What is a Term Sheet?
If you’re thinking of a start-up or you’re a founder of one, you should probably know what Term Sheet is all about. It is a very crucial document if you need to raise capital and particularly important to mention all the relevant points as it can widely affect your business in the long-run. Though the term sheet is a non-binding document if you’re not well through with the components of the term sheet you might get into trouble. This is the stepping stone for the funding, where you don’t want to slip in the water. Let’s get started and we will be telling you all the important components.
A Term Sheet is a non-binding template that defines the important terms and conditions of the deal. It serves as a document that shows broad key points involved in the deal. This is prepared so the differences between founders & investors can be resolved and they can save their time before starting the legal procedure. Post this, another document is followed up which confirms the details of the term sheet and legal procedures get started.
While drafting a term sheet, keep in mind neither it should be much detailed nor it should be kept short. It just needs to be crisp, perfect, and to the point.
Components of the Term Sheet:
Some important terms need to be covered in the term sheet, missing out on them will automatically reduce your chances of moving onto the next step of legal proceedings with the investors.
Some important things that you need to keep in mind are:
Non-Binding: Neither the founders nor the investors are legally obligated to follow the guidelines mentioned in the term sheet as it is a non-binding document.
Investment Amount: The amount that will be invested by the Venture Capitalists (VC) into the company should be mentioned.
Company’s Valuation: The valuation of a company can be determined by two aspects which are Pre-money & Post-money. We’ll be explaining both the terms in the latter part of the article.
Percentage Stake: The percentage stake that investors will be picking up should be mentioned, so there are no clashes in the future.
Voting Rights: This is an important decision that needs to be considered for the start-ups as the company’s major decision can be heavily influenced if the founder is unmindful about voting rights.
Investor Commitment: The investor should specify the period for which they want to remain invested in the company.
Liquidation Preference: A pay-out order needs to be decided in-case of liquidation of a company. We’ll be taking you through this in the further section of the article.
Anti-dilutive provisions: This provision is also very important for the company & especially for existing investors. This clause is basically to protect existing investors because when new shares are issued, the price per share might be lower than what they have previously paid for it. There’s more to this provision, we’ll be explaining it to you in the further part of this article.
These terms give us a basic overview of the concepts that need to be enumerated in the Term Sheet. Now, let’s dive into some major terms their meanings & usage in the term sheet.
Some Binding provisions in the Term Sheet are sensitive-information and need to be followed.
Confidentiality: This part contains sensitive information regarding the company receiving the funds and investors are prohibited to share this information with any other party.
No Shop Provision: This is to protect the investors, so the target companies don’t approach other potential investors for the deal. This helps in saving time, efforts & money of both the parties.
Basic provisions in the Term Sheet –
Security Offered: It is important to mention the type of security - Equity, preference shares, debt, warrant, and the price per security that will be offered in the deal.
Capitalization & Valuation: We already know how capitalization plays a crucial part in the Term Sheet. Founders should mention the pre-money & post-money valuation of their company.
Pre-money can be defined as the valuation of the target company before the investment.
Post-money can be defined as the valuation of the target company after the investment.
Let’s understand this with the help of an example:
The investor and the entrepreneur agree that company is worth $1 million and the investor will put in $250,000. The ownership percentages will depend on whether this is a $1 million pre-money or post-money valuation. If the $1 million valuations are pre-money, the company is valued at $1 million before the investment and after investment will be valued at $1.25 million. If the $1 million valuation takes into consideration the $250,000 investment, it is referred to as post-money. (Source: Investopedia)
3. Dividend: There is a clause in the Term Sheet which specifies if a dividend needs to be paid or not. The dividend is usually given out in two forms: Cumulative basis or Non-cumulative basis. Mid-level companies do not prefer to give dividends when they are starting, thus they cumulate it and prefer to give at the time of liquidation.
Liquidation: This clause is important for the investors as it safeguards their initial amount of investment if a company goes bankrupt. A payout order needs to be set who will be getting the money and in what amounts. Sometimes, it can be in the range of 2 to 5 times the initial amount invested.
ESOP: Employee Stock Option Plan provides the company’s employee the choice to purchase the shares of the company at a discounted price for a certain period. ESOP is set aside from the founder’s equity.
Board of Directors: This provision deals with how many Board of Directors is going to be from the investor's side. This clause needs to be drafted properly by the founders so there is no effect on the major corporate decisions of the company.
Anti-dilution Provisions: We know that Anti-dilution is to protect the existing investors of the company. There are two protections attached to it namely Full Ratchet & Broad Based Weighted Average. The full ratchet method is a much harsh method as it can dilute the shares of founders to a large extent. In India, Broad Based Weighted Average method is preferred as it is a fair method. It doesn’t dilute the whole percentage of founders and impartial to investors as well.
First Refusal Rights: This clause mentions that founders must approach the preferred shareholders of the company first to offer their shares, and on their refusal, they can move to the third party.
Voting Rights: Voting rights are the shareholder's rights who have a say on different matters of the company. The founders of the target company must specify clearly where the power resides.
Board Rights: This is a crucial clause in the term sheet as founders can lose their control over the target company, if not specified. There should be a friendly ratio to which there are founders & investors elected on board. Major decisions of the company are taken by the board and it can affect the working of a company in the long-run.