November 15, 2023

Term Sheet Basics

The Seedfunders Podcast
The Seedfunders Podcast
Term Sheet Basics
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Show Notes

Key Insights

  • A term sheet is a non-binding agreement.
  • It might also be called a Letter of Intent (L.O.I.) or a Memo of Understanding (M.O.U.).
  • A term sheet may be authored before, during or after due dilligence.
  • Terms sheets typically include 3 parts: Financial terms, control elements and confidentiality.
  • Valuation is one of the biggest elements included in a term sheet.
  • Control issues include board seats, voting rights and dilution clauses.
  • The confidentiality portion may limit discussing the deal or the founders shopping the deal elsewhere.

Dave, I’ve got to know. What’s a term sheet?

Thanks Joe. First, let me say I’m not attorney. And I’m not giving any legal advice here. I’m basically just going to talk about term sheets and about various terms on the term sheets, but I’m not an attorney. I think I previously said I’m also not a financial advisor in a previous podcast. So, I’m not sure what I am but…

Thank God you can still give me medical advice. That’s all I care about.

I guess I’m more of an orchestra leader. I just have everybody else make the music, but what is a term sheet? Well let me say, first of all. Term sheet is a non-binding agreement. So, terms and conditions of the investment are listed on a term sheet, but again it’s non-binding. It’s an agreement of what’s going to be the legal binding agreements and what’s going to be signed. It’s an outline of what people agree to, before there’s actual legal documents that are signed. It basically serves as a basis for the more binding documents. Legally, contracts are then drawn up.

But basically, the term sheet lays the ground work. It basically assures that the parties agree on the major aspects of a pending deal. But again, it’s not the legal document that binds the parties to an agreement. It’s also called – you may have heard the terms, Letter of Intent or LOI, a Memo of Understanding an MOU, agreement principle. Those kinds of things are also typically called term sheets.

Final agreements, those are always subject to due diligence. Investors can usually walk away subject to due diligence, looking at the details of a deal, and say that, “It wasn’t what we thought. There are things that we didn’t know.” And the investor can typically walk away from a term sheet. If a deal is finalized however, it’s pretty unusual to have significant variance from the term sheet from the original term sheet, because it’s the basics of the agreement, of what is going to happen in the legal documents.

When exactly in the coding process does the term sheet usually come to play?

Different Angel groups use different structures and time tables for term sheets. I would say there are three ways. One is a pre-due diligence term sheet. This is basically when an investor issues a term sheet and signs a term sheet and says, “Well, we want to make sure that before we do any due diligence that we all agree on the terms. We the investors and you the entrepreneur or the founder agree on the terms before we waste a lot of time with you or with us doing due diligence. That’s what I would call a pre-due diligence term sheet. But that’s one philosophy.

The second one is the one I think most widely used. It’s basically, during due diligence. So, due diligence has started. Basically, everybody is on board and the investors doing the due diligence, at some point during that due diligence it becomes that the investor is really interested in closing a deal. At that point, there will typically be a term sheet issued, and the investor and the entrepreneur or a founder would get together and come to the details of the deal – what it’s going to look like. As the due diligence proceeds, basically the term sheet is developed and executed at that point.

The third way is what I would call post due diligence. This is when everybody on the investors’ side has completely done due diligence. They’ve done all the due diligence. They’re sure now they want to make an investment. Then they issue a term sheet. That, I think is more rare. Some Angel groups do that, they wait until everything is done before they issue a term sheet. In those cases, the term sheet is pretty much finalized. It just goes into the legal documents, because all the due diligence is done. As I said, SeedFunders we prefer the middle option there is, during the due diligence at some point, we will come up with a term sheet to make sure everybody is on the same page as far as what the investment is going to look like.

And the term sheet itself, is there a typical structure for that?

Sure, I would say again there are about three parts. I always recall three parts to a term sheet. The first is the financial terms. These are financial terms such as the type of investment, whether it’s going to be human or money that’s going to be invested. The valuation, very important. Valuation or the cap on a convertible note. There’ll be liquidation preferences and anti-dilution terms, but those kinds of things are all what I would call the financial terms of a term sheet. Other than that, there’s what I would call control terms.

The control terms are things like the board of directors; who is on the board of directors? Approval rights of the investors; what do they get to say after the investment is done? Things called tag a long and a drag along provisions that I’ll talk a little bit about. Voting rights; who has the voting rights to elect officers or to vote on certain things? Veto powers; can the investor have any veto power over what’s being done with the company? So, those are all things I would call control terms. Then the third area is confidentiality. And in that, there is list of non-disclosures and no-shop and exclusivity. Terms that are listed in the term sheet as far as who can say what to whom.

All right, a lot to dig into there. So, let’s start with financial terms.

In the financial terms, there are quite a few things that need to be discussed in a term sheet. First of all, and most important is the type of investment. Is this going to be an equity investment, a convertible note or a SAFE. I talked about those in the previous podcast. So, I won’t get into the details of what those three things are, but really the type of investment is one of the most critical things in a term sheet. Is the investor going to invest in equity in the company or is it going to be some type of a note or SAFE?

The second thing of course is the amount of the investment. How much is the investor going to invest? Most importantly, what is the valuation of that? If the investor is going to invest a certain amount of money, what equity does that investor get? And in that case, I would like to talk about pre-money valuation and post-money valuation. I might have mentioned this in the previous podcast, but let’s use an example. If an investor in the term sheet says, “We want to invest $200,000 at a pre-money valuation of $1.8 million, the post money valuation then is $2 million. It’s the $1.8 plus the investment of $200,000.

So, the post investment amount is basically $2 million. The investor then with $200,000 owns 10% of the company. It’s a simple calculation $200,000 out of $2 million. If the pre-money valuation is $2 million, the post money valuation is then $2.2 million. So, then the investor is investing $200,000 at a 2.2 million-dollar post money valuation and the investor only gets 9%, 9.1% or so of the company. So, that’s the difference. It’s very important in the term sheet to measure whether this is a pre-money valuation or a post money valuation.

The other thing is the funding schedule. Is the funding going to take place all at once when the term sheet is signed or when the investment documents are signed and executed or are they going to be what’s called tranches where the money is released over a period of time? Again, that could be based on time. That could be based on milestones. For example, if a term sheet says specifically that it’s $50,000 per quarter. There’s 200,000 investment at $50,000 per quarter, what’s that going to be based on? The final documents might say that. The term sheet typically would not say what those milestones might be. That typically would be negotiated later, but the term sheet should say it’s $50,000 in foreign payments over one year.

Finally, the liquidation preference is very important. Is it a participating preferred? I’ve talked about this previously, or non-participating? What that means basically, when the investor invests, and again use the $200,000, if it’s a participating preferred investment when there’s a liquidation, the investor gets the $200,000 back and then converts to the equity of 10% in the case of the two million-dollar post money valuation. That’s participating preferred. Non-participating preferred, the investor gets either or. Either they get the $200,000 back or they get the 10% in the equity.

Basically, participating preferred, the investor gets the investments returned plus the equity. In a non-participating, the investor gets either the investment back or the equity. That’s very important to be outlined in the term sheet, because it really makes a big difference when there’s a liquidation. Those are really most common terms that need to be outlined in a term sheet.

So, that closes the book on the financial terms.

Actually, there can be a lot more financial terms. What we discussed is pretty much, every deal needs to address the terms that we discussed: the valuation, the liquidation preference and things. But on some deals, there could be special circumstances or financial requirements that the investor or founder might want. Some of those have to be dealt with, and should be dealt with in the term sheet so that there won’t be any legal dispute when the legal documents are being prepared.

Those other types of terms are a little more specific and a little more complicated. I won’t go into depth on a lot of them. Really, as I said, everybody needs to consult attorneys when executing these, but one is called an option pool. Think of it this way. If the founder wants to give employees options for stock, for equity in the future, when the investor invests they can be basically be deluded in the future by something the founder already planned to do.

What the investor wants to do is make their investment what’s called fully-diluted. There’d be an option pool set aside. Even though that equity is not issued, the equity will be put aside, and the investor’s investment would be based on the total amount of equity including the future equity that would be issued. That puts an option pool. The same thing with investing for founders. Does the founder get all of their equity at the beginning of the investment or is that spread over time? It could be all upfront, or if there is what’s called a cliff which may be a one-year waiting period before the founder gets their equity. Then quarterly, they get additional equity for the next year or two or annually. So those terms, if there is a vesting schedule for the founders, that can be in the term sheet as well.

Then anti-dilution provisions. That can really get complicated. Really, the purpose behind anti-dilution provisions is to protect against future what’s called downward rounds. Again, say the investor invests $200,000 for 10% at a two million-dollar post money valuation, if the future investment comes in, and it’s at $1.5 million valuation, the original investor wants to be protected against that down round. So, they might have a provision in the term sheet, and in the final documents for anti-dilution. Meaning, if there is a down round, they get additional equity so that they aren’t diluted by the future down round.

There are different types of down rounds. You could have what’s called a full ratchet where the investor gets all their money or weighted averages. Again, it gets a little complicated with when you talked about anti-dilution provisions. Then there’s full anti-dilution where the investor says, “We have 10% equity in this company. We want to keep 10% no matter what in the future. If the company is valued at $20 million or $100 million, we still get 10% equity.” That’s pretty rare and pretty harsh on the entrepreneurs. And pretty much, not really acceptable to future investors to say we’re putting money into this company. And that previous investor keeps getting ratcheted up with more equity just because we invested, but I have seen that done.

Finally, there’s warrants or options. That’s protection the investor against again future investment where they have warrants or options to invest at future prices.

With all this information and all these options, this brings me back to another great reason to be part of an Angel group, because you could learn this on your own. Spend your 2o hours or 40 hours on YouTube or a lot of money with a lawyer, but that’s the real benefit to have some help with taking care of this sort of thing.

Yeah, it sure is, because again if the attorneys need to be involved, if the Angel group hires an attorney, the attorney will do all this for the Angel members, for the members of Angel group. If you’re an individual Angel investor, you’re going to need your own attorney, and pay your own attorney for every deal to do this type of analysis and this type of reviews.

So control issues. That’s the second part. Let’s dig into that.

Sure, first thing that’s potent in control issues is the board of directors. Will the investor have a seat on the board of directors. Typically, what we’ve seen in this really early seed-stage, that would be a five-person board, and the investor would get one seat. We’ve actually got two seats on a couple of our deals, a couple of our larger deals. So, the investor gets one or two deals. That typically is put in the term sheet. It also can be, if there’s not space available on a board of directors or the entrepreneur doesn’t want to open up a space on the board of directors, there could be a board of advisors. And the investor could have a seat on the board of advisors. That is also usually outlined in the term sheet.

The next thing regarding control is approvals. There are certain things that the investor wants to approve, certain actions like changes to the operating agreement or cash taken by the founder. So, even though the investor has a minor interest say again a 10% equity in this, they want to be sure that the founder doesn’t take out excessive amounts of funds out of the company. And they have no control over that. Typically, the investor will ask for some kind of approval level of certain types of actions.

There’s also what’s called the right of first refusal, as far as a control term. That’s ROFR, Right of First Refusal. That basically says, if someone sells their equity, like the entrepreneur sells some equity, who can buy that equity? If one of the other investors sells the equity, who can buy it? So, the Right of First Refusal gives the investor the first right to buy that equity before someone else does. Before an outsider or anyone else buys that equity. Then there’s what’s called tag along, drag along rights. Tag along rights basically says, if the founder sells, then the investor can participate in that sell.

So, if the founder wants to sell 5% of their equity, the investor then is allowed to sell 5% of their equity at the same terms as the founder. That’s called tag along. There’s also drag along rights. Drag along rights is where the investor sells and the founder must sell. Now, that’s pretty rare and that’s pretty harsh to say, if the investor wants to get out of a deal then the founder has to sell some of their equity. You don’t see as much drag along rights as you see tag along, because the tag along, the investor wants to be equal with the founder as far as selling their rights. But to force them to sell when the investor wants to sell is actually kind of rare.

Then there are things like voting rights. Are all shares equal? Does everybody have equal rights to vote? Is it one on one vote? Is it the percentage of equity vote? Those things need to be outlined in a term sheet. There’s also things for information rights. What rights do the investors have to information? What kind of financial reports? What kind of reporting and things do the investors have? That is usually in a term sheet. There’s something called pre-emptive rights. This is where the investor can buy additional shares in future issues. This is also called pro-rata rights where if there is a future issue, and the company is raising $500,000 the investor gets to participate in that on those terms if that’s outlined in the term sheet and in the final documents. Those are some of the key parts of control issues that are usually burned in a term sheet.

That’s great, and you mentioned confidentiality. Is that something you’re allowed to talk to us about?

Sure. Confidentiality typically in a term sheet, there is what’s stated, “The founder can’t disclose the terms of the term sheet or even in a lot of cases, even its existence to anyone outside of their officers, directors, accountants and attorneys.” This protects the investor from things of other people knowing what’s being done and what’s being offered for investment in a company, and prevents others from jumping in and jumping on top of the original investor.

There’s also a no-shop agreement, which does not allow the founder to take other deals for a period of typically 60 days. There’s under action where somebody wants to invest in the company. The founder basically has to notify the investor and say, “Someone else wants to invest in this deal.” So, for a period of 60 days, there’s typically what’s called no shop agreements in a term sheet that says that the founder has to tell the investor if there are other people interested, and can’t go out and actually solicit other investments to try to compete against the investor’s term sheet.”

That’s great info, as always. Closing thoughts…

I want to emphasize again. The term sheets are not binding. The terms can change during due diligence or preparation of final legal documents. We did have one deal. At SeedFunders, we had a term sheet that was signed. We had one additional term in the legal documents during the final document preparation in due diligence completion. The attorney for the entrepreneur flat out refused and said, “No, it’s not in the term sheet.” That’s not typical. The deal fell through because we thought it was important to have this additional term that wasn’t in the term sheet.”

It’s not typical that a term sheet is totally binding, but I’ve seen cases as I said where the attorney says, “It’s not in their term sheet. It’s not going to be in the final documents.” The final thing is that term sheet is really a guide to how the legal document should be prepared and how the final agreement will look. But it’s really the changes can’t be negotiated. So, I hope this helps our listeners understand the seed stage term sheets. As always, if anyone has any questions email me, dave@chitester.com.

 

END

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