Drafting A Term Sheet: Essential Factors Founders Should Look For

Every entrepreneur should understand the different aspects of drafting a term sheet. You might ask why this is crucial, considering that you’ll receive a term sheet from investors. Or potential partners with whom you intend to collaborate in a merger or acquisition (M&A) transaction.

Understand that this vital document outlines all the key terms and conditions of the investment deal. You should view it as a preliminary agreement that investors or their legal counsel draft before you sign the final contract. Of course, the term sheet is not legally binding and is open to negotiation.

When you receive the term sheet, you’ll scrutinize it with the assistance of professional legal advisors. You’ll keep a close watch for toxic or predatory conditions hidden amidst legal jargon. At this time, you have the option to request changes or walk away from the offer.

Drafting the Term Sheet: Key Components to Expect

A well-drafted term sheet sets the tone for negotiations and guides dealmakers through the complex process while explaining their obligations. You’ll get an understanding of what to expect once you sign the finalized deal and accept capital.

The final legal agreement is drawn up only after the negotiations are complete and both parties have accepted the conditions. The term sheet is also called a “letter of intent” (LOI) but in the case of an M&A deal. An investment term sheet forms the basic framework for drafting the final agreement.

Here are some of the key components of the term sheet:

• Identification: Specifying the names of the investors and other entities involved in the deal.
• Valuation of the company in which investors will invest capital.
• Cap table offering details of the existing share ownership structure
• The investment amount or the exact funding amount that the investors will provide
• The percentage stake or the ownership stake investors can expect in lieu of their capital
• The time frame within which the concerned parties must make their decision to finalize the deal
• Voting rights or the say investors will have in the decision-making process
• Drag-along clauses that force major stakeholders to push their decisions on minority holders
• Dividends investors expect to receive by way of profit-sharing
• Pro-rata rights or the right to participate in further funding rounds
• A no-shop clause limiting the company’s right to scout around for other investors after receiving the term sheet
• The number of board seats the investors expect and how they can exercise their rights

While this is the basic information you’ll examine, a dirty or predatory term sheet may have additional provisions. These provisions are designed to protect investors’ interests and investments while maximizing their returns and limiting the founder’s rights.

Characteristics of a “Clean Term Sheet”

Regardless of who is drafting the term sheet, here are the key characteristics of a “clean” or fair and equitable term sheet.

• All the terms and conditions should be clear and in an easy-to-understand format. Confusing and ambiguous language typically results in disputes down the line that you want to avoid. Be mindful of legal terminology that can have different meanings and implications. If needed, request clarification and changes to the term sheet.
• Ensure that all the key information is included and explained in simple language.
• Aside from the valuation and rights, there should be an explicit mention of the milestones investors expect.
• The document should address and protect the interests of all the parties involved. Fairness fosters an atmosphere of trust and cooperation, which is essential for building a productive and long-term partnership.
• The terms and conditions should ensure compliance with relevant legal and industry-specific standards and regulations.
• The document should be flexible and account for contingencies. It should outline the action parties can take in case of unexpected situations. Furthermore, it should maintain open lines of communication to enable reasonable adjustments.
• Whatever the type of deal–investment or merger and acquisition (M&A)–it typically involves sharing sensitive information. All the parties should commit to safeguarding the data shared with them during the due diligence process.

Although the term sheet is not legally binding, much of the information and data it contains has legal implications. It’s advisable to have expert advisors at the table when navigating the negotiations. They can identify issues that may have been overlooked.

Additional Information in the Term Sheet You Should Scrutinize

Aside from the fundamental details listed in the foregoing section, legal counselors include other terms when drafting the term sheet. Here’s what you need to know:

Types of Securities and Their Rights and Privileges

The particular type of shares or securities you’ll offer for the capital, such as preferred shares or common stock. This information is crucial, as it confers certain rights and privileges on investors.

They get preferential treatment when receiving dividends or their capital, along with accumulated interest in the event of an exit. Whether founders choose to sell the company or enter into a merger or acquisition (M&A) deal, investors typically receive preferential treatment.

If the company goes bankrupt, they are entitled to recoup their capital from the sales of its assets. Even if you, the company owner, get nothing, investors can claim their fair share. Scrutinize liquidation preference clauses as they outline what happens in the event the company faces financial hardship.

Founders are usually open to offering preferred shares since this asset class indicates that the company is stable. They can also raise their chances of securing funding because investors are more confident that their money is safe.

However, offering preferred shares can also mean that you get nothing, even if the company is sold for billions. Don’t let the need for capital cloud your judgment. Read the fine print to understand how investors calculate the multiples of their initial investment, aside from the original capital.

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Voting Rights

Contemporary venture capitalists (VC) in the business landscape are more than just investors. They are also strategic partners with a vested interest in the company’s long-term success and profitability. Having VC-assigned board members can be a significant advantage since you can count on them.

VC representatives offer valuable, industry-specific guidance, steering the company along complex pathways to assured growth. However, board seats come with voting rights that investors include when drafting the term sheet.

Before accepting the terms, you’ll define the scope and extent of those rights. Also, define veto rights and VC rights to receive regular updates on the company’s ongoing performance. As long as the VC’s objectives align with your long-term vision for the company, voting rights are a benefit.

However, these rights can quickly become hurdles when a conflict of interest arises. Never lose sight of the fact that VCs have a fund lifecycle of around 10 years. Though, in some cases, they extend this time frame by a couple of years.

Accordingly, the board member may push for accelerated growth, even though the company is not stable enough to support it. Or, they may push for a premature sale or an initial public offering (IPO). These moves can prove to be disastrous.

Voting rights can interfere when you need to make critical decisions that may not necessarily favor investor interests. This is why you should ensure that the term sheet clearly specifies how votes are cast and counted. Particularly when they impact the company’s future.

To prevent that from happening, you’ll limit the issues on which investors will have a say. For instance, when allotting option pools to employees and hiring talent and skill sets to expand the team. Or, when purchasing critical business assets and acquiring intellectual property (IP).

Anti-Dilution Provisions

Investors typically require anti-dilution provisions and may add relevant clauses when drafting the term sheet. They use this strategy to secure their ownership stake in the company when you raise further funding rounds. Each round involves issuing new shares that can result in dilution.

Investors typically have the right to convert their stake into common stock using either of the two primary methods. These can be a weighted average (based on a formula) or a full-ratchet by adjustable rate. Anti-dilution provisions thus sweeten the deal when you’re prospecting for capital.

However, you should be aware of the impact of these clauses on your ownership stake. If the company raises a down round, you may need to offer stock at a lower valuation. You’ll raise funding by offering shares at a price lower than the price in a previous round.

Not only do you risk diluting your stake, but you also stand to lose control over the company’s decision-making. Prevent this situation from happening by negotiating for more founder-friendly clauses. For instance, you could include only broad-based weighted average anti-dilution provisions.

These provisions can secure your ownership and controlling rights while keeping the doors open for further funding rounds. You can’t risk discouraging future investors because of the anti-dilution clauses you offer in the current round.

Dividend and Profit Sharing

Since investors own stock in the company, they are entitled to receive fair dividends and a share in the profits. These returns are over and above the profits they’ll make when they exit the company. The term sheet specifies the regular income stream investors can expect to earn from the investment.

When companies earn profits, the board of directors can choose to retain a portion of the earnings. It rolls the earnings back into the company to fuel growth and lower its dependence on investor capital. Investors and shareholders receive the remaining profits through cash distributions.

Alternatively, the board may buy back the shares issued to external holders. This strategy lowers the number of outstanding shares in the market and also returns cash to investors. A buy-back also helps to boost a company’s earnings per share (EPS). Several factors can influence the board’s decision.

For instance, industry standards, the company’s internal financials, and its ability to sustain the high dividends in future payouts. Dividends can also be cumulative or non-cumulative, depending on the asset class. Most preferred stockholders have the right to cumulative or assured returns.

Even if the company is unable to pay dividends at a given time, the dues add up over time. It must make cumulative payments when the funds are available. If investors include cumulative returns clauses when drafting the term sheet, you’ll review feasibility before accepting the provisions.

Ready to learn more about what a term sheet is? Check out this video, in which I explain the details in detail.

Additional Clauses

Several other clauses in the term sheet may be a cause for concern and require further negotiation. Leaver clauses are one of them. Recognize that investors require founders to remain on board and oversee company operations for as long as possible.

More than the company’s business model, product-market fit, or customer base, they focus on the face behind the company. Investors bank on the founder’s business acumen and experience with successful startups in the past.

This is why they may include leaver clauses that make it harder for you to exit. Ensure that the term sheet does not have any unfavorable conditions that result in your losing out on fair compensation. Then again, you’ll check for clauses that allow investors to exit the investment.

Look out for provisions that allow them to sell their stake to third parties without your knowledge. As mentioned in the foregoing sections, investors are also strategic partners. Current stakeholders may sell their stake to other investors whose interests may not align with the company’s vision.

These are contingencies you should plan for when negotiating the term sheet and its clauses.

The Takeaway!

Understand that a term sheet is a preliminary document that merely outlines the basic investment terms and conditions. It is not a commitment from the investors to provide capital. Most importantly, it is open to negotiations.

Take your time reading and analyzing the contents with the assistance of your fundraising consultant and legal team. Ensure that the language is clear, and there are no pitfalls concealed in the legal jargon. Don’t hesitate to ask questions if something is unclear and request changes as needed.

Drafting the term sheet is only the first step. Once all the concerned parties agree on the provisions, they can move forward with creating the definitive agreement. Only then is the investment deal final, and they can sign the paperwork according to the pre-determined deadline.

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