As an owner of your start-up, it is essential to understand everything about the term sheet to make informed decisions. Follow along to guide the terms and clauses in the Term Sheet.
If you have already pitched to the investors and some investors, have shown interest. Before proceeding further into concrete negotiations, you must know all about the term sheet and its standard clauses. The term sheet determines the growth of your start-up and the deals with your investors. Therefore, knowing the basic foundation, terms and clauses in the term sheet is essential.
What is the Term Sheet?
The Term Sheet is a written draft document with the terms and conditions regarding the deal. The paper comprehends the key points included in the agreement agreed upon by both parties before executing legal agreements and beginning with the tedious due diligence. The document serves as a template later for drafting an express agreement by the legal teams.
The Importance of the Term Negotiation Sheet
As a founder, you must raise the required capital while retaining upside, controlling, and limiting downside risks. The term sheet deals with dividing the risk and upside between parties. Numerous standard clauses can help anyone with the same. Situations can differ, yet understanding the clauses should be the first step to making the necessary decision. This document shows your investor’s actual colour, and you can assess their standpoint by judging what they ask or push for.
Types of Shares
Before letting your investors into the business entity, you have established your company, creating common shares. To ensure further investment, you need to issue additional shares. In this process, you might have to add some clauses which can facilitate creating a different share class. For example, a B class new share is created where holders might have fewer voting rights than the original A class shareholders. Preferred shares are another related instrument. It is used for startups to facilitate creating different rules. It is senior to average equity, meaning that these shares hold more on the company’s assets than ordinary shareholders. This can play a significant role in the case of liquidation. Venture investments are generally issued in those preferred shares so we will discuss negotiating the term sheet of preferred shares.
What is a Capitalization Table?
A capitalisation Table is an overview of the capitalisation of the business entity. Generally, this critical document is stored in a spreadsheet. It tracks down the equity ownership of the security and shareholders of the company and the value of the equity. Cap tables have to be accurate and comprehensive. They need to include every element of the stakeholders, such as stock options, convertible debt and warrants, and the preferred and common stock. The table underlines basic information like key investors and founders’ holdings.
What are the Key Term Sheet Clauses?
Investment can be dictated by investment and valuation. But as investors try to minimise the risk by preparing themselves for the best return, numerous additional clauses that can hugely impact the deal need to be added. An agreement with a lower valuation and better terms often turns out to be good. The principal clauses of the term sheet are-
-
Deal Economics:
To protect your small share in the big company, it is needed to know the deal economics. You need to be careful with specific terms, as your current term sheet will drive your upcoming financing round.
- The term sheet outlines the investment amount per lead and non-lead investor
- Pre-money valuation means the value excluding the raised fund, and post-money valuation implies the company’s value after receiving investment, which is another essential item in the sheet
- Conversion rights make the preferred stock more valuable than normal stock. Conversion rights can be mandatory and optional
- A sizeable option pool can be organised to attract talent via shared equity
- Liquidation preference can determine the party who will receive the money first and its amount in case of a liquidation, a sale or bankruptcy
- If the preferred equity participates, there may be a double-dipping since the participating preferred receives a shared pro-rata
- Asking for dividends can guarantee a certain amount of return.
-
Investor Rights and its Protection :
The most preferred clause for protecting the investment is anti-dilution rights which can be of different types. Full-ratchet anti-dilution refers to a condition when new shares are issued in the future at a lower price, and thus, the Series A cost is also reduced to a lower price. Another type can be Weighted average anti-dilution, where the new price is decided upon considering the number of issued shares. Other rights include pro-rata rights for maintaining the ownership level of the investments, Co-sale privileges and ROFR and the No-Shop Clause, which prevents the business from asking for investments from other companies.
-
Governance Control and Management :
Term Sheet should also consider who is in control of the business. The terms include voting rights which saves the rights of the shareholders to vote regarding corporate policy. Board rights are establishing policies for managing corporates and oversight and making significant decisions. Other rights are Information rights and founder vesting, which helps control and manage company policies.
-
Liquidity and Exits :
When it is cashing time, the drag-along rights prevent minority shareholders from blocking the sale of the business entity which was pre-approved by majority shareholders. Tag-along rights help minority shareholders with the right to participate in any action along with the majority shareholders. Redemption rights help the investors with the right to ask for the redemption of the stock in a specific timeframe.
Conclusion
A term sheet is a pre-contractual agreement signed by the target and the potential buyer and outlines the proposed transaction’s key terms. It is generally non-binding. Nevertheless, term sheets frequently include legally binding clauses relating to non-solicitation, exclusivity, secrecy, etc. Before signing final agreements, a term sheet, also known as a head of agreement or memorandum of understanding, is created. The terms of a term sheet are heavily negotiated between the parties to a transaction, as was already said. After the investor agrees with the target firm, the term sheet enters the scene. The first crucial stage in the transaction is the creation of a term sheet.
Follow Vakilsearch to discover an answer to any of your legal-related questions and clear up any doubts you may have.
Read more:
