A term sheet is essentially a legally non binding document that a business presents to the investor. Term sheets are documents that lay down the critical terms of any venture capital investment. It is very important to remember that a term sheet has no legal force, and is merely a document through which the initial negotiations between a business and its investor take place. There may be many versions of a term sheet exchanged between the two parties before an investment is actually made.
Benefits of Term Sheet
A term sheet may not even result in an investment, as negotiations may fall through. Yet, it is crucial to have a document that represents the terms and conditions of the future transaction. Despite not being legally binding, a term sheet is a document essential to both the company as well as the investor for the following reasons.
- It acts as an overview of all the critical terms that need to be negotiated between the parties. Having a clear view of the terms of an investment in one document gives an element of transparency to an otherwise complicated transaction.
- While a term sheet has no actual legal obligation, it does have certain binding clauses such as confidentiality and exclusivity clauses.
- Confidentiality clauses are self explanatory. They bind the parties to the term sheet into confidence.
- Exclusivity clauses are also known as “no shop clauses”. They prevent the company from looking for other investors for a certain period, while the term sheet is being negotiated.
- A term sheet acts as a ready reference in latter stages of negotiation between a company and the investor.
While it is not necessary to present a term sheet, the above benefits of term sheets have now made it a common practice for entrepreneurs and startups. While there are no legal consequences for not having a term sheet, it is highly recommended to have a term sheet on hand prior to approaching investors.
Drafting a Term Sheet
A term sheet contains the broad parameters upon which an investment is finalized. Broadly, it contains the summary of what is to be present in the transaction agreements (certificate of incorporation, the stock purchase agreement, investor rights agreement, voting agreement, right of first refusal and co-sale agreement). These agreements are later negotiated on the basis of the initial terms finalized in a term sheet. A term sheet also contains information on which an investor makes his investment.
A term sheet helps supply to an investor the economics of the company in which he is about to invest.
“Pre-money valuation” is the estimated value of the company prior to the inflow of cash from the investor. This valuation is also subject to negotiations as the parties have to put a number on an idea and a product that as yet has no real existence. Thus valuation is done by a consensus between the parties as to what is a reasonable price to put on a particular business idea.
“Post-money valuation” is pre-money valuation plus the total investment received.
Types of Stock
There are normally two kinds of stocks- common and preferred. Common stock is generally held by the founders. Preferred stock is the stock given to investors. Preferred stock has “special rights” that show the financial control and protection of the investor. Legally, preferred stock comes with what is called “rights, preferences and privileges”, owing to the financial interest that holder of this stock has in the company.
Dividends are a monetary amount paid periodically to shareholders by the company. A term sheet lays down the dividends to be paid by the company, in order to provide clarity to the investor.
This again is incorporated for the protection of the investor. Liquidation preference (or simply, preference) is where the importance of the preferred stock comes into play. It simply means that the money owed to the preferred stockholders is returned first, in a certain proportion, when a “liquidation event” occurs. One of the most important functions of the term sheet is to define what exactly constitutes a liquidation event. Mergers, acquisitions, selling of assets are the most common liquidation events.
Liquidation preference is paid in proportion to the original investment. If the original investment is X, and the liquidation preference is 2X, the preferred stockholder gets back twice his original investment before the common stockholders are paid. The proportion normally lies between 1X and 3X, in most agreements.
This is another pro-investor provision of a term sheet. Participation lays down who gets a share of the remaining proceeds of sale. “Fully participating” preferred stock means that a preferred stockholder gets not only their preference, but also a share in the leftover proceeds alongside the common stockholders.
“Capped participation” is when preferred shareholders receive a share of the leftovers up to a certain limit (usually up to 3 or 4 times the initial investment made).
“Non participating” is when, after the preference is paid, the stockholders get no further share in the leftover proceeds.
Conversion of Stock
Converting stock from preferred to common is done in a pre determined ratio that is negotiated in the term sheet in the initial stages of an investment. Conversion is usually done in a 1:1. A conversion price is a price that results in the ratio at which the conversion is to take place. [Investment Amount/Conversion Price = Conversion Ratio]
Now, why would a preferred stockholder convert to common stock? Conversion usually takes place when a liquidation event occurs. For example, the preference for preferred stock is 3X, however, its participation is capped at 2X, while the common stock gets 10X of the remaining proceeds. By converting to common stock, a stockholder thus gains 5X more than what he would have as a preferred stockholder.
Before the completion of a liquidation event, preferred stock holders are usually given notice, in order to have enough time to convert, if they so choose.
Option pool is the reserve of stock kept for existing or future employees, consultants, service providers etc. Normally, the option pool is used as a “reward” for service to the company. It is essentially a way of compensating services to the company through stocks instead of money. Option pool is usually between 10-20% of the valuation of the company, pre or post money.
In case of an event that alters the number of shares or lowers the share price, anti dilution rights come into play. Anti dilution rights basically protect an investor from any future dilution of his investment. Thus it is an adjustment to nullify changes in the economic structure of a company.
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