Negotiating a Term Sheet

The term sheet is not a legal document. It is used to negotiate the broad parameters of an investment. The actual agreement is set in several other documents including the stock purchase agreement and investor rights agreement.

Term sheets are non-binding agreement between parties involved except for certain terms that include confidentiality and no-shop provision. Most deals that get negotiated using a term sheet are finalized. Term sheets have an exit date and agreements must be signed before the expiry date.

Term sheets can be for a debt offering or equity offering. Terms common to debt offering and equity offerings include pre-money valuation, amount to be invested, post-money valuation and cap-tables. Debt-offering terms include convertible offering, fixed or indeterminate conversion price, automatic or optional conversion, assets used for security and interest rate. Interest rates are not usually negotiated if it is in a reasonable range. Anything between 3% and 8% is considered reasonable.

Equity offering terms include shares (common or preferred), liquidation preference, conversion price and valuation, automatic conversion, anti-dilution, pre-emptive rights, protective provisions, voting rights and shareholder rights.

Additional common terms in a term sheet include full legal name, type of security (debenture, common shares, and preferred shares), size of round, price per security, number of closings, number of tranches and milestones, targeted closing date, use of proceeds and expiration date.

A term sheet can be for a note deal (debt) or for an equity deal. Usually it is cheaper and quicker to do a convertible note deal because there are a lot fewer terms to negotiate and draft as compared to an equity deal. Additionally, a convertible note term sheet kicks the valuation can down the road to when the note matures. For example, in case of a convertible note deal if the investor invests in 100 thousand when the deal matures (say after 1 year) the investor will get $106 thousand worth equity at the negotiated equity price.

The convertible note puts a stop in the valuation discussion and frees up the business to go and get work done. In effect the valuation discussion is pushed to a later point in time when the business is more established. Convertible notes are only useful if it includes terms that protect the investor from runaway valuation. For example, the investor may invest $100,000 in a business at an early stage, but then if the company gets an investment in millions of dollars the original investor is completely diluted. Suddenly the investor who took the biggest risk has the lowest percentage in the company and correctly compensated for the risk. Convertible debt makes sense only if the term sheet has terms to protect the original investor investing through convertible debt.

The most negotiated terms in a term sheet are valuation, type of security, board of directors, significant financing threshold, IPO threshold, drag along threshold, anti-dilution provisions, pay-to-play and management carve-out.

The term sheet is usually served up by the investor to the entrepreneur. However, in case of a seed round or party round it may fall up to the entrepreneur to create and serve up term sheet and serve it to the investor. Both investors and entrepreneurs should take the opportunity to get legal advice before signing a term sheet.

Ideally, all inside rounds of financing should be shopped around using term sheets. Doing so facilitates a market check that helps determine the correct valuation for the business, which is the correct outcome for everyone involved. That said a term sheet may include a no-shop provision.  During due-diligence investors should be mindful of this provision because can affect the valuation of the company long-term.

Exploding terms sheets are term sheets that must be signed in a very short time. Ideally, investors should avoid exploding term sheets because it does not give them sufficient time to complete due-diligence on the company.