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A Guide to Financial Term Sheets

Posted by Ryan M. Newburn | Mar 03, 2021 | 0 Comments

Any business owner knows investments are critical to starting and expanding your company. At Newburn Law, we support our clients at every step of the way, regardless of their size or industry. One of the most important guiding documents in the investment relationship is the financing term sheet. Consider visiting with our experienced business lawyers to negotiate and review any term sheets to ensure your business is getting the investment you need but not signing away too much. If your business is negotiating with investors, contact our experienced transactional lawyers today. Whether this is your first term sheet or your hundredth, our lawyers will be there to guide your business through this complicated process.

What Is a Financing Term Sheet?

A financing term sheet is traditionally associated with venture capitalists investing in startups but it can be any document that outlines the terms and conditions of an investment. One important thing note, however, is that a term sheet does not necessarily create binding contract. While a term sheet should contain some of the basic terms of the investment, it does not typically include all of the details, as a contract would. The general purpose is to ensure that the investor and the company agree on the basic structure of the investment.

What Terms Should a Term Sheet Include?

As mentioned, a term sheet should not be as detailed as a contract, but it should include the basic terms of the investment. At Newburn Law, we have extensive experience working with startups and helping them understand the legal and business implications of term sheets. Some of these common terms may include:

Whether The Term Sheet Is Binding

The term sheet should explicitly state if it is binding. A term sheet can either function as a proposal or a contract, depending on how it is written. Either the whole document or specific provisions can be made binding.

The Investment

The investment amount is typically a short bullet point stating how much money the investor will put into the company. It may also state how much money the company is receiving from other investors.

The Valuation of the Company

The term sheet should identify the valuation of the company, both before and after the investment. The pre-investment valuation is important because it determines the price per equity unit (share, membership unit, etc.) the investor pays when their investment is complete. The term sheet should specify if the valuation of the company is pre-money or post-money, as that will impact the amount of the investor's equity in the company. For example, if the company is valued at $10 million pre-money, and the investor is making a $5 million investment, then they would receive 50% equity if it were a pre-money valuation or 33% if it were a post-money valuation.

The valuation of the company may also address issues like option pools and dilution. An option pool refers to the amount of equity reserved for employees. This is a standard arrangement for startup companies that incentivizes employees with the potential to make a lot of money when the company goes public. Investors may prefer that this employee stock ownership plan is created pre-investment because this type of employee incentive improves the likelihood of the company's success - which, in turn, improves the chance of the investor's return on investment. Such a plan does, however, dilute the investor's ownership if done on a post-money basis. Some investors will include anti-dilution or similar provisions to protect them in the event more shares are issued.

Liquidation Preference

The term sheet should also identify what happens if the company liquidates or is sold. Generally, an investor will receive a liquidation preference meaning the investor gets paid out first, in some agreed-upon proportion to their investment, while the rest of the shareholders receive a prorated portion of the liquidation or sales proceeds. The term sheet may also lay out what constitutes a liquidation. For example, it may specify that a sale of all or a substantial portion of the company's assets or a merger will qualify as a liquidation for purposes of the investor's liquidation preference.

Dividends

The term sheet can also specify the dividends the investor will receive, if any, including the dividend rate, whether such dividends can be paid in kind and whether such dividends accrue.

Issues Regarding Control

While much of the focus of the term sheet is the economics of the investment, it should also address issues of control. For example, the investor may receive one or more seats on the company's board of directors to ensure that they have voting rights on major decisions, such as a sale or merger. The term sheet may also identify reserve matters, which is an issue over which the investor has veto rights. One common example of a reserve matter is when the company's founder wants to pull money out of the company. This directly relates to the investor's investment, so they may wish to have control over these types of decisions.

Other Common Provisions

Each investment is unique, but some of the other common provisions include:

  • Information rights
  • Drag-along, tag-along, ROFR and ROFO provisions
  • The investor's term of commitment
  • Redemption rights
  • Founders' vesting schedule
  • Tax relief

Contact Our Experienced Business Lawyers

While financial term sheets largely seem like business documents, they can have a significant legal impact on your ability to run your company how you want to. Investors are a critical component of a startup company, but at the end of the day, you need to be able to retain some control of your business and ensure your financial and legal rights are protected. Consider visiting with our experienced business attorneys to learn more about your rights and help you understand how we can help you throughout the process. We can negotiate, review, and even draft term sheets to best fit the needs of your business. We enjoy supporting entrepreneurs to help them turn their ideas into reality. Contact us for a free consultation.

About the Author

Ryan M. Newburn

Ryan Newburn is a business and legal expert trusted by Executive Teams and Boards of Directors to apply sound business principals to solve legal and financial problems. Ryan's practice focuses on mergers and acquisitions, financings, corporate formations and corporate governance in a broad range of industries including energy, distribution services, healthcare, medical devices, and technology. Leveraging his formal business training and years of practical experience, including as an executive at public and private companies, Ryan has advised hundreds of companies in dozens of industries of unique legal and financial issues.

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