Term Sheet- Basics

16 June 2021


A Term Sheet is a letter of intent outlining the basic terms and conditions under which an investment will be made. It is essentially a brief understanding between the founders and the potential investor(s) and is usually not binding in nature. The document summarizes the key points of the commercial agreement set by both parties, before actually executing the definitive agreement(s) and initiating the time-consuming due diligence. 

The primary purpose of executing a term sheet is for both parties to concur on the important terms by means of negotiations. Typically, the negotiations for termsheet(s) are not long and the number of iterations between the parties is limited.

While term sheets vary for different companies, investors, and even between rounds, there are a few essential terms that should be kept in mind in any fundraising round as they are crucial and most importantly, negotiable. 

  1. Valuation of the company and ownership percentages:

The company’s valuation, along with the amount of money invested, determines the percentage of the company the new investors will own. This is one of the most crucial components of the termsheet because it has the most direct impact on ownership and rights in the event of liquidation of the company.

Valuation is expressed in terms of pre-money and post-money values. The pre-money valuation is the company’s valuation before the new investment and is a vital factor for determining the price per share at which the new investors will be subscribing to the securities of the company. The post-money is simply equal to the pre-money valuation plus the amount of the new investment. 

  1. Option Pool 

A key tool to attract and retain talent in companies is by granting equity ownership to the employees. Granting ESOPs to employees can have multifold benefits as the employees gain vested interest in the company. Investors often require the promoters to organize a sizeable option pool prior to their investment so that their shareholding in the company does not dilute in the event that the company decides to grant ESOPs. Option pools are notional in nature and can either come directly out of the promoter shareholding or by creating a separate pool which is reflected on the fully diluted shareholding pattern of the company.

  1. Liquidation Preference

The liquidation preference clause ascertains the mechanism of chronology and amount of payment in the event of liquidation, bankruptcy or a sale. Including a liquidation preference protects the investment of the investors by ensuring that the investors get their money back before any other shareholders. While negotiating, Founders should try to ensure that the liquidation preference right granted to the investors is on a non-participatory basis so that there can be a sufficient balance of the liquidation proceeds remaining to distribute among the equity shareholders of the company.

  1. Anti-Dilution

With an anti-dilution provision in place, subject to the terms of the anti-dilution clause, the company is prevented from diluting investors' shareholding while issuing shares to any third party. The company should issue additional shares free of cost to the investor or transfer shares from their own shareholding to the third party to prevent dilution of investor shareholding. There are two key varieties; broad-based weighted average anti-dilution and ratchet based anti-dilution.

  1. Right of first refusal

The right of first refusal protects shareholders in the case of a secondary offering. This refers to the sale/transfer of existing shares. It is a right that grants the holder of such a right to be offered the shares being sold in such a secondary sale, prior to it being sold to such a third party purchaser. It is a right granted in order to protect the existing shareholders to maintain their shareholding in the company, as they often do not have the same ability to negotiate an attractive deal as certain shareholders or founders. It signifies that if one of the shareholders has negotiated a sale of their shares with a third party purchaser at a certain price, the holder of the right can opt-in that round of sale to purchase such sale shares, at exactly the same deal terms.

  1. Board rights

The investors may wish to procure the right to get appointed as the board of directors or as the board observer in order to take more control of the board and to participate in the day to day workings of the company. It is advisable that the founders gauge their power on the board, especially at the early stages, to ensure that they still retain some primary decision-making powers in the company.

  1. Information rights

Information rights require the company to share the company’s financial information and business condition with the investors on a regular basis. In most cases, the information rights will oblige the company to provide quarterly management reports with some financial or management dashboard data.

  1. Founder lock-in

The investors decide to invest in the company not just basing their decision on the future prospects and past progress of the company but also on what the founders bring to the company. If the founders start to divest their shares of the company, it may signify that they have lost faith in the company and thus want an exit. The founder lock-in and transfer restrictions ensure that the founders don’t exit the company after the investment for a considerable amount of years by creating unattractive provisions with regards to the transfer of shares, in order to deter the founders from taking an exit from the company.

  1. Exit rights

Achieving a successful exit from a company is the primary end game for most financial investors. While there are many routes via which an investor intends to obtain an exit, such as through an IPO, third-party sale or buy-back of their shares, there are other contractual mechanisms available such as a drag-along right and tag-along right which also aid in achieving the target. A 'drag along' clause allows the investors to 'drag' the other shareholders into a joint sale of their shareholding too. Usually, if the investor is a minority shareholder it may become difficult to find a buyer for such shares, hence the investors usually demand a drag-along right to make the sale attractive for any buyer by offering a significant chunk of shareholding of the company. A tag-along provision is a clause that allows the investors to 'tag-along with the promoters or group of shareholders if they find a buyer of their shares on the same terms and conditions.

The term sheet is an important document and may create issues for the parties involved if it does not correctly reflect what has been agreed on or fails to deal with key terms which may lead to ambiguity and uncertainty over the exact nature of the relationship between the parties.

Disclaimer:
This article has been prepared for general guidance and information on the subject matter and does not constitute professional advice or a legal opinion and are the personal views of the author. The matters described herein are general in nature and have not been evaluated based on applicable laws. This article is based on information available in the public domain and has not been verified for its accuracy. You should not act upon the information contained in this note without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this note. Treelife Consulting and its employees accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. Without prior permission of the author / Treelife Consulting, this note may not be quoted in whole or in part or otherwise referred to any person or in any documents.

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