The term sheet is usually a non-binding agreement that contains all the important points related to the investment like capitalization and valuation, stake to be acquired, conversion rights, asset sale, etc.
Private equity identifies a target company, goes through the business model, studies the business plan, performs due diligence and then do the necessary discussions & negotiations before making a decision on the target company.
Term sheet comes into picture after a Private equity fund has decided to get into an agreement with Target Company. A term sheet is the first step of the transaction between the Private Equity fund & the Target Company. It has all the important & key points of the agreement.
Every term sheet contains certain key elements, starting with the company’s valuation. This might seem straightforward, but be aware of the difference between the company’s value prior to the investment and its implied value after. Considering the ownership stake you will retain should be a key consideration. Any agreement will specify how shares in the business are allocated between the founder(s) and the investor(s).
Typically this means common shares for the founder(s) and preferred shares for the investor(s). As reasonable and experienced investors naturally want a say in how their investment is run, other key provisions spell out voting rights pertaining to each class of shares. The preferred shares usually accrue dividends. And the term sheet will specify the dividends to be paid as well as the payment schedule. For instance, since cash is likely limited at this stage, dividends might initially be deferred, but continue to accumulate, with payout taking place at a future date.
Key elements in a term sheet
A standard term sheet will include/cover:
Whether the investor is represented on the company’s board of directors, how many seats the investor(s) will control, and whether these will be voting or non-voting members.
Disclosure requirements such as regular financial statements.
Pro rata rights, which stipulate how existing shareholders will participate in any, further capital raising. This is to ensure the first investor’s stake is not diluted in later funding rounds involving other investors.
Change-of-control clauses are included to prevent existing investors from being disadvantaged in a sale of the business. For one thing, they define which events will be deemed to result in the sale of all or a substantial part of the business. They can be crafted to allow for minority shareholders to veto a sale, to give them a right of first refusal, and/or to establish liquidation preferences for the investor’s stake. Also, look here for how founders’ shares will be treated.
Exclusivity/“no-shop” period of anywhere from 30 to 90 days.
Understanding the Parts of a Term Sheet
Term sheets typically contain a great deal of important information, set out in three specific sections:
These sections, taken together, address two specific investment issues: the economics of the investment (funding and liquidation); and control of the company (corporate governance). Crossover between these two issues is inevitable, as discussed below.
Term Sheets: Breaking Down the Economic Issues
It is important to pay close attention to every section of the economic portion of a term sheet. Here’s a look at those sections of the term sheet that deal with the economic issues of the proposed investment:
Term Sheet Company Valuation
The valuation section concerns what an investor believes the company is worth. Valuation issues addressed in the term sheet will include:
Pre-money valuation: the investor’s estimate of what the company is worth before his or her investment of funds.
Post-money valuation: the expected value of the company after investment of the proposed funds.
Capitalization table: indicates the ownership of both founder and investor, equity dilution and equity value in each round of financing. This is required to ensure against any misunderstandings regarding share issuance and valuation, including options and warrants.
Price per share: the per share value of the company stock.
Investor Rights in Term Sheets
Investor rights play a part in both the economic and company control subject matter of a term sheet. Three investors’ rights issues typically included in a term sheet are:
Pro Rata Rights: the right of an investor to participate in additional funding. This allows the investor to maintain the same level of ownership in a company when further funding is sought. Pro rata rights are usually good for the company in that they provide a level of security regarding future funding.
Voting Rights: the right given to a shareholder to participate in decisions made by the company. In most cases, voting rights are vested only in common stock shareholders. While preferred stock owners (most venture capitalists) do not generally have voting rights, they may nevertheless insist on a say in board decisions.
Information Rights: refers to information that a venture capital investor requires be provided to it by the company on a regular basis, including financial statements, budgets and other documents. The right to physically visit the company from time to time may also be included.
Advantages of Term Sheet:
Here are some important advantages to the use of term sheets for a company:
Allows you to discuss funding deals with a potential investor in greater depth.
Allows you to push the potential investor to value your company at a higher amount.
Helps you to avoid overly aggressive contract terms.
Allows you to walk away more easily from a deal if you cannot reach an agreement.