Term Sheets for Non-Dummies
-- by Molly Tranbaugh
The term sheet for a company’s financing is a critical document that can have a significant impact on the transaction as the parties draft and negotiate the deal documents. Here are a few key provisions and dynamics to keep in mind before you sign your next term sheet.
What is the point of a term sheet? We are sometimes asked about the importance of a term sheet when the terms are largely non-binding on the company and the investor. While only a few key provisions are in fact binding (more on that below), the term sheet still plays a critical role in the financing process. By agreeing to the major terms of the deal in advance, the parties can get on the same page from the start about the structure of the financing and the rights of the company and the investor. This streamlines the drafting process and the path to closing, before the parties agree to invest even more time and money in papering and further diligencing the deal. To that end, you should be sure to understand the entire term sheet before you sign—if you want to depart from those terms later, you risk losing the trust of the other party and delaying the deal. We recommend getting your lawyer involved as early as possible at the term sheet stage to avoid these issues from jeopardizing the financing.
Which terms are binding? A few key provisions of a term sheet are binding on the parties and can have a significant impact on the financing for both the company and the investor. The “no-shop” provision means that the company cannot talk with any other potential lead investors for a certain amount of time after the term sheet has been signed, usually for 60 days, and the confidentiality provision typically prevents the company from disclosing the term sheet to anyone outside its organization (other than potential smaller investors that have been approved by the lead investor). We recommend keeping the exclusivity period short to minimize the risk of a protracted negotiation—if the term sheet is ultimately pulled, the parties will have saved valuable time and resources. Finally, keep an eye out for legal fees. Companies often agree to cover the lead investor’s legal fees upon the first close, but some term sheets will require the company to cover fees even if the deal does not go through. Founders and investors should negotiate this provision carefully—a lead investor can dedicate significant time and resources to the deal and will want to be covered if it falls through. On the other hand, the company can get stuck with legal fees for a lead who walks away for reasons unrelated to the company.
What do I need to look out for? If you’ve seen even a few term sheets, they may all start to look the same. But these provisions often contain nuanced language that can have a big impact on your deal. For example, pay close attention to the composition of the board that you’ll be agreeing to in connection with the financing: what threshold of stock ownership does the lead investor need to maintain to keep its seat? Will the founder be entitled to appoint a director if she is no longer employed by the company? What happens to the CEO’s seat if she steps down or is removed? And in determining the company’s valuation in a priced round, be sure to understand how the share price is calculated, the size of the option pool, and what your ownership will look like after the final close. Whether we are representing a startup or an investor, we typically run a detailed pro forma at the term sheet stage so our clients understand what the cap table is likely to look like when the deal is done. Whether you are a founder giving away ownership in your company or an investor writing a significant check, you want to know what you’re getting (or giving up) for the money. Another key term addresses the founder’s current equity: will she receive an additional award and/or be unvested? We often find that term sheets are silent on founder equity, which can prolong and complicate the process of drafting the documents when the deal is already in full swing, leading to delays in funding.
Term sheets can have a big impact for both startups and investors in a company’s financing. Keeping these dynamics in mind when drafting and negotiating a term sheet can facilitate the transaction and help to avoid any speed bumps along the way.
