Startup Funding: Understanding the Term Sheet BasicsA funding round is a crucial milestone for any startup. After initial discussions with potential investors and obtaining a soft commitment, the term sheet comes into play. But what exactly is a term sheet, what role does it play in a funding round, and which key aspects should be considered? In this article, we explain the fundamentals.
What is a Term Sheet?
A term sheet, also known as a Letter of Intent (LOI) or Memorandum of Understanding (MoU), is a legal document that outlines the fundamental conditions of an investment. It serves as the foundation for the final agreements and helps identify dealbreakers early on.
Although the term sheet is mostly non-binding, there are some binding clauses. One of them is the confidentiality agreement, which ensures that no sensitive information is shared with third parties. Another important clause is exclusivity, which prevents the company from negotiating with other investors in parallel until the legal due diligence is completed. Additionally, the jurisdiction and applicable law are defined, although disputes based on a term sheet are rare.
Key Components of a Term Sheet
A term sheet can be divided into three main categories:
A) Economic Terms
Economic terms form the core of a term sheet as they define the financial parameters of an investment.
- Investment Amount: Specifies the exact amount of capital an investor is providing to the company and under what conditions.
- Company Valuation: A key aspect is the pre-money and post-money valuation of the company. The pre-money valuation represents the company’s value before the investment, while the post-money valuation indicates its value after the investment. This valuation is crucial for determining how much equity the investor receives and how existing shareholders’ stakes are diluted.
- Liquidation Preferences: These provisions protect investors in case the company is sold at a low valuation or liquidated in the future. In such cases, liquidation preferences ensure that investors recover their investment before any distributions are made to other shareholders.
- Anti-Dilution Protection: To prevent existing investors from being negatively affected by future financing rounds, protective mechanisms can be integrated into the term sheet.
- Vesting: Vesting ensures that founders remain with the company over a defined period before they gain full ownership of their shares. Typically, a four-year vesting schedule with a one-year cliff applies. The cliff refers to the waiting period before any shares are granted to founders or employees. Afterward, shares vest in regular installments, meaning that full ownership is only achieved upon completion of the vesting period. This mechanism prevents early leavers from retaining unreasonably high equity stakes and ensures that key personnel stay committed to the company.
B) Control Rights
Control rights grant investors influence over significant corporate decisions.
- Investor Veto Rights: Investors often have veto rights over major decisions, such as the sale of company assets or the initiation of new funding rounds.
- Board Seat: The lead investor frequently secures the right to appoint a board representative, providing them with deep insights into corporate strategy and decision-making.
- Significant Decisions: A term sheet specifies which decisions require investor approval. These typically include mergers, company sales, or major capital measures.
C) Additional Provisions
Besides economic and control-related aspects, a term sheet contains several other clauses that are essential for a smooth financing process.
- Information Rights: Investors generally receive regular reports on business performance and access to key corporate documents.
- Transfer Restrictions: To maintain control over shareholder structure, different stock transfer regulations exist. The Right of First Refusal (ROFR) ensures that existing shareholders have the first opportunity to purchase shares before they are sold to external parties. Tag-along and drag-along clauses define the conditions under which minority shareholders may participate in or be compelled to join a company sale.
- Cost Allocation: In most cases, the company covers part of the investors' costs if the financing round is successfully completed, particularly legal and advisory fees.
- Required Documents: Besides the investment agreement, additional documents may be needed to finalize the financing, such as an updated shareholders' agreement or a potential corporate restructuring (e.g., converting a limited liability company into a stock corporation).
Good Leaver vs. Bad Leaver
A crucial aspect of the vesting process is distinguishing between good leavers and bad leavers:- Good Leaver: A person who exits the company for legitimate reasons, such as health issues or a company sale. In this case, they retain their vested shares.
- Bad Leaver: A person who leaves the company without a valid reason or is dismissed for cause. The company may repurchase their shares at nominal value, meaning that even vested shares could be forfeited.
Standardization of Term Sheets
In Switzerland, the Swiss Private Equity & Corporate Finance Association (SECA) offers standardized term sheet templates. These templates include established contractual clauses but are often investor-friendly. Startups should therefore tailor these templates to their needs and review them with experts.
Conclusion
The term sheet is a fundamental element of any financing round, setting the framework for further negotiations. It is worth investing sufficient time in its preparation, as subsequent contract negotiations are based on the term sheet. By clarifying critical points early on, potential conflicts can be avoided, and the financing process can be conducted more efficiently.
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You’ve secured investor interest and aligned on a Term Sheet – what comes next?
In our next session, we’ll take a closer look at legal due diligence: what to expect, what documents you need, and how to prepare your company for investor scrutiny.
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