Every funding round will be concluded with a set of agreements collectively called investment documents. These are the term sheet, the shareholders’ agreement, and the investment or subscription agreement.
In this blog post, we look at some key elements of a typical term sheet. Later, we will dive deeper into the term sheet and address the shareholders’ agreement and investment agreement in upcoming posts.
What is a Term Sheet?
A term sheet is typically the first document to be signed between the investors and the startup. It is intended to lock down key terms of the investment and related conditions. Whereas a typical shareholders’ agreement can run for twenty pages or so, a term sheet is a relatively short document (a couple of pages) that summarizes the key terms of the investment.
As a shareholders’ agreement is a heavy document with detailed clauses for legal reasons, it does not form an ideal basis for negotiating the key terms of an investment. Contrary to the shareholders’ agreement term sheet is meant to be used in the negotiations to agree on the main elements of the transaction.
Typical Terms in a Term Sheet
As the term sheet is about investment, the apparent term to agree on is the actual investment. The first one, of course, is how much is to be invested and, in the case of a syndicated investment, how the investment is allocated between the investors.
It can also be agreed the investment is made in tranches. In this case, the trigger of each tranch should also be agreed upon.
The second important element to be agreed upon is the company’s valuation, i.e., the consideration of what the investors get in exchange for their investment.
Be clear about what you agree on: Specify if this is a pre- or post-money valuation, or what is the price per share or the stake in the company investors will get; using more than one of these is totally fine and even recommendable (you do not want the investment to fall down just because there was a misunderstanding on the valuation, to begin with).
Governance of the Company
Investors typically require a seat on the board of directors, so it is feasible to agree on the board’s composition and the rights to nominate and remove board members.
Minority shareholders usually also require some kind of veto rights to the significant decision regarding the company, e.g., exiting it. These kinds of qualified majority decision requirements can also be outlined in the term sheet.
Especially early-stage startups are running with incomplete teams and need to hire some key personnel in the future. And these key persons are usually incentivized with options or shares. To align the views of the founders and investors from day one, it would make sense to agree on the size of the option pool already on the term sheet.
Liquidation preference refers to the investors’ right to receive their funds back before other shareholders get proceeds from the company. Despite the name, liquidation preference usually applies both in liquidation and exit.
In practice, 1x non-participating liquidation preference would mean that in case of an exit below the valuation the investors have invested in, the investors get their money back first, and proceeds above this, if any, are distributed to other shareholders. On the other hand, in an exit above the investment valuation, the proceeds are spread pro-rata between all shareholders.
A participating liquidation preference differs from a non-participating liquidation preference, so after the investor has received the preference, the rest of the proceeds will be distributed pro-rata to all shareholders (i.e., there is no catch-up for the other shareholders).
The terms above are typical ones that included most of the term sheets for investing in early-stage companies. However, there might need to agree on additional terms on a case-by-case basis. These terms may include clauses on, e.g., founders’ compensation, recruitments, IPRs, applying for grants, and so on.
Is a Term Sheet Binding?
It is often asked whether a term sheet is binding or not. And unfortunately, here come’s a typical lawyer’s answer: It depends. Some term sheets are not binding in any shape or form; some give a right to deviate from the terms only if something material comes up in due diligence; some give exclusivity for a certain period for the investors to negotiate the investment, and so on.
Whether the term sheet is binding or not, one should remember that one should only sign a term sheet once one is committed to concluding the transaction. Renegotiating terms after signing this is not a good practice.
In many ways, the term sheet is a more critical document in investing in a company than a shareholders’ agreement. In practice, it concludes the negotiations between the parties into key terms they are prepared to accept. While finalizing these terms, the shareholders’ agreement is more of a document to provide the backbone for running the company after the investment.
A following blog post will dive into the shareholders’ agreement in more detail.