If you are a founder or a potential investor, at some stage you are likely to encounter a term sheet. So, what are term sheets actually for and what issues do you need to consider?
A term sheet may also be known as a letter of intent, a memorandum of understanding (or MOU) or heads of terms. The label isn’t important, and in terms of their structure and drafting there is no “one size fits all” approach, but they will generally set out the key commercial and legal terms in respect of a proposed transaction.
Although term sheets are not generally legally binding, other than in respect of confidentiality, exclusivity (if applicable), costs and jurisdiction, they evidence the intent of the parties to them. Therefore, once something is agreed in a term sheet, it may be difficult for either side to renegotiate. Even if renegotiation is possible, you may be forced to concede another point on the deal which is also important to you. A renegotiation may even have an impact on the relationship between the parties, and it may mean that the transaction never progresses beyond this point. In other words, the consequences of agreeing a non-binding commercial point at an early stage of a proposed transaction may be more serious than you anticipate.
As a result, term sheets are important documents for both investors and founders for a number of different reasons, and you should always take legal advice before you sign them. Term sheets should;
- encourage the parties to focus on the important commercial issues in the transaction at an early stage;
- allow the parties to address any misunderstandings or problems;
- allow key legal principles to be settled, which in turn can be used as a framework for drafting the more complex, legally binding transactional documents;
- outline any conditions which need to be satisfied before binding documentation can be entered into;
- provide an outline of the process with regard to due diligence;
- outline the timetable for negotiation and completion of the transaction; and
- set out any binding elements which have been agreed between the parties.
A term sheet in respect of an investment into a startup would generally include:
- details of the company, the current shareholders and the current directors;
- the valuation of the company and the amount the company hopes to raise;
- any information rights for investors;
- any rights for particular founders or investors to remain as directors;
- whether investors will have ‘reserved rights’ in respect of certain major decisions of the company;
- details of what the invested funds will be used for;
- any restrictions on the activities of the founders; and
- a summary of the rights relating to the issue and transfer of shares, and what happens when the company is sold or wound up.
If they do not correctly reflect what has been agreed, or fail to deal with key issues, term sheets can be risky documents to use since any ambiguity can cause uncertainty over the exact nature of the relationship between the parties. There is also a balance between too much detail and too little. Too much detail will cause delay and increase your costs as you may end up negotiating the deal twice. Too little may mean that none of the key commercial issues have been addressed, and you may find out later that you never had a deal in the first place. A good term sheet should save you time and money, but a poor one will have the opposite effect!
Before entering into a term sheet, you should decide whether the document will be legally binding, partially binding or not binding at all. As a founder, you should be particularly wary of binding obligations that prejudice your ability to work with other investors for too long a period, and be even more wary of an investor who wishes to impose a penalty on you if for some reason the terms of the letter are breached. Since the position may not always be clear, legal advice and clear legal drafting will eliminate most uncertainties. If in doubt, seek legal advice.