Decoding Deal Success: Understanding and Negotiating Term Sheets
What is a term sheet?
A term sheet is a summary of the key commercial terms of a proposed transaction. It is typically signed at the outset of a transaction and serves as a record of the main points the parties have agreed to and the basis on which they are prepared to proceed with their negotiations.
Term sheets are used in a wide variety of legal transactions, such as in the negotiation of large commercial contracts, mergers and acquisitions and various other types of contracts. Term sheets are also commonly associated with fundraising and investing in startup companies, where their use allows for both founders and investors to agree on the key commercial terms of the investment (e.g. valuation)and determine whether or not to proceed with their discussions.
Why is it Useful?
The main purpose of signing a term sheet is to align the intentions of the parties before they commit precious time and resources to finalizing a deal. Particularly in the case of early-stage investment, founders of a startup company are often under tight pressure to meet fundraising goals and need to shop around extensively for investors. For these businesses, there is a significant opportunity cost in going into time-consuming due diligence and negotiating the details if there is a high chance that the deal will not materialize.
Negotiation on the key items under the term sheet allows the parties to focus on the important commercial issues of the transaction and decide whether it is worth it – or not - to continue pursuing the deal. If the parties are not able to commit to the key terms of the investment, then it is better for both to move on and seek other opportunities.
Two considerations often arise in connection with term sheets. The first is whether all or some of its terms are legally binding. The second is whether the investor is giving an exclusive right to negotiate with the founders for a certain period of time. Typically, most provisions of a term sheet are not binding. This means the parties are only obliged to negotiate but not to close a deal in the agreed terms.
Exceptions are normally made for provisions establishing confidentiality and exclusivity. When agreed to, exclusivity means that the founder cannot seek other investors while the negotiations are ongoing. Confidentiality will allow the founders to reveal certain sensitive commercial information more comfortably and to allow for a legal and financial due diligence to take place.
Key Issues to Cover:
A term sheet should cover the key commercial terms of the investment. Typically, a “capitalization table” will be used to illustrate the ownership percentages in the company upon completion of the investment. The valuation of the business is one of the key terms negotiated and will determine the ownership in the company which the investor will acquire.
A term sheet should set out special rights which will be granted to the parties. These may include rights for particular founders and/or investors to take on directorship or management roles in the company. They may also include reserved voting or veto rights regarding certain company decisions. The term sheet could also address other relevant matters, such as how the invested funds will be used, whether a stock-option pool will be created to attract talent, and other issues which the parties consider relevant.
A term sheet will normally set out certain rights for the parties for future fund raising or share sales in the company. These may include anti-dilution rights for the current investors, as well as pre-emption rights and drag-along/tag-along rights for different shareholders of the company.
Term sheets should contain standard confidentiality, non-disclosure, and non-solicitation clauses to protect the startup business if the deal is not finalized for whatever reason.
Finally, the term sheet should also set out what are the key conditions to closing, typically this will include conclusion of a satisfactory due diligence by the investor and meeting certain conditions (such as resolving a major dispute or litigation).
Things to Pay Attention To:
Not all term sheets are created equal. Negotiations around a term sheet will often start around first draft which is provided by the investor, and which is weighed heavily in their interest. For this reason, it is important for founders to familiarize themselves with the key aspects of a term sheet and be able to protect themselves in negotiations surrounding the “investor draft”.
Founders should be particularly careful about what special rights are being offered to investors. While it is reasonable that investors will want a certain degree of supervision or involvement in the management of the company, the balance of power can easily tip in favor of the investor. Management and veto rights can be intrusive to the operations of the business and can be difficult to get rid of. Meanwhile, aggressive non-dilution or drag along rights can leave investors with outsized leverage in the negotiations of any future financing rounds.
Founders should be confident in negotiating their market valuation and the stake which they are selling. While the percentage for any given financing transaction may look small in isolation, dilution of founders’ stake will compound in each new financing round. Accepting a low valuation will leave less of the company to be offered to new investors in future financing rounds.
Finally, the most important thing to remember there is no “one size fits all” approach. A term sheet is a very flexible legal document. If there is any crucial matter or issue which needs to be clear from the very beginning, a founder must make sure it is discussed and agreed on in the term sheet.
This is the third in a series of articles offering practical legal tips for young entrepreneurs, to be published by the author in co-operation with the Macao Young Entrepreneur Incubation Centre, where he provides mentorship and consultation for its members.
