What is a Term Sheet?
What is a term sheet and why do investors draft a term sheet before proceeding with negotiations?
A term sheet is a document that is commonly used in the world of investors, venture capital, business angels, and private equity firms. A term sheet can be considered as a "list of terms". And that's what it is: a list of terms drafted to lead to a definitive agreement with a party to attract equity financing. A term sheet almost always precedes the negotiations that should result in the definitive agreement. This latter document is called a participation agreement. It includes the final and definitive terms for an investment.
Term Sheet and Letter of Intent
A term sheet fulfills a comparable role to that of a Letter of Intent (LOI). An LOI is also intended as preparation for the definitive agreement. A term sheet is often a list of points, while an LOI contains more elaborated text with fancy phrases. Both documents are intended to be non-binding. However, it is not stated anywhere that they cannot be binding. In such a contract, you can agree on anything. You can use many beautiful words to state that you intend to achieve a certain goal together without any specific consequences. However, it is often seen that a term sheet or LOI does contain binding agreements with corresponding consequences. Please, be aware of this and read carefully what you sign for. For example, what are the consequences if you terminate the negotiations and seek another partner for financing your startup?
Term Sheet and the Articles of Association of your startup
How does a term sheet relate to the articles of association of your startup? The articles of association, along with any shareholder agreements, form the basis of your company. These contain the agreements and internal rules that apply within the company as a legal entity. According to the law, the articles of association always state which legal entities own the shares of your company and in what proportion. Legal entities in this case can be other companies or natural persons. When you agree with an external party, such as a business angel or private equity firm, to invest in your company, this investment will always take place in exchange for shares, so that the investing party becomes a co-owner of the company. The investment is therefore always accompanied by a partial transfer of shares from the current shareholders to the new shareholder, and this requires an amendment to the articles of association. The rules governing the amendment of articles of association vary from one country to another. In some jurisdictions, such as the United Kingdom, a company may amend its articles of association internally, typically with the consent of its shareholders. This process involves passing resolutions at either a general meeting of shareholders or a board meeting of directors, depending on the nature of the proposed amendments. In other jurisdictions, however, amendments to articles of association must comply with the regulations of a governmental authority or regulatory body. For example, in the United States, amendments to corporate bylaws typically require approval by the board of directors and, in some cases, may also require approval by shareholders. Additionally, the amended bylaws must be filed with the appropriate state agency, such as the Secretary of State, for formal registration.
When you are negotiating with an experienced investor who is interested in your project or startup and may want to invest in it, they often come up with a proposal for a term sheet. As mentioned above, the term sheet basically does not contain legally binding agreements (it is therefore a so-called non-binding offer), except for some provisions that are binding. This may concern confidentiality and exclusivity (you agree, for example, not to negotiate (further) with other parties during the negotiations, which is logical in itself). The term sheet is usually drafted by the investor, with the intention that as many of the points mentioned will be included in the final participation agreement.
Get Your Term Sheet Checked by a Lawyer
It's wise to have your term sheet reviewed by a lawyer. While it often contains standard provisions, it's still good practice (if you have te money for it, of course) to have someone else with legal expertise take a look. Especially if your negotiating partner is a large company with a complete legal department where the knives of dozens of lawyers are already sharpened...
Also, note that not everything is filled in detail. Try to keep as much flexibility as possible, so there's room for negotiation later on. Use terms like "to be determined" and "as customary." An important item, for example, is the percentage of shares you're willing to give away in exchange for the investment. Often, a final decision on this is made only at the end of the entire process. It's also better to decide this later when more trust has been built between you and the investing party and it's easier to be accommodating to each other. After all, trust is crucial for financing.
Due Diligence Investigation
After all parties have agreed on the contents of the term sheet, the so-called "due diligence investigation" often follows. This is an investigation conducted by the potential investor to verify whether all facts and assertions made by the entrepreneur are correct and to ensure that "no skeletons are found in the closet." If this investigation is also satisfactorily completed, negotiations will proceed towards the aforementioned participation agreement. If new, unexpected facts come to light during the due diligence investigation, it may result in the terms of the participation agreement looking different from those in the term sheet. Naturally, the final participation agreement is binding.
A term sheet can include agreements on the following topics:
- What amount is involved? What is the size of the investment?
- What percentage of the shares does the investing party receive for this investment? This also determines the price per share, the total value of the shares, and thus how much the investing party has estimated the value of the company or project.
- What is the purpose of the investment, and what can the money be used for? Not a nice car for the founder of the startup :-(
- What are the conditions for closing? Closing is the final step in the whole process. This mostly includes a business plan with a robust budget approved by the investing party.
- Provisions to ensure that in the event of subsequent investment rounds by other parties, the share of the current investing partner is not diluted too much (anti-dilution protection).
- What is the period during which shareholders are not allowed to sell their shares (this is called the lock-up period)?
- What are the special rights of the investor? For example, the appointment of members of the Board of Commissioners.
- What information about the company's operations must the management send to the investing party and how often?
- What other documents are relevant? For example, this may involve articles of association of the company) and a separate shareholder agreement. Certain matters can be addressed in a shareholder agreement but could also fit into the participation agreement. These are choices that are made, but it is important that the documents align well. This is legal work for specialists.
- The deadline by which closing must take place at the latest, as well as the validity period of the term sheet.
And here is a list of non-binding agreements that are usually included:
- Exclusivity. It is agreed that no negotiations will be conducted with anyone else during the negotiations.
- What is agreed regarding confidentiality?
- Which law applies in case of disagreement?