Quick Guide To Understand Term Sheets in Business Funding

While raising business funding, one of the most common terms that entrepreneurs come across is the term sheet. Term sheets are nonbinding documents presented by the investor to the entrepreneur which is a prequel to the shareholder’s agreement. The document includes the requirements by the investor for small business funding which can be negotiated by the promoters of the enterprise. The document is issued to arrive at a preliminary arrangement to determine whether both the parties involved are in agreement regarding the potential business funding.

Following this document, investors conduct a detailed due diligence study on the company and its promoters. In case the investors are convinced post the due diligence, they further extend a shareholder’s agreement for discussion. However, this is the simple part of a term sheet, the subsequent content which is included in this document is esoteric, abstruse and cryptic. The term sheet is usually like a letter of intent which provides a blue print of the proposed start-up capital investment, containing specific clauses regarding the conditions that the investor expects the entrepreneur to abide by.

Based on the term sheet a more detailed legal document is drafted. Term sheets typically contain a significant amount of information which can be classified into distinct sections like funding, corporate governance, and liquidation. All together they address the economics of raising startup capital and control of the company. Following is a detailed breakdown regarding the contents of the term sheet.

1. Company valuation for business funding

This section contains the worth of the company in the eyes of the investors. It outlines pre and post money valuation, capitalization table and per share value of the company stock. The pre money valuation is investor’s estimate of company’s worth before raising capital, and post-money valuation is the expected value of the company post the investment of the proposed funds. The capitalization table indicates the ownership of the promoters and investors, the equity dilutions and value in each round of funding.

2. Dilution and anti-dilution clauses

This term highlights how future business funding will dilute the ownership percentage of the promoters and the investors. To protect themselves from the future sale of shares at a lower value, an investor will typically insert an anti-dilution clause. There are two primary flavors of anti-dilution protection viz., full ratchet and weighted average adjustment. Full ratchet is very onerous and increasingly less common.

3. Option pools

It concerns with the amount of stock that a company sets aside to be used for various purposes like employee stock options, offering to service providers or an incentive to attract new talent. It is usually recommended to reserve 10% of a company’s stock for use in the option pool. However, the valuation of these shares is generally pre-money basis, and it may dilute the other pre-money shares.

4. Founder vesting schedule

Investors like to know how the founders of the company earn their shares, including dates of vesting commencement, circumstances of vesting acceleration or any other related information. Usually, credit is designated towards any time the promoter has invested into the company. Thus if the entrepreneur has a vesting schedule of five years and the company has been in existence for two years, then the entrepreneur has earned the first two years of vesting.

5. Shares Offered

It refers to the type of shares that will be taken by the investor. A company can issue equity or preference shares depending on their agreement. Preference shareholders receive additional rights over equity shareholders. Usually, investors indicate a preference for preference shares over common stock in the term sheet.

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6. Liquidation Preference

Typically to protect their interest against business failures, investors commonly request a ‘1x’ invested capital liquidation preference. Upon liquidation, it entitles the investor to receive the return of the amount of money it has invested in the company before any other shareholders receive their payouts. At times, the investors also choose a right to convert their preferred shares to equity shares to receive the ownership payout in cash.

7. Control Rights

Investors include co-sales or right of first refusal (ROFR) clauses in their term sheets to protect their interests. Co-sale is a situation where the investor can sell their share if a founder sells any part of their stake in a company to the same prospective buyer. An ROFR clause refers to offer of sale of stock first to the investor. The investor receives an option to purchase such shares before anyone else.

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8. Drag along clause

The drag along right enables a majority shareholder to allow a minority shareholder to join the sales of a company, hence avoiding the havoc that minority shareholder might cause when a company is sold. It is commonly found in term sheets to ensure that the founders and the investors have the complete power of the sale of the company by dragging the other shareholders. Including such a clause can lead to additional legal fees.

9. Pay-to-play

This requirement ensures that the investors are active in the future rounds of raising business funding by penalizing investors who are reluctant to follow through on the startup capital investment plan. Investors may be reluctant when the entrepreneurs are unable to achieve their intended goals, and they are usually avoiding to include such a clause. The penalties may include conversion of shares, loss of anti-dilution protection or loss of other forms of control in the company.

10. Warrants

This clause provides an investor with a right to purchase additional stock in the company at a pre-determined price within a particular period. They are usually exercised when the value of a company exceeds the price of a warrant. Since such a clause also affects the dilution for other stakeholders, it is important to review the clause before agreeing to any warrant for debt investors.

To conclude, term sheets contain legal provisions which are challenging for an entrepreneur to decipher, it is suggested to consult with a chartered accountant and a corporate lawyer before agreeing to the document. It is important to pay attention to every section of the economic portion of the document for business funding. Terms sheets are usually valid for a period of 30 – 60 days and offer a period of exclusivity to the investor. An entrepreneur must be able to ensure that apples are not being compared with oranges while checking a term sheet.