What do you Need to Know About Term Sheets?

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Entrepreneurs often find themselves looking to investors to raise capital to fund their business. Early stage investors, like friends and family, may offer financial aid to help you get your feet off the ground, but growing and scaling both your team and your business can be a slow and costly process. Oftentimes, the generosity of family and friends may not be enough to achieve your large scale financial milestones.

As your business progresses, you may decide to seek investment from venture capital investors (VC) in exchange for equity in your company. VCs invest in high potential businesses with the goal of earning a significant financial return once the businesses reach success.

Before any money exchanges hands, both parties must negotiate and agree on the term sheet. But how do entrepreneurs navigate a term sheet? What are some key parts that you should be aware of? What should or should not be included in the document?

What purpose do term sheets serve?

Term sheets act as an agreement between the investor and the company, and outline the most important terms that will govern the financial investment. The term sheet includes guidelines surrounding the amount of investment, protection from dilution, liquidation preference, participation rights, and exit strategy, among many other aspects.

   Term sheets act as an agreement between the investor and the company, and outline the most important terms that will govern the financial investment.

Although either parties can draft the term sheet, it’s most commonly provided by the investor. Term sheets can occur at the beginning or the end of the investment process. Some investors prefer to generate the term sheet early to ensure they have alignment on the most important terms with the entrepreneurs and the company. Other investors may wait until the end of the process to produce a term sheet after they have completed their due diligence and have established that there is a good fit between the investor and the company.

Term sheets are not legally binding, with two exceptions: the no shop clause and any confidentiality provisions. The no shop clause prevents the company from talking to other potential investors while the initial investor completes their work. The confidentiality provisions prevent the investors from disclosing any of the company’s private information.

David Harris Kolada, an Entrepreneur-in-Residence at the Altitude Accelerator, explains that like any deal, term sheets are negotiable. “One of the things I advise Altitude Accelerator clients I work with is to not underestimate your ability to negotiate. A lot of companies think that they can’t say no. You absolutely can say no,” Kolada says. “But, if you over-negotiate, the investor will walk away. Find that balance of how hard you can negotiate to get a good deal.”

Key terms entrepreneurs should know

Term sheets function as a framework, or an outline, of the final deal that you will enter with an investor. Good term sheets can be quite detailed and it’s important for entrepreneurs to hire an experienced lawyer who can help navigate the complexities of the document before signing and committing to the deal.

Some common key terms you should be familiar with include:

Agreement Types. When navigating term sheets, it’s important to understand the difference between a shareholder’s agreement and a share purchase agreement. A shareholder’s agreement governs the rights of shareholders and focuses on the ownership of the company. The shareholder’s agreement regulates how shares will be transferred or sold, how shareholders vote on certain key corporate matters, and who can sit on the board of directors. As soon as you have more than one shareholder, you require a shareholder’s agreement.

A share purchase agreement outlines the price of shares sold to a buyer by the seller. When an investor joins, the company needs a share purchase agreement because that will govern the terms of the purchase of shares, Kolada explains.

Liquidation Preference. After a company grows in value and is sold, the liquidation preference determines where, how, and in what order the money is distributed. According to Kolada, money is distributed first to statutory obligations, such as a payroll and tax remittances, then secured creditors, like loans, then unsecured creditors, and finally to shareholders. Upon liquidation, preferred shareholders (investors) receive their investment back before any of the common shareholders, which include company founders.

Preferred shares are structured in two basic types, Kolada explains. Non-participating preferred and participating preferred:

  1. Non-participating preferred allows investors to choose between receiving their liquidation preference, which may be one times the initial amount of money they invested, or converting and redeeming their proportion of ownership.Kolada provides a fictional example to illustrate this description. If a company sells for $90 million, an investor who initially invested $1 million can either receive their liquidation preference of one times the initial investment (essentially they’d receive their $1 million), or they can convert and redeem their 10% ownership equivalent to $9 million.This choice can produce drastically different results depending on the sale. Kolada offers another example of a fictional company that sells for $12 million. After paying off $10 million in debt, they have $2 million to distribute among shareholders. If the same investor as the previous scenario chooses to convert, they will get 10% of $2 million ($200,000). If they choose their liquidation preference, they can receive their $1 million.
  2. Participating preferred allows investors to do both, receive their investment and convert their ownership.

Some common key terms on term sheets you should be familiar with.

Convertible Debt. Convertible debt is a loan that can be converted into equity. With a convertible loan, it can either be repaid or converted into shares at a fixed or variable conversion rate.

Warrants. Warrants allow investors to purchase more shares at a fixed price at a later date. Warrants function as another form of investment and provide the investor with a larger return on their initial investment. One caveat Kolada notes is that warrants have an expiry date. If they are not exercised by the end of the term, they expire and can’t be redeemed.

Tranches. To mitigate risk, investors may provide money to entrepreneurs in tranches, also know as in stages. For high-risk companies, investors can use tranches to help protect their finances by establishing specific milestones that a company must achieve before they receive the remaining portions of the investment.

Building relationships with investors

Once you find an investor that shows interest in your business, it may still take a while before you officially negotiate term sheets and secure capital. Kolada recommends that entrepreneurs start the hunt for funding early and build relationships with potential investors.

“Don’t sneak up on money because it’s going to take longer than you think. The second reason why I say that is because you are in your growth phase. Your relationship with investors is more than just money. My advice usually is to get to know them a little bit, tell them what you’re doing. Find out whether there is a fit, not just in terms of what you’re doing, but what the investor might offer,” Kolada says.

For Kolada, he emphasizes that businesses should understand what the most important aspects of the deal are, and they should make those things clear to investors upfront.

“The term sheet is just a milestone in the financing process,” Kolada says. “It’s not the end of it, or the beginning. It’s an important step in the middle. The more you align with the investors before you get to the term sheet stage, the better the term sheet discussion will go.”

 

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