How can Term Sheets be Helpful for Entrepreneurs and Investors?

By Aesha El-Nahas
2021-09-19


Since entrepreneurs usually need capital to expand their start-ups, they resort to investors to provide such needs. By allowing foreign investment, the entrepreneur chooses to reduce his/her share of a bigger company, rather than keeping a big share of a small company. The relation between entrepreneurs and investors can be both rewarding and risky, yet the term sheets come to regulate such relations. Term sheets act as a guide to the agreements between entrepreneurs and investors in terms of defining profits and risk.

 

What is a term sheet?

The term sheet is a nonbinding document that includes the terms and conditions of the agreement between an entrepreneur and investors. This is a preceding document, which takes place before taking any legal actions or due diligence. In addition, term sheets are a way of understanding between the parties, so that each of them knows who they’re getting into business with. It also reflects on all upcoming agreements between parties.

 

What does the term sheet include?

  1. Different Types of Share

Different types of shares include B class shares and preferred shares. B class shares are those which have fewer voting rights. As for preferred shares, they have more rights regarding the company assets than those of regular shares.

  1. Capitalization

The capitalization table gives an analysis of the financing of the company, which is usually in the form of a spreadsheet; it uses its own specific language. It tracks the equity of the company’s shareholders and security holders. Moreover, the capitalization table involves all elements of stakeholders which includes: convertible debt, stock options and warrants, and preferred stocks.

 

What are the key clauses of the term sheet?

Deal economics

Investors guarantee their gains and limit their losses by using special clauses such as some of the following clauses

  1. Investment amount; one of the essential elements of the term sheet, which establishes each investor’s amount.
  2. Valuation; is divided into pre-money valuation and post-money valuation. Pre-money valuation is apparently the valuation of the company before the investment, however, the post-money valuation is the valuation of the company after the investment.
  3. Conversion; is the right to convert shares of preferred stock into shares of common stock at a specific rate called the conversion rate, such right could be either optional or mandatory.
  4. Option pool; a tool required by investors to attract talent by sharing ownership with employees, and is directly linked to the valuation.
  5. Liquidation preference; shows who is paid first and how much in case of liquidation, bankruptcy, or sale.
  6. Participating preferred; if the preferred gets paid first and then the remaining goes to common shareholders, then the participating preferred gets paid twice.
  7. Dividends, which guarantees the investors receiving their interest.

 

 

Investor rights and protection

The following clauses protect the investors’ contribution.

  1. Anti-dilution rights; the most crucial clause is the anti-dilution right, which prohibits the company from reducing shares, or selling new shares with prices less than the original investor has paid for. Such rights can either be weight average or ratchet based.
  2. Pre-emptive or pro-rata right; they allow shareholders to maintain their share in the company by allowing them to buy proportionate shares when new stocks are issued.
  3. Right of first refusal and co-sale rights; these rights protect the investors by offering the sale of more stock at the issuance of new ones. Specifically, the right of refusal obliges shareholders to offer sale to existing shareholders before third parties, and co-sale rights allow their holder to enter into secondary transactions.
  4. No shop clause; it prevents the company from making investment proposals with other parties.

 

Governance management and control

  1. Voting rights; are shareholders’ right to vote on matters of corporate  policy.
  2. Board rights, such as hiring, firing, setting goals, and other powers.
  3. Information rights; these rights require the company to share its financial and business conditions with investors frequently.
  4. Founder vesting, a mechanism that minimizes the risk of losing the founder.

 

Exits and liquidity

  1. Drag-along and tag-along rights; the former prevents situations in which minor shareholders impede the company sale agreed upon by the majority, while the latter gives minority shareholders the right to join in actions taken by the majority. This is due to the capability of the majority to find the most favorable deals.
  2. Redemption rights; this clause gives investors the right to demand redemption of their stocks within a specific time.

 

To sum up, the term sheet is an influential document for sharing equity. It allows both the entrepreneur and investor to make sure they have a mutual agreement on basic operations, which guarantees a level of mutual understanding between parties. Term sheets include some crucial clauses that have an extensive effect on future agreements between parties.