What You Need to Know About Term Sheets
June 30, 2016
Term Sheets & Their Role in Business
Whether seeking to obtain financing, negotiating the purchase of real property, or entering into a partnership, most small business owners will encounter term sheets at some point. In its most basic form, a term sheet is a non-binding document that sets forth the material terms and conditions of a business agreement. It then serves as a blueprint for drafting the final contract.
The Benefits of Term Sheets
When negotiating a complex business deal, a term sheet ensures that everyone is literally on the same page because key terms are outlined in bullet points. It also ensures that the parties have reached an understanding of at least the key elements involved in the deal before they spend additional time and resources to reach a formal legal agreement.
“…term sheets are often an essential part of securing financing…”
While the parties are generally not bound to the elements of the agreement laid out in the term sheet, there are often two aspects of the document that are specifically stated to be legally binding. For instance, term sheets may contain non-disclosure provisions that require the parties to keep the negotiations confidential. Term sheets may also contain exclusivity provisions that prevent the one or both parties from negotiating with other potential business partners for a specified period of time. The provisions are intended to prevent businesses from using the term sheet to negotiate a better deal with someone else.
The Role of Terms Sheets in Start-Up Funding
For new and growing businesses, term sheets are often an essential part of securing financing. Even though they are intended to be stripped down versions of the final agreement, term sheets can still be overwhelming for first-time entrepreneurs.
While the entire document should be carefully negotiated, below are some key provisions to watch out for when meeting with venture capital (VC) firms and other potential investors:
- Valuation: Determining the price per share is clearly one of the most important terms. However, entrepreneurs should remember that a higher price is not always best. In some cases, agreeing to a slightly lower price can result in more favorable investment terms. In addition, start-ups should be cognizant of the impact a high valuation can have on successive rounds of financing.
- Liquidation Preference: This provision determines the division of proceeds between shareholders (common and preferred) should the company be later liquidated via a sale, merger, etc. In essence, the liquidation preference dictates which parties get paid first and how much. Prior to agreeing to any liquidation preference, it is imperative to do the math to determine how much the venture capital funders and the company founders will receive under each scenario.
- Vesting Schedules: Term sheets may be used to establish a vesting schedule for stock and/or options held by company management, employees, and even those held by founders. VC’s often seek to negotiate for the founders to re-vest their equity over time, it is important that all founders are on the same page in terms of stock allocation and vesting, i.e. monthly vesting over a period of years. Other issues to address include what happens if one of the founders leaves the company due to resignation, termination, or even death/incapacitation; in addition, there may be potential negative tax consequences to be considered in the event of re-vesting.
- Board Structure: Board composition and structure is another key issue addressed in a term sheet with investors. While bringing in outsiders is often essential to growing a business, founders should be mindful of how this will impact the day-to-day operations of the business. Key issues to consider include the skill sets of board members, what decisions will require board approval, and voting procedures.
While term sheets can be headache-inducing for small business owners, experienced lawyers are well-versed in how to negotiate and document complex business transactions. Therefore, it is advisable to consult with experienced counsel early in the process rather than simply relying on your attorney to draft the final contract.