A term sheet is a nonbinding agreement outlining the basic terms and conditions of an investment. It acts as a template for more detailed, legally binding documents. Once the involved parties agree on the details articulated in the term sheet, a binding agreement or contract is drawn up that conforms to these details.
Key Takeaways
- Nonbinding Proof of Intent: A term sheet is a nonbinding agreement outlining the basic terms and conditions under which an investment will be made.
- Startup’s Essential Document: Entrepreneurs find this document crucial for attracting investors, particularly venture capitalists, who provide capital to fund startups.
- Detailed Provisions: It covers company valuation, investment amounts, percentage stakes, voting rights, liquidation preferences, anti-dilution provisions, and investor commitment.
- Broader Applications: Also used for mergers, acquisitions, and long-term debts, such as commercial real estate development.
- Good Faith Indications: Though nonbinding, term sheets often require an initial good faith deposit or other indicators that both parties aim for an executed full agreement.
Uses of a Term Sheet
A term sheet sets the stage for resolving significant aspects of a deal without delving into every minor detail covered by a binding contract. This document ensures that all parties involved are on the same page regarding major aspects of the transaction, reducing the likelihood of misunderstandings or disputes. Furthermore, it keeps expensive legal fees at bay until the deal is more concrete.
Typically, every term sheet includes crucial information like assets, initial purchase prices including contingencies, timeframes for responses, and other pivotal details.
Particular to startups, this document is vital for easing negotiations with investors and venture capitalists who fund fledgling companies. Beyond investments, term sheets are pivotal in mergers and attempted acquisitions, containing initial purchase price offers, preferred payment methods, and comprehensive coverage or exclusions of deals.
What’s Included in a Term Sheet
The components of a term sheet depend heavily on the specific agreement. The details will vary greatly between an angel investment term sheet and one for a commercial real estate development project. Here are some commonly included elements:
For Investment Agreements:
- Nonbinding Terms: Specifies that neither party is legally obligated to the term sheet’s outlines.
- Details on Valuations, Investments, Percentage Stakes, and Anti-Dilution Provisions.
- Voting Rights: Investors often seek greater influence, tactically negotiated in the term sheet.
- Liquidation Preference: Clarifies the distribution order of sale proceeds between involved parties.
- Investor Commitment: Indicates the duration the investor must remain vested in the company.
For Debt Agreements:
- Economic Details: Encompasses terms, loan amount, interest rate, and general financial conditions.
- Risk Mitigation Preferences: Conditions that lenders require about timely and specific information.
- Extension Rights: Terms and costs for extending loans.
- Due Diligence at Closing: Specifies requirements for drafting the loan agreement.
A term sheet might be signed to denote preliminary agreement, allowing legal counsel to draft a formal agreement.
Terms Commonly Found in a Term Sheet
Many terms are standardized within term sheets, creating familiarity for both parties involved. Here are specific phrases commonly found:
Investment Term Sheets
- Valuation (Pre-Money & Post-Money): Defines valuations before and after the investment.
- Valuation Cap: Sets the value at which convertible notes transition to equity.
- Drag Along Clause: Ensures that minority stakeholders follow the lead of the majority.
- Dividends: Clarifies net income distribution details.
- Liquidation Preference: Details the payout hierarchy upon a company’s sale.
- Voting Rights: Specifies the investor’s operational influence.
- Pro-Rata Rights: Discusses rights for future investment rounds.
- No-Shop Agreement: Protects from other investments within a stipulated period.
Loan Term Sheet
- Loan Amount: Specific borrowing sum, related metrics may apply.
- Guaranty: Details on legal backing by an entity with higher credit.
- Interest Rate: Terms may vary widely by loan type.
- Term: Payable loan period or interest-assessment duration.
- Collateral: Requires asset posting for loan default security.
- Financial Covenants: Mandates financial health substantiation to the lender.
- Loan Costs: Covers assorted fees, emphasizing upfront loan expenses.
Tips for Writing a Term Sheet
Term sheets differ broadly, considering the parties, conditions, situations, and agreement nuances. Critical pointers:
- Summarize Conditions: Initiate with an overarching summary of the agreement’s purpose and outcome, involving all legal parties.
- State Binding/Non-Binding Terms: Clearly define expectations early.
- Enumerate Terms: Balance detail levels to acquaint but not overwhelm the opposing party.
- State Timeframes: Prescribe deadlines to encourage timely actions and avoid deal staleness.
- Encourage Feedback: Facilitate documented draft reviews to highlight nonconformity areas.
Companies generally solicit multiple term sheets for favorable negotiations, often moving forward with the most appealing one.
Similar Documents to Term Sheets
While a term sheet may resemble a letter of intent (LOI) or a memorandum of understanding (MOU), the differentiating factor is its bullet-point format against the former’s formality. All achieve similar outcomes with nuanced stylistic disparities.
An Example of a Term Sheet
In 2021, the New York City Department of Housing Preservation & Development released a term sheet for its Supportive Housing Loan Program. This document details eligibility, loan amounts, terms, and construction requirements while offering a point of contact.
Key Points of a Term Sheet
A well-drafted term sheet typically covers four primary domains: deal economics, investor rights, governance, oversight, and exit terms. It must be explicit enough for investors to glean insights without prematurely finalizing lesser terms.
Who Prepares a Term Sheet?
Primarily, the responsibility hinges on the financing instrument: investors often draft them for seed rounds, and lending institutions do so for prospective borrowers.
Is a Term Sheet Legally Binding?
Generally nonbinding, term sheets indicate serious intent. Agreements become legally binding upon signing detailed instruments such as loan agreements.
Term Sheet Format Variations
Adaptable depending on the agreement type, a term sheet must effectively outline the economic transactions, reflecting business uniqueness in mergers, acquisitions, loans, joint ventures, and other ventures.
The Bottom Line
A term sheet signifies serious intent between parties, illustrating projected transaction foundations. Although generally nonbinding, they may entail a good faith deposit as an escrow indicator suggesting an anticipated agreement.
Related Terms: Letter of Intent, Financial Covenant, Convertible Note, Pre-Money Valuation, Pro-Rata Rights.
References
- New York City Department of Housing Preservation and Development. “Supportive Housing Loan Program (SHLP) Term Sheet”.
- Thomson Reuters. “Term Sheet”.
