A term sheet is a commonly used tool in the financing of a new or growing company, although term sheets are used in many other types of transactions or negotiations (sometimes called memorandum of understanding (MOU), memorandum of terms (MOT), letter of intent (LOI), and other variations). Basically, a term sheet is a written mini-agreement between the parties to try to get on the same page. I explain it to clients that it may involve some costs and time for an attorney to help put this together, but it can eliminate or cut down on some misunderstandings and items of disagreements. The company will put down some of the material, i.e. major, proposed terms of the agreement the parties are trying to reach, write them into a written term sheet, and sign the document before moving any further in negotiations. This can significantly reduce costs in the long run because many times parties realize when they are paying attorneys to draft a lengthy agreement that the two sides don’t actually agree on some deal breaker points.
There are strategic issues involved and decisions to be made on whether to require a term sheet early on because many startup or small companies are afraid to ask a potential investor, VC fund, or other financing source to sign something very early on in the process. That is a decision that each company’s management must make, but you are usually better off having one and most investors are very familiar with term sheets.
Here are some common aspects of term sheets that need to be considered when dealing with financing of a business:
- Current and future capitalization of the company, including any outstanding options or other grants that could affect these number (this and the next bullet point usually come down to valuations of the company)
- Amount invested, number and class of shares and per share price if equity finance, or amount loaned and terms of loan repayment if debt finance
- Dilution- Will there be any anti-dilution provisions for the investor and what type of anti-dilution protection?
- Future capital issuances- Is the company reserving some equity or stock options to grant to employees, directors, management, or otherwise?
- Will the investor have rights to dividends or what is the company’s dividend policy?
- Does the investor have any liquidation preferences or rights in the event of winding up or bankruptcy of the business?
- Does the investor have any conversion rights to convert their stock or debt into some other interest in the company (e.g. convertible preferred converts into common stock) and what are the conversion ratios and other terms? Are there any rights of redemption (repurchase of their stock by the company)? What are their voting rights? What are their rights to information about the company?
- When dealing with a potential exit transaction by going public, what are their registration rights to have their stock registered to be more liquid? Will their be a lockup agreement and what will any lockup or market standoff agreement look like?
- Do they have rights in future raises, such as rights of first refusal or co-sale agreements?
- Will they have rights to place someone on the board of directors or into management?
- What are the terms for existing stock, options, etc? For example, are the founders shares subject to vesting to give them an incentive to stay with the company?
- What are the confidentiality provisions that the parties are subject to during the negotiations?
- Is the term sheet exclusive and does it terminate at a time or upon an event? Can the company agree to funding from other sources while still in negotiations with another investor?
- Payments from the funding are sometimes included, such as who chooses and who pays the attorneys who close the deal and if there was anyone who will be paid a commission, are they licensed and registered broker/dealers (see Finder’s Fees)?
Term Sheet Resources / Generators:
There are existing term sheet resources and term sheet generators with standardized forms on the web, some of which are listed below by hyperlink to outside websites. These documents and resources should not be a substitute for legal advice. They are meant to be educational in nature and, if they are used, are customized by the attorneys involved in the transaction. No representations, warranties, or guarantees are provided as to their content or use and use of these resources are subject to the outside website’s terms & conditions of use, including trademark and copyright laws.
Blog Posts and Articles with inside perspective and focus on startups and venture capital:
Related Blog Posts:
How could I discuss term sheets without referencing Brad Feld’s blog series on Term Sheets. Here is just one recent post: Using Veri to Understand Term Sheets
Legal Disclaimer: All answers and discussions in this article are meant to be general and educational in nature only and should not be relied upon as legal, business, or tax advice for your specific situation. Most discussions refer to laws and regulations as applied to a California corporation and these can vary by location, as can other factors in certain situations within California, so it is always best to consult with a licensed local attorney with experience in these matters. Use of, or any discussion as a result of these articles does not create an attorney-client relationship and is not governed by rules on confidentiality.