If you are part of a growing business that requires a source of outside funding, chances are that you will at some point have to review a “term sheet”. What is a term sheet? Basically it is a high level summary of the terms on which someone is willing to invest in or lend money to your business. In this post I am going to discuss financing term sheets only. There are other circumstances in which you may be on the receiving end of a term sheet — a sale of your company, for example — but those will be left to be discussed in future posts.
Financing term sheets can vary widely in their terms and structure, but there are generally a few areas that are common (or should be common) to most:
Who: Who is the party (or parties) who will be investing, lending etc.?
What: What are they receiving in return for their investment? This might be preferred shares, common shares (if you’re lucky), convertible debt, non-convertible debt or a host of other possibilities. To give two examples, with high tech startups you’re often talking about preferred shares and with publicly listed companies you are often going to dealing with common shares and maybe warrants. If your term sheet contemplates preferred shares, debt or other complex securities the term sheet will also include a fairly detailed breakdown of the terms of those shares, debt etc.
How Much: How much $ will the investor(s) be putting up?
Price: The term sheet has to include a price per share (or a price per whatever you’re selling). With private companies this is typically the investor’s best guess (or best offer) of the value of your company. This could be stated in the form of a “pre-money valuation” which attaches a value to the company before the investment. If you know the number of shares you have outstanding prior to the investment you can use this number to determine the value per share. That’s what the investor hopes to pay. Less frequently, the price might also be expressed as a post-money valuation. Just take the aggregate amount to be invested away from this number to reach the “pre-money valuation” and do the math as described above to determine a per share price. Sometimes the investor will do the math for you and just give a per share price in the term sheet. If you are dealing with a public company the price is probably based on the most recent market price, a discount to the market price or some average of the market price over a recent period of time. The price or valuation can also tell you how much of the company is being purchased for the aggregate investment amount. For example, if your pre money valuation is $2,000,000 and the investor is investing $2,000,000 the investor will own 1/2 of the equity in the company post investment.
Timing: When do the parties hope to close the financing?
Other Closing Deliverables/Conditions: There will typically be a laundry list of other deliverables and conditions to the closing possibly including: a shareholder agreement, board of director seats, delivery of certain information, amendment to the articles of incorporation etc. This is where the investor will tell you what, if any, controls they expect to have over the operation of the business on a post closing basis.
Expenses: Typically the term sheet will describe who is responsible for the expenses incurred by the investor and the company as part of the transaction. Here’s a hint: It’s almost always the company. As a company, if you are stuck paying the fees your goal should be to negotiate a cap on investor legal fees.
Exclusivity: Sometimes there will be a commitment to exclusivity — i.e. once you sign the term sheet you won’t talk to other potential investors for some defined period of time.
With the help of good advisers you can often negotiate some of the key points on a term sheet so if you are handed a term sheet you do not necessary have to sign it in the form presented. If you want to see an example of a financing term sheet you can check out this term sheet generator developed by US law firm Wilson Sonsini, Goodrich and Rosati. There are a few web based term sheet generators out there similar to this one and they generally get a lot of buzz. They are definitely neat, but I often wonder whether they have any real life benefit to companies aside from preparing you for the types of things you will see in a term sheet that is handed to you. Generally speaking the investor is going to present the term sheet to you in the investor’s “standard” form and a sophisticated investor is unlikely to accept or generate a term sheet from an Internet based term sheet generator.
Once everyone is happy with the term sheet, it is signed and the lawyers get to work preparing the definitive documentation to reflect the high level terms agreed on.
Posted by Shane McLean