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What is a term sheet for investment?

If you’re a founder or a business owner looking for investment, you may have heard the phrase ‘term sheet’. These documents are extremely important as they signal the terms on which an investor is prepared to fund your business. As they also lay the groundwork for legal documents, you should pay close attention to their wording and understand the detail so you can push back against any conditions you don’t agree with. Let’s take a look at term sheets and what they look like at typical stages of funding rounds.

What is a term sheet?

A term sheet is a list of terms and conditions on which an investor is prepared to fund your business.

At a basic level, term sheets describe the amount of the proposed investment and the share of your business the investor would like in return. It may also include finer detail like voting rights and the role the investor would like to play in your business in future.

Your proposed investor will send you their draft term sheet, and from there the terms will be negotiated between you. Once these have been agreed in principle, formal legal documents will be drawn up.

Term sheets are useful as they ensure that the parties in an investment transaction agree the major points of the deal up front, avoiding major misunderstandings or disagreements (or at least flushing these out at an early stage).

Here are the most important aspects to remember about term sheets:

  • They are not legally binding contracts, they are just agreements in principle on key issues
  • They should be clearly worded and can be negotiated by both sides
  • They will likely contain provisions about the following issues:
    • How the company will be valued
    • How much the investment will be
    • What percentage of your business the investor is looking for?
    • What steps the investor (and business owner) wish to take to protect their percentage investment (anti-dilution provisions)
    • Whether the investor wants a say in the way the business is run (voting rights)
    • If the company is sold or liquidated, how the proceeds of this liquidation will be shared between the business owner and the investor (liquidation preference)
    • The exit strategy for the investor

How a term sheet should look at different stages of investment

The more established and successful a business is, the less risky it is to invest, and so the founders will generally have more leverage to negotiate favourable terms. Early-stage businesses with less trading history are riskier, so investors will expect to negotiate much harder terms including a higher percentage of equity. 

As a business progresses through different funding rounds, the term sheets get longer and more complex. A successful term sheet negotiation aims to balance the rights of both founder and investors, so the parties can move quickly to funding and final execution of legal documents.

Seed and early-stage capital term sheets

Seed capital is funding provided to start-up or early stage businesses. Because these businesses are usually not yet trading, and may even still be at the concept stage, funding amounts are generally small and also high risk. Seed capital may be ‘bootstrap’ funding provided by founders, friends or family, but seed capital can also be provided by angel investors or venture capitalist firms (VCs) who specialist in early-stage finance. Angel investors and VCs will generally expect to receive an equity stake in the business in return for their investment.

Seed capital investors may fund an early-stage business in several ways:

  1. Convertible loans or convertible loan notes where the investor loans the business money with a view to converting that loan to equity at a later date
  2. Equity investments where the investor takes an immediate stake in the business, usually preferred shares
  3. Advance subscription agreements where an investor provides funding but shares will be issued in a later funding round at a discount or SAFEs (simple agreements for future equity)

Here are some of the most common issues that will be covered in a seed capital or early-stage capital term sheets:

  • Whether the funding will be in the form of debt (a convertible loan note) or equity (immediate share issue, SAFE or advanced subscription agreement for example)
  • Valuation and the capitalisation table.  The ‘cap table’ describes the shares issued and potentially to be issued (under employee option schemes for example) at a point in time. The cap table is used to calculate the price per share and percentage ownership, once the company has been valued. The percentage of shares that investors will receive will depend on whether this is calculated prior to the investment being received (pre-money) or after the funding has taken place (post-money)
  • Whether any shares issued will be ordinary or preferred shares, and the terms of any preferences such as liquidation preferences
  • What role, if any, the investor expects to play in management of the company and what rights to information they will have
  • What discounts will be available to investors if shares are to be issued at a later date, and what, if any, valuation caps will apply when the company is valued in order to mitigate the risk to investors
  • What anti-dilution provisions will apply - to prevent early-stage investor’s percentage interest in the company being diluted by shares being issued in future funding rounds and investors’ rights to participate in future funding rounds
  • What conditions, if any, will there be prior to funding being made, for example, that advance assurance has been received from HMRC that the investment will qualify for preferential tax relief under the EIS or SEIS
  • How investor rights will be protected
  • What the structure of the company will be and whether investors will have a seat on the board
  • How the investor expects to exit the company, and the terms of that exit

VC and later stage funding rounds

The main difference between seed and early-stage term sheets, and VC and later funding rounds (Series A and beyond), is that these term sheets tend to be much more complicated and detailed, and also contemplate what happens in the event of an IPO (floatation).

While the terms that apply to seed and early-stage businesses will equally be included in VC/later stage term sheets, in addition, the following issues are more likely to be covered and in more detail:

  • Drag and tag-along rights. These rights are intended to protect the rights of minority investors in the business. Drag-along provisions are intended to allow shareholders to force others to sell their shares if an offer is made to buy the company. The drag-along rights will apply once a certain percentage of shareholders have agreed to sell. Tag-along provisions enable minority shareholders to sell their shares at the same price as majority shareholders if a sale is agreed.
  • Veto rights. As funding rounds progress, and the percentage ownership of the company by external investors increases, investors are more likely to want a say in the way the company is run in order to maximise the value of their investment.
  • Board appointments and board approval. Later stage investors are likely to want a seat on the board of directors in return for their investment.
  • Warranties. VCs are likely to want business owners to provide detailed warranties about the business and statements made in the course of funding and due diligence.

What needs to be included in a term sheet

There are no hard-and-fast rules about what should be included in a term sheet. However, at a minimum the term sheet will describe the type of investment (convertible loan, equity investment, deferred equity investment for example), and what the investor expects in return.

These are the most basic items a term sheet will contain:

  1. The names of both parties
  2. The legal identity of the investor
  3. The type of investment being offered
  4. How and when the valuation of the company will take place
  5. The amount of the funding
  6. How the price per share will be calculated
  7. Exit provisions (liquidation, sale or IPO)
  8. Board seats, voting rights, veto
  9. Anti-dilution provisions
  10. Confidentiality
  11. Pre-emption rights

Common pitfalls to look out for when reviewing your term sheet

If you’re a founder or small business owner looking for investment, here are some red flags you should avoid when reviewing your term sheet:

  • If the investment is in the form of a loan (a convertible note), interest rates or repayment terms that might cause you financial problems.
  • An investor that is looking for too high an equity share. Investors looking for a larger share of your business might end up with too much control over your business. Up to 20% per funding round is a reasonable limit to set.
  • Investors that want to limit or control your ability to seek further funding in order to prevent their shareholding being diluted.
  • Investors that want too many seats on the board or too many voting rights.
  • Investors that are not interested in supporting your business in the short term, but simply want to make a quick profit.

It’s also important to remember that term sheets are not legally binding documents. Even if you have signed a term sheet, you can still walk away from the deal if you change your mind about the terms being offered. Once a term sheet is in place, investors will still need to conduct due diligence and further information may come to light about both sides, so nothing is final until legal documents are signed.

It’s very important to seek legal and financial advice if you are negotiating a term sheet. Consider working with a firm that has experience in providing legal advice for start-ups and small businesses specifically, as they will have the knowledge that could protect your business financially.

It’s also prudent to get the right legal advice in place because calculations about company value and share price are very complex, and the percentage of the business you will be giving away will differ depending on whether the share price is calculated prior to the investment being made (pre-money) or after (post-money).

Don’t be afraid to ask for advice, particularly if you’re not confident making these calculations yourself. Ask your corporate lawyer to prepare a capitalisation table and explain to you how this works.

Avoid ‘no-shop’ clauses in a term sheet that try to tie you in to particular investors, or that would restrict your ability to seek other investors for too long a period of time.


What next?

For more answers to commonly asked questions and advice on term sheets, convertible loan notes, SAFEs, advanced subscription agreements, equity funding, venture capital, private equity and EIS/SEIS schemes, consult our corporate solicitors. Get in touch on – 0800 689 1700 , email us at enquiries@hjsolicitors.co.uk, or fill out the short form below with your enquiry.

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