A term sheet is a document that outlines the terms of a deal between two parties. It’s an essential tool during the negotiation process. This article will go over 17 clauses to know about when negotiating a deal.
A term sheet is an agreement between two parties during a deal negotiation. It lays out the terms of a potential transaction.
A term sheet contains details of the key financial and other terms of a proposed investment between a founder and a finance source. It is also known as a ‘letter of intent,’ ‘memorandum of understanding’, or ‘principal agreement.’
It is the first step in a financing transaction in which the transaction terms are negotiated. These remarks are aimed at angel, venture capital, and private equity transactions. Still, they could apply to more traditional straight debt financing as well.
This article discusses the potential pitfalls that can lead to a founder inadvertently losing control and liquidity in their business during negotiations for funding for their company.
Here Are Some Fundamentals to Review:
Is the Term Sheet Legally Binding?
In general, no, except for legal liability for confidentiality, exclusivity, and costs. The goal is to define the terms and see if the deal has enough legs to close between the parties.
Valuation of Your Business?
Realistically assess your company’s worth using comparable companies as a benchmark. A high valuation may look great on paper. Still, it would also raise the bar for your level of performance if you want to get another round of funding in the future.
The founders must conduct thorough due diligence on anyone they will do business with. One of the major concerns raised by venture capital and private equity sources is that the founder does not complete their own due diligence on their long-term partner. Be precise about how your investors will help your company in ways other than funding.
Stocks, which include preferred stocks and common stocks, are the most common types of equity. Convertible debt notes are becoming more popular.
- Stock Classification: The preferred stock allows investors to have special terms and conditions that do not apply to other types of shareholders. And voting rights are often unevenly distributed among common shares. Preferred stockholders benefit from receiving their money before other shareholders. It also ends up paying a fixed dividend, is callable at any time, and can be converted to common stock at the shareholder’s discretion. These benefits are not available to common stockholders.
- Convertible Notes: Convertible notes have gained popularity as an alternative to a traditional stock equity structure. The main distinction is that a convertible note is a debt instrument with the option to convert into equity later. Convertible notes eliminate the need for a valuation discussion and are easier to negotiate than straight equity. Keep an eye on the capitalization rate, lower discount, interest rate, and when the note converts to equity or liquidity. When the note is converted, these will have an effect.
Partner Participation Rights:
There are three types, ranging in their economic upside potential to investors.
- Capped Participation
- Full Participation
The most owner-friendly choice. The investor must choose between a straight preference for liquidation or a pro-rata share of all proceeds.
The total return from liquidation and participation rights is capped at a defined multiple, just like the full.
The best for investors. The investor is given their liquidation preference first, followed by a pro-rata share of any remaining funds.
Determine the voting rights of each of the three types of investors.
Pro-rata rights give initial investors the option but not the obligation to invest in future rounds in order to maintain their ownership, which will otherwise be diluted.
The hierarchy of payouts upon a liquidation event, such as a company sale or merger, is determined by liquidation preferences. Liquidation preferences allow investors to specify their payout’s initial amount and breadth.
This right serves to protect an investor from equity dilution caused by future stock issues if the stock is sold for less than what the original investor paid in. This also adjusts relative ownership percentages to prevent new stock from reducing an investor’s stake.
Protective Provisions offer investors veto rights that they wouldn’t be able to exercise at the board level. Otherwise, their percentage stake doesn’t equal a majority vote. Examples are forcible discussions, such as a company sale, stock issuance to expenses, or hiring sign-offs.
Drag Along Rights
This clause allows shareholders to compel other stock classes to agree to their voting demands in the event of a liquidation event such as a sale, merger, or dissolution.
Right of First Refusal/Right of Co-Sale
To help prevent secretive stock transfers, all investors are notified when stocks are available for purchase by other investors. The board must approve all transfers of ownership of directors.
Include specific language as when and how the guarantor will be removed from the note if the founder is required to be a guarantor.
Vesting is the process by which a company’s shares/equity is earned over time typically four years or fewer. When a founder with vested stock leaves unexpectedly, the cap table is left with dead equity. This event may have significant ramifications for the remaining founders and funders.
Liquidation preferences allow investors to specify the initial payout amount they will receive.
Confidentiality and Non-Compete
These shield investors from potential conflicts of interest that could arise if they try to leverage their portfolio by sharing information or investing in competing companies. The duration of this insurance ranges from two to twenty years (as seen in oil and gas deals.) In addition, the founder wants the investor to be entirely focused on ensuring the success of the company.
Some deals, unfortunately, do not work out. Disputes arise that necessitate the intervention of a third party. If this action is required, make sure it is handled in the most convenient jurisdiction for you. For example, if the opposing party is from another state, you want your case to be heard in your own county and state.