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5 Term Sheet FAQs for Startups & Growing Companies

Published:

March 18, 2021

Author(s):

• Duncan Harvie

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Your startup idea has blossomed into a viable business: you’ve incorporated a company, it’s been growing steadily, and you’re at the stage at which the company needs money – more money than you, your family or friends can contribute. You’ve been out beating the bushes for an investor that fits. One morning you open your email, and there it is: a “Term Sheet” – and eight pages of legal jargon. Before you sign on the dotted line, here are the answers to five frequently asked questions to help you start to understand Term Sheets.

1. What’s a “Term Sheet”?

A Term Sheet is a non-binding agreement that sets out the basic terms and conditions of a proposed investment. A Term Sheet is beneficial because it can save the parties (the proposed investor and your company) time and money if and when the deal proceeds. First, it allows the parties to agree on the major business terms of the proposed investment, so (if and when) the deal proceeds, it’s likely to move more quickly. Second, it serves as a guide for legal counsel and advisors to develop more detailed and binding legal documents to conclude the deal, which typically include a purchase agreement, a shareholders’ agreement, and terms for a new class of shares.

2. Where does a Term Sheet come from?

Typically, an investor prepares and delivers a Term Sheet to a company seeking investment, although sometimes the company seeking investment prepares a basic Term Sheet to describe its offering to prospective investors. It’s usually only more sophisticated investors, such as larger angels, angel groups, and venture capitalists (VC) that use a Term Sheet.

3. What terms are typically in a Term Sheet?

A typical Term Sheet contains numerous terms that can generally be grouped into one of these four broad categories:

Funding Terms. The “funding terms” essentially set out the economics of the proposed investment, including:

• Who the investor is and whether the company can allow other investors to participate in the round.
• The total size of the round and the amount of the proposed investment by the investor.
• The investor’s valuation of the company.
• The type of securities (such as convertible debt, common shares, or preferred shares) the investor will purchase from the company.
• A cap table that analyzes the company’s percentages of ownership, equity dilution, and value of equity in each round of investment by founders, investors, and other owners.
• How the company can use the investment proceeds.
• Any conditions the company must meet before the investor will actually fund the investment.

Corporate Governance. The “corporate governance” (which, broadly, means the processes, practices and structures through which a company manages its business and affairs) terms effectively set out who (or what entity) will have control of the company, and include:

• How the Board of Directors will be structured, and in particular, the right of the investor to have Board representation.
• A list of decisions that require the approval of the major investors.
• The ongoing rights of the investor to certain company information, such as its financials and business plan.

Investor Protections. These are terms setting out what might happen in certain circumstances (such as on the company’s sale or bankruptcy) after the round closes and the investment is complete, and protecting the investor from dilution of their ownership stake in the company.

General Terms. The Term Sheet will also include a variety of additional clauses that appear in most legal agreements. Of particular note in the context of Term Sheets are these terms that are binding, and generally continue whether or not the proposed investment transaction is completed:

• Payment of professional fees (such as legal or accounting fees) the parties incurred in negotiating the Term Sheet, conducting due diligence, and closing the transaction. Often, the investor demands that the company pay the investor’s professional fees in connection with the investment transaction, but the company can try to negotiate a cap of those fees to provide cost certainty and control.
• Confidentiality provisions prohibiting the parties from telling anyone about the fact or the content of their investment discussions.
• Exclusivity provisions prohibiting the company from negotiating with any other prospective investor unless the parties to the Term Sheet agree. If you’re lucky enough to be presented with competing Term Sheets from more than one prospective investor, you’re in a great spot – but once you sign a Term Sheet, you’re expected to “dance with the one that brought you”.

4. What happens next?

A prospective investor’s issuance of a Term Sheet is an invitation to begin a conversation about a potential investment. If the company wants to continue that conversation, here’s how it usually goes:

Negotiate the Term Sheet. Before you sign, negotiate; and before you negotiate, you’ll benefit from consulting with your legal counsel and other advisors. This might entail some expense upfront, but investors do far more deals than you do and (at least in this case) experience probably isn’t your best teacher. It’s important that before you negotiate, you know what is, and what is not, negotiable. It’s also crucial that the final Term Sheet be clear and unambiguous so it can effectively guide your legal counsel and advisors to prepare the more detailed and binding legal documents, saving the company time, aggravation – and money – down the road.

Due Diligence. Signing the Term Sheet isn’t a guarantee the actual investment deal will close. Term Sheets are non-binding because the investor will usually need to first conduct more due diligence investigations into the company. These include inquiries into, for example, the company’s corporate documentation, tax returns, financial statements, and intellectual property.

Binding Legal Documents. Once the investor(s) and the company sign the Term Sheet, they (ideally via their legal counsel) prepare binding legal agreement(s) that reflect the Term Sheet details. This can take a bit of time, so give yourself some breathing space in your budgeting.

Funding. After the parties finalize and sign the binding legal documents, the investor advances the funds in accordance with the terms of the deal.

5. How long does it take to finalize a Term Sheet and get to funding?

That depends on a number of factors, usually including:

• The length of time it takes to negotiate the Term Sheet itself, which can depend on the nature of the parties involved, or the size of the transaction.
• The length of time it takes the investor to conduct its due diligence.
• If one of the terms is that the investor will be an anchor investor only, and the company must secure additional investment from other sources, then the time it takes for the company to secure that additional investment. Additionally, the more parties there are, the longer it typically takes to finalize the deal because more parties must review the documents.
• The complexity of the transaction, which is usually proportionate to the size of the transaction: the bigger the deal, the more complex it’s likely to be and the longer it’s likely to take to complete.

Please contact your McInnes Cooper lawyer or any member of our Emerging & High Growth Companies Team @ McInnes Cooper to discuss how we can help you with your Term Sheet.

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