What is a Term Sheet?
In the venture capital community space, a term sheet outlines the terms for a deal; it serves as a letter of intent given to a company seeking investments by a venture firm/ seeking a strategic partnership or takeover in order to outline the proposed terms for an investment/ acquisition transaction between the two parties. A term sheet has two important functions: it summarizes all the important financial and legal terms related to a contemplated transaction; and it quantifies, both in numbers and qualified terms, the value of the transaction or the venture capital financing. Typically, a term sheet is not a legal and binding document but is often considered a ‘gentleman’s promise’, from which the parties will not deviate 180 degrees. Often this ‘gentleman’s promise’ is linked to reputation an investor or a venture capital firm.
If the terms for a financing or acquisition as captured in the term sheet are agreed to by the parties, the document then serves the basis by which to draft the legal document surrounding the class of securities contemplated by the financing and to make modifications to the articles of association, where necessary. The value of a term sheet is its ability to focus parties in a deal on the essence of the deal prior to initiating costly legal drafting and to move them to close the transaction.
As a part of the process of agreeing on the terms of a term sheet, the two parties (the investor and the investee (typically represented by CEO or a core executive team of the company seeking investment)) participate in a series of discussions, with the expectations from the investors that the company will accept their proposed terms.
When an entrepreneurs or the company(ies) receives the first term sheet, they should consult their lawyer and decide whether the economics of the deal are close to what they expected them to be. If not so, then they should negotiate and square back the term sheet to the venture capitalist and their lawyers and finalize the tentative terms of the proposed transaction.
Section by Section Analysis of a Term Sheet
1. The Preamble: There can be certain exclusions or assumptions as to the length of time that a term sheet will remain in place, provisions as to entrepreneur’s ability to shop a deal to other investors, language pertaining to any quiet period or lock-up period.
2. Opening Information: Fairly standard provision and it has information on name of the parties, binding value of the term sheet and documentation of the fact that the proposed investment/ transaction is specifically subject to signing of definitive documents, legal due diligence, and other conditions precedents.
3. New Securities offered/ preferential issue: Information on number of equity shares/ preference shares/ options to be issued to the investor/ venture capitalist. This may have reference to SEBI ICDR guidelines on preferential allotment of equity shares (in case of listed companies). This clause could be expanded to include, board rights, level of influence etc over the company.
4. Total amount raised, number of shares, and purchase price per share
5. Post-Financing/ acquisition capitalization: The purpose of the post-financing capitalization section is to summarize what the capital structure of the company will look after the proposed new financing/ acquisition.
6. Liquidation Preference: This doesn’t necessarily have to be devastating for a venture capitalist. This tool enables favorable treatment for preferred shareholders in the event of liquidation.
7. Redemption: One way for venture capitalists to ensure the company does not become a lifestyle company. The purpose of the redemption clause is to make certain that the investors do not invest in companies that are unable to generate liquidity.
8. Conversion and Automatic Conversion: The purpose of this clause is to enable preferred shareholders to convert in the event of a liquidity event that is likely to generate a return that is higher than the multiple that is prescribed as mandated in the liquidation preference section (such as IPO of the company).
9. Dilution: Dilution clauses are the single most important tool for investors who want to ensure that any subsequent financing will, at the very least, not dilute the value of their investments below the price they paid in prior round.
10. Voting Rights
11. Protective Provisions: This would include prior approval in cases of merger, reorganization, sale, amendments to the company’s certificate of incorporation, be-laws, increase or decrease in the company’s number of authorized shares or the size of the board, declaration of dividends.
12. Board Composition
13. Information Rights
14. Share Purchase Agreement: This clause contain a brief on some of the important clauses in a share purchase agreement along with representations, warranties etc.
15. Conditions Precedent: This is provided more for education purposes, because it is often not necessarily included in entirety in most term sheets. This clause has information on completed due-diligence and customary share purchase agreement, satisfactory review of company’s compensation program etc.
16. Use of proceeds
17. Additional definitive agreements: Non-disclosure and no-competition agreements.
18. Restriction Agreements: such as right of first refusal, right of first offer,Tag-along rights, drag-along rights etc.
19. Miscellaneous: Clauses include, confidentiality, closing date, expenses, employee matters, legal counsel clauses etc.
In the venture capital community space, a term sheet outlines the terms for a deal; it serves as a letter of intent given to a company seeking investments by a venture firm/ seeking a strategic partnership or takeover in order to outline the proposed terms for an investment/ acquisition transaction between the two parties. A term sheet has two important functions: it summarizes all the important financial and legal terms related to a contemplated transaction; and it quantifies, both in numbers and qualified terms, the value of the transaction or the venture capital financing. Typically, a term sheet is not a legal and binding document but is often considered a ‘gentleman’s promise’, from which the parties will not deviate 180 degrees. Often this ‘gentleman’s promise’ is linked to reputation an investor or a venture capital firm.
If the terms for a financing or acquisition as captured in the term sheet are agreed to by the parties, the document then serves the basis by which to draft the legal document surrounding the class of securities contemplated by the financing and to make modifications to the articles of association, where necessary. The value of a term sheet is its ability to focus parties in a deal on the essence of the deal prior to initiating costly legal drafting and to move them to close the transaction.
As a part of the process of agreeing on the terms of a term sheet, the two parties (the investor and the investee (typically represented by CEO or a core executive team of the company seeking investment)) participate in a series of discussions, with the expectations from the investors that the company will accept their proposed terms.
When an entrepreneurs or the company(ies) receives the first term sheet, they should consult their lawyer and decide whether the economics of the deal are close to what they expected them to be. If not so, then they should negotiate and square back the term sheet to the venture capitalist and their lawyers and finalize the tentative terms of the proposed transaction.
Section by Section Analysis of a Term Sheet
1. The Preamble: There can be certain exclusions or assumptions as to the length of time that a term sheet will remain in place, provisions as to entrepreneur’s ability to shop a deal to other investors, language pertaining to any quiet period or lock-up period.
2. Opening Information: Fairly standard provision and it has information on name of the parties, binding value of the term sheet and documentation of the fact that the proposed investment/ transaction is specifically subject to signing of definitive documents, legal due diligence, and other conditions precedents.
3. New Securities offered/ preferential issue: Information on number of equity shares/ preference shares/ options to be issued to the investor/ venture capitalist. This may have reference to SEBI ICDR guidelines on preferential allotment of equity shares (in case of listed companies). This clause could be expanded to include, board rights, level of influence etc over the company.
4. Total amount raised, number of shares, and purchase price per share
5. Post-Financing/ acquisition capitalization: The purpose of the post-financing capitalization section is to summarize what the capital structure of the company will look after the proposed new financing/ acquisition.
6. Liquidation Preference: This doesn’t necessarily have to be devastating for a venture capitalist. This tool enables favorable treatment for preferred shareholders in the event of liquidation.
7. Redemption: One way for venture capitalists to ensure the company does not become a lifestyle company. The purpose of the redemption clause is to make certain that the investors do not invest in companies that are unable to generate liquidity.
8. Conversion and Automatic Conversion: The purpose of this clause is to enable preferred shareholders to convert in the event of a liquidity event that is likely to generate a return that is higher than the multiple that is prescribed as mandated in the liquidation preference section (such as IPO of the company).
9. Dilution: Dilution clauses are the single most important tool for investors who want to ensure that any subsequent financing will, at the very least, not dilute the value of their investments below the price they paid in prior round.
10. Voting Rights
11. Protective Provisions: This would include prior approval in cases of merger, reorganization, sale, amendments to the company’s certificate of incorporation, be-laws, increase or decrease in the company’s number of authorized shares or the size of the board, declaration of dividends.
12. Board Composition
13. Information Rights
14. Share Purchase Agreement: This clause contain a brief on some of the important clauses in a share purchase agreement along with representations, warranties etc.
15. Conditions Precedent: This is provided more for education purposes, because it is often not necessarily included in entirety in most term sheets. This clause has information on completed due-diligence and customary share purchase agreement, satisfactory review of company’s compensation program etc.
16. Use of proceeds
17. Additional definitive agreements: Non-disclosure and no-competition agreements.
18. Restriction Agreements: such as right of first refusal, right of first offer,Tag-along rights, drag-along rights etc.
19. Miscellaneous: Clauses include, confidentiality, closing date, expenses, employee matters, legal counsel clauses etc.
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