What is a term sheet and why they are important?


Understanding the value of a term sheet during the investment journey

It’s important to understand why your business may need a term sheet for your upcoming investment round. Speaking to Helen Goldberg, COO of LegalEdge, find out when they’re necessary, what to expect and what they should cover.

Do I need a term sheet?

Not necessarily, particularly for early stage/seed investment, but it can help sort the wheat from the chaff.

Why? It will show if an investor is serious and if so, whether their terms are going to be acceptable before you spend too much time/energy/ money on the process and formal legal docs.

Aren’t they all the same? No! They can and do vary so don’t just accept it, make sure you understand it and are ok with it, and if not negotiate. Don’t accept “this is market standard”.

Why do I care if it’s not legally binding? It will highlight if there’s anything you can’t live with early on, which will save you time and money in the long run, i.e. before you get into the big legal docs. It can also be hard to row back later on in negotiations if you’ve agreed something at the outset that you don’t like. Even if it’s not legally binding (and beware of the bits that are). An investor may pull out if you do try to renegotiate. And you could be on the hook for their costs if you do (the binding bit). So, it’s worth putting the effort into getting it right at the start. It also might give you a flavour of how committed the investor is, how easy they’ll be to deal with longer term, etc.

What happens afterwards? The investors will carry out due diligence and full legal documents (which contain more detail) need to be produced/ reviewed/ signed. These can (should) be nice and simple for early-stage investments. Potential problems can arise if something significant is found in the due diligence, market conditions change, or there’s a disagreement on the detail. Otherwise, once signed, investment funds will be transferred, and shares issued.

What should a term sheet cover?

  • Investment amount, valuation and % ownership: (Key stuff, obviously). The valuation can be pre-money (before the investment) and/or post-money (afterwards) and determines the ownership stake % the investor(s) will receive in exchange for their money.
  • Leaver provisions: It’s common for investors to insist that founders’ shares ‘vest’ over time. That’s super important for founders because it’s how ownership of the company can be taken away from them. And on the flip side it’s important for investors/other founders to ensure the business can run without those that have left and their shares reallocated to key incoming staff. So, you’ll hear about:
    • Good Leaver: if a founder can’t work due to disability or death, or is unfairly dismissed, they may be allowed to keep some shares or get paid out for them at the then market value.
    • Early leaver: if a founder leaves, maybe for personal reasons because they need to take another job, or move country, again they may be allowed to keep a % of their shares or get paid out for them at the then market value or at a % discount.
    • Bad Leaver: if a founder leaves (or is terminated) in negative circumstances they usually forfeit all their shares for nil value. So, for example, serious misconduct/bad behaviour, working for a competitor, leaking confidential information, etc.
  • Veto /consent rights: investors often want a veto over certain key decisions, sometimes in addition to a board seat (which only gives them a say). This usually covers big stuff like key deals, approval of the yearly budget and business plan, key hires, big opex and capex, etc.   But be aware that giving away too much control can make it difficult to run the business.
  • Board seat/rights: investors holding a certain % may want a seat on the board and/or to be able to observe board meetings. Knowing that early-stage companies don’t always have formal meetings they may also want to be provided with certain key financial and other information/reports on a regular basis.
  • Pre-emption rights/ right of first refusal: these are usual and protect investors' shares from being diluted by allowing them the right to buy additional shares in future funding rounds.
  • Anti-dilution provisions: less common for early-stage investments, this is gives investors greater anti-dilution protection by issuing them with more shares (for free), if the company does a ‘down round’ (i.e. a future fundraising at a lower valuation). There are different types such as full ratchet and weighted average.
  • Tag-along and drag-along: if the majority (usually 75%) decide to sell (exit) this allows minority shareholders to ‘tag along’ on the same terms, and also allows the majority to force the minority to sell (‘drag-along’).
  • Liquidation preference: again, less usual for early-stage investments, this sets out who gets what on a liquidity event (e.g. sale/exit) so investors can get their initial investment back (or more) before the rest is distributed.
  • Exclusivity: Some investors insist on having an exclusivity period so you can’t talk to other investors while negotiating with them. This can be known as ‘no-shop’ agreements, i.e. you can’t shop around for better deals.

LegalEdge can help with your term sheets and investment rounds – to find out more drop them an email today on info@legaledge.co.uk. They can also manage your day-to-day legal matters, helping to prioritise what’s important, reducing risk and proactively managing your legal strategy, workflow and budget using the right people, processes and tech.

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3rd party contribution by
Helen Goldberg | LegalEdge

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