What is a Term Sheet?
Term sheets (also known as letters of intent or memoranda of understanding) set out the key terms of a transaction agreed upon in principle by the parties. Parties usually sign a term sheet at the beginning of a transaction, once preliminary terms are agreed to but before commencing due diligence and drafting the definitive transaction documents.
Why Create a Term Sheet?
There are several reasons why parties to a transaction will want to use a term sheet.
First, it enhances deal stability and creates a level of commitment and sense of momentum to complete the transaction. Although parties are not usually obligated to complete the transaction under the term sheet, a well-crafted term sheet is usually detailed enough to provide meaningful representation of the parties’ intentions. The term sheet negotiation process itself can also create a sense of shared vision between the parties, and give them more confidence to commit more resources to proceed with the transaction.
Second, term sheets guide the drafting and negotiation of the definitive transaction documents, as the principal terms of the deal have already been determined and the expectations of the parties have been set. When done properly, this reduces the amount of time to finish a deal and the level of uncertainty.
Third, in a start-up venture capital context, early investors in emerging companies – particularly in a family/friends round – may not be very sophisticated. It may help those parties understand the deal better if a term sheet sets out the basic structure and key terms. It is worth noting that the complexity of a term sheet typically is a function of the stage of the financing and the transaction structure adopted. Early seed stage common stock term sheets are shorter and simpler than later stage convertible preferred stock term sheets.
Finally, term sheets often provide for binding provisions in areas such as exclusivity, confidentiality, and payment of expenses. These provisions can be important at the early stage of discussions even before the key economic terms have been discussed or agreed upon.
What Should a Term Sheet Include?
As a general rule, all significant deal points should be covered in the term sheet. Failing to follow this principle is the most deadly mistake made. Term sheets that are just too short and too general provide little value. Term sheets should be short enough to accurately summarize the parties’ intent, but detailed enough to avoid surprises when the definitive transaction documents are negotiated.
For financing transactions involving emerging growth companies, term sheets should at a minimum include the following:
- The size of investment, company valuation and any funding milestones
- Type and price of securities being issued (i.e., common stock, preferred stock, LLC interests or debt securities)
- A description of the rights and preferences of the offered securities (i.e., voting rights, dividend rights, distribution rights, liquidation preferences; redemption provisions, conversion rights and protective provisions); depending on the type of security, this section can be quite complex
- If debt securities are being issued, terms regarding interest rate, maturity date, ranking and subordination, and affirmative/negative covenants, as well as conversion features if the debt is convertible
- Corporate governance rights of the investors and founders, including board seats, committee representation, information rights, pre-emptive rights and any special voting rights
- Transfer restrictions, such as ROFR, co-sale and drag-along rights
- Treatment / vesting of founders’ equity
Binding or Non-binding
Parities should be aware that, other than customary binding provisions such as exclusivity, cost sharing and confidentiality, term sheets are usually not legally binding as to the key economic terms and do not require parties to conclude the transaction on the terms set out in the term sheets, or even at all.