How to Understand Term Sheets
Posted: Jan 2, 2023 10:00 AM ET
A term sheet is a document that outlines the key terms and conditions of a business transaction or investment in a non-binding manner. It serves as a preliminary agreement that helps all parties involved in the deal reach a mutual understanding, reducing the risk of future misunderstandings or disputes. A term sheet can also help prevent unnecessary legal fees by allowing the parties to iron out the details before committing to a more formal agreement.
Once the parties have reached an agreement on the terms outlined in the term sheet, a formal, legally binding contract can be drafted that conforms to these agreed upon terms. Both parties may sign the term sheet to formally signify their agreement to the terms and to indicate that their legal counsel can proceed with drafting a formal agreement.
Key Terms and Conditions
The content of a term sheet will vary depending on the specific agreement being negotiated. For example, the terms included in a term sheet for an angel investment in a startup will likely be different from those in a term sheet for a real estate development deal.
In the case of an investment term sheet, some common details that may be included are:
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- Nonbinding terms: This clause specifies that neither party is legally required to follow through with the terms outlined in the term sheet.
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- Company valuations and investment amounts: The term sheet should clearly state how much the company is worth and how much the investor is willing to invest, as well as the percentage of ownership stakes and any anti-dilution provisions.
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- Voting rights: Startups seeking funding may be at the mercy of venture capitalists (VCs) who want to maximize their return on investment. This can result in the VCs having significant influence on the company’s direction.
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- Liquidation preference: This clause outlines how the proceeds of a sale will be distributed between the entrepreneur and the investors.
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- Investor commitment: The term sheet should specify how long the investor is required to remain invested in the company.
In the case of a debt agreement, some common details that may be included are:
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- Economic details: This includes the term of the loan, the loan size, the interest rate, and other financial matters related to the debt.
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- Risk mitigation preferences: The lender may require certain conditions to be met or specific information to be provided on a regular basis in order to mitigate risk.
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- Extension rights: The borrower may be allowed to extend the loan, but the term sheet should specify the conditions and cost of extension.
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- Due diligence at closing: The lender may stipulate certain requirements that the borrower must meet in order to be approved for the loan as part of the term sheet.
The Benefits of Term Sheets
Term sheets can help to align the incentives of investors and the companies they invest in by clearly outlining the terms and conditions of the investment. By specifying the ownership stake or interest being acquired by the investor, the term sheet can help to ensure that the investor’s financial interests are aligned with those of the company.
Term sheets can also help to reduce agency costs, which are the costs that arise when the interests of the investor and the company are not aligned. By clearly defining the rights and obligations of both parties, term sheets can help to ensure that the investor and the company are working towards the same goals and that the investor is not acting solely in their own interests.
Term sheets can also help to mitigate information asymmetry, which is the unequal distribution of information between the investor and the company. By clearly outlining the terms and conditions of the investment, term sheets can help to ensure that both parties have a clear understanding of the investment and can make informed decisions about the deal.
Overall, term sheets serve as an important tool for aligning the incentives, reducing agency costs, and mitigating information asymmetry in the investment process.
Conclusion
It’s important to keep in mind that a term sheet is a non-binding document that serves as a preliminary agreement. Its purpose is to help parties reach a mutual understanding on the major points of a deal, but it does not carry the same legal weight as a formal, legally binding contract. Once the parties have agreed on the terms outlined in the term sheet, a full contract can be drafted that reflects these agreed upon terms. It’s important to carefully review and negotiate the terms of a term sheet before moving on to the more formal contract stage.
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