisions.
Anti-Dilution Provisions
Anti-dilution clauses protect investors in the event of a down round, where shares are sold at a lower price than in previous funding rounds. There are different types, such as full ratchet (adjusting investor’s shares to the new price) or weighted average (a proportionate adjustment). These terms can heavily impact founder equity, so evaluate the specifics carefully.
Board Composition
The term sheet may stipulate how the board of directors is structured post-investment. This includes how many seats investors, founders, and independents will hold. A balanced board ensures diverse perspectives while preventing any one party from dominating decision-making. Look for terms that align with the company’s governance needs.
Drag-Along and Tag-Along Rights
These rights are essential in addressing future sale scenarios. Drag-along rights allow majority shareholders to force minority shareholders to sell under the same terms in a sale. Tag-along rights let minority shareholders join the sale and sell their stake at the same terms. Both terms should strike a balance between facilitating deals and protecting smaller stakeholders.
Exclusivity and No-Shop Clauses
Exclusivity clauses prevent the company from soliciting or negotiating with other potential investors for a set period. This ensures the current deal progresses without distractions. However, founders should ensure the timeframe is reasonable, avoiding prolonged periods that could harm the company if the deal falls through.
Confidentiality Provisions
A confidentiality clause protects sensitive information disclosed during negotiations. It’s crucial to verify that the terms safeguard both parties and explicitly outline what can and cannot be shared. This provision prevents competitors or third parties from gaining access to proprietary information.
Exit Terms
Exit terms define how and when investors can liquidate their investments. This may include IPO plans, acquisitions, or buybacks. Founders should ensure the terms are realistic and won’t prematurely pressure the company into an unfavorable exit. Investors, in turn, will want clarity on their path to returns.
Closing Conditions
The term sheet may specify conditions that must be met before the deal closes. These conditions can include completing due diligence, securing regulatory approvals, or resolving specific contingencies. Pay close attention to these as they may delay or derail the transaction if not addressed properly.
Conclusion
A term sheet is more than just a summary of a deal; it sets the foundation for the future relationship between the parties. By thoroughly analyzing the legal terms and seeking expert advice when needed, founders and investors can ensure that the agreement is equitable and positions both parties for success. Each term carries implications that extend far beyond the initial negotiation—so tread carefully and negotiate wisely.
