UNDERSTANDING TERM SHEETS: THE FOUNDATION OF STARTUP FUNDING DEALS

In this fast-paced realm of startup funding and venture capital investments, term sheets establish the groundwork for a fruitful collaboration between visionary entrepreneurs and forward-thinking investors. Term sheets are an integral part of the startup ecosystem, acting as a bridge between the initial discussions and the legally binding definitive documents and agreements.

Let us explore the ambit of term sheets and dissect its key clauses that are essential to be agreed upon before the finalisation of the definitive documents and agreements.

What are Term Sheets?

Term sheets are documents that outline the key terms and conditions under which an investor (or group of investors) is willing to invest in a company. They serve as a blueprint and origin for negotiating the definitive documents and agreements. Term sheets define essential deal points before the investment that include, amount of investment, pre-money valuation of a company, percentage of equity or ownership stake of the investor(s), liquidation preferences, anti-dilution provisions, rights of the investor(s) and vesting schedules for founders’ equity.

Although term sheets are not legally binding, they establish a company’s fundamental finance, rights and control – which later form the foundation of initiating a deal for investment. To simplify, term sheets can be equated with prenuptial agreements, as they set expectations and boundaries ensuring that the investor(s) and the company are on the same page before finalizing the investment.

Legally Binding or Non-Binding?

While most clauses outlined in term sheets are not legally binding, allowing the parties involved to alter or modify the final transactional documents to an extent, there are certain clauses that the parties typically choose to treat as binding in term sheets which are as follows:

i. Exclusivity – It restricts the company’s promoters/ founders from engaging in discussions with other investors simultaneously during the current negotiations. It benefits the investor(s) by ensuring that their offer is not subject to comparison with other potential offers, allowing them to proceed with further negotiations without such concerns.

ii. Confidentiality – It benefits both the investor(s) and the company. It works as a safeguard against any confidential and private information, preventing the investor(s) from disclosing any such information and making the negotiation process smoother. A company can disclose its confidential information without an array of doubt that such information will be revealed, and hence, it is crucial for a company.

iii. Termination – It defines the termination of the term sheet after the time period specified for investment has lapsed.

iv. Governing law and dispute resolution – It mentions that laws applicable to both parties in case of any dispute between the parties concerning the interpretation of the term sheet.

Essential Clauses to be looked for in a term sheet:

While term sheets can vary in complexity and scope, certain clauses are considered as essential components to be examined before moving forward with further negotiations:

i. No-shop clause– This clause grants a period of exclusivity to the investors engaged in negotiations with the company. During this period, the company’s promoters/ founders are prohibited from entertaining or pursuing discussions with other potential investors. This clause ensures that the current set of investors can conduct negotiations and finalize deal terms without competition from other parties.

ii. Conversion– Investors in early-stage companies often seek a conversion right, which allows them to convert their preferred shares or debt into common equity shares. This conversion can be optional or mandatory. Many early investors choose to invest through convertible notes (loans that later convert to equity) or convertible debentures (debt instruments that eventually convert to equity shares). The conversion right is an attractive option for these initial investors, as their ultimate goal is typically to gain an equity stake and ownership in the company. By holding securities that can be converted to common stock, early investors position themselves to potentially acquire equity control as the company grows and matures.

iii. Liquidation preference- This outlines the method upon which the proceeds would be distributed to shareholders if the company is acquired or undergoes liquidation of dissolution. Preference shareholders (investors if any) get paid first, receiving their initial investment back before common shareholders. After that, preferred shareholders may participate alongside or get preference over common holders for remaining proceeds. This clause protects investors by ensuring they recover at least part of their investment in an exit event.

iv.Drag-along rights– Drag along rights allows majority shareholders to force minority shareholders to join in selling their shares, but only under identical price and terms. This benefits buyers by enabling full control, allows majority shareholders to sell without minority objections, and generally helps minority shareholders by ensuring they receive the same favorable terms as the majority.

v. Tag-along rights- Tag-along rights protect minority shareholders by allowing them to join majority shareholders in selling their stakes under the same terms. Unlike drag-along rights where the majority shareholders forces minority shareholders to sell, tag-along rights enable the minority to demand inclusion in the sale, ensuring they’re not left behind when majority shareholders exit.

vi. Anti-dilution clause- Anti-dilution clauses protect investors from equity dilution when a company issues new shares. These clauses typically include an adjustment formula that maintains the investor’s original ownership percentage, addressing their concerns about reduced stake value due to share issuance.

vii. Investor’s right of first refusal- Right of first refusal gives investors priority to purchase founders’ shares if founders decide to exit, subject to any lock-in period restrictions. This clause safeguards investor interests by preventing founders from selling to third parties without first offering their stake to existing investors.

viii. Confidentiality information- The confidentiality clause benefits both investors and companies by ensuring sensitive information shared during negotiations remains private. This protection fosters open communication, making the deal-making process smoother and more likely to succeed.

Conclusion

Term sheets are the foundation upon which successful startup-investor relationships are built. They establish a clear understanding of the terms and conditions from the outset, fostering trust, transparency, and a shared vision for the future.

As an entrepreneur or investor, approaching term sheet negotiations with diligence and seeking legal counsel is crucial to ensure a thorough understanding of each clause’s implications. A well-crafted term sheet can be the difference between a harmonious partnership and a contentious one, setting the tone for the company’s growth and success.

Author:- Subham Khanna – Senior Associate, Swaranjali Kapoor – Intern
Aumirah Insights

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