A GROWING COMPANY’S GUIDE TO TERM SHEETS
Kyle D. Winey, Esq.
Companies in growth mode are exciting, appealing, and of course, profitable. As they grow, companies are often presented with a variety of new opportunities in the marketplace. Many of these new opportunities are capable of catapulting the company to the next level.
However, in order to capitalize on these new opportunities, a company often needs one critical ingredient: money. As the saying goes, “It takes money to make money.” Occasionally, companies will opt to finance these new opportunities through “bootstrapping” – using the profits from current operations to finance new growth initiatives. However, bootstrapping comes with several disadvantages, mainly, time. With bootstrapping, generating sufficient cash to finance growth opportunities often takes years, and inside a world changing faster than ever, many companies do not have years to wait. That is why many growing companies seek to raise outside capital.
In raising capital, entrepreneurs, business folks, and companies will likely encounter a “term sheet.” The purpose of this article is to explore what term sheets are, why they matter, and how negotiating a favorable term sheet is key to long-term business success.
What are Term Sheets?
A term sheet is a proposed list of key terms and conditions that relate to an investment. Term sheets cover the major elements in any financing transaction.
The purpose of a term sheet is to confirm the major items of the transaction on the front-end, so that the deal does not fall apart on the back-end. Term sheets allow all parties to come to a mutually beneficial arrangement before actually going through the process of establishing a legally binding arrangement. In essence, term sheets are meant to reduce the cost and risk to all the parties by entering into a non-binding arrangement prior to the execution of a binding agreement.
Many people are familiar with “letters of intent” in purchasing real estate, which outline the key terms and conditions of buying property. Term sheets are to businesses what letters of intent are to real property. Upon the parties finalizing a term sheet, a lawyer will draft up a binding contract, which the parties will sign, finalizing the deal.
At a high level, term sheets generally focus on two (2) areas: control and economics. In regard to control, term sheets propose who manages the company, how they manage the company, and the scope of their authority to manage the company. In regard to economics, term sheets propose the amount of the investment, the investors’ rights relating to the investment, and the company’s rights after receiving the investment.
Term sheets can be as simple as one-page letters (e.g. “We would like to invest $100,000 in your company and buy 78% of it.”). More commonly, term sheets are several pages that spell out the terms and conditions of the investment (e.g. “We could like to invest $100,000 in your company and buy 78% of it, subject to the following terms and conditions.”). In more complicated transactions, term sheets can be extensive and complex, proposing all sorts of “protective provisions” “vesting arrangements,” and “drag-along rights.” Over the years, the art of the term sheet has grown, and with it, terms sheets have gotten longer in length and more sophisticated in language.
As the owner of the company, it’s your job to negotiate the details of the term sheet. How can you ensure the terms are beneficial to your company if you don’t understand what the terms mean? Below are four (4) major considerations to keep in mind before signing a term sheet.
The 4 Things to Know Before Signing a Term Sheet
- Pre-Money versus Post-Money Valuations
The price (or the amount raised in exchange for the amount of equity given) is the most important part of the deal. The price of a transaction is often referred to as “valuation.” However, negotiating a company’s valuation is not as straight-forward as negotiating the price of a car, for example.
One of the most common oversights is the pre-money versus post-money trap. A pre-money valuation of a company is the value assessed before the proposed investment occurs. A post-money valuation is the valuation of the company after the investment occurs. This subtle difference can result in a significantly different company valuation.
For example, suppose that you are seeking a $2.5 million investment in your company. At a pre-money valuation of $10 Million, that investment would equal a 25 percent equity or ownership. At a post-money valuation, a $2.5 million dollar investment would equal 20 percent equity or ownership. Merely based on whether a pre-money or post-money valuation is used, you may be forced to surrender 5 percent more of your company for the same investment amount. As a result, knowing whether pre-money or post-money valuation is at issue can produce drastically different results.
- Liquidation Preferences
After price, the liquidation preference is the most important economic consideration. Liquidation preferences determine how the profits are shared in a “liquidity event,” which is usually defined as a sale of the company or a majority of the company’s assets. To be accurate, “liquidation preferences” pertain to money returned to a particular series of the company’s stock ahead of another series of stock.
Suppose the liquidation preference in a term sheet is for the benefit of “preferred stockholders.” In the event of liquidation, a common liquidation preference might be to award preferred shareholders an amount equal to [X] times the amount of the original investment before the holders of common stock receive any return. If you are a holder of common stock and the company is sold, you are going to have a deep interest in knowing how much of the proceeds are going to the preferred shareholders, who are going to receive money pursuant to their liquidation preference before you receive a dime.
The importance of liquidation preferences grows as a company grows. If the company seeks to raise more money later, existing liquidation preferences can scare off new investors, or at the very least, reduce the amount of money new investors are inclined to invest.
- Protective Provisions
Protective provisions are effectively veto rights investors have on certain actions by the company. Not surprisingly, investors love these provisions, while companies do not.
While there are a variety of protective provisions for which an investor may advocate, the most common protective provisions pertain to the ability of the company to:
- change or alter the rights of preferred shared holders;
- authorize the issuance of additional stock;
- issue stock senior or equal to that of the investors;
- buy back any common stock;
- sell the company;
- change the certificate of incorporation or bylaws;
- change the size of the board of directors;
- pay or declare a dividend; and
- borrow money.
In order to soften the effect of these provisions, many companies (or, ideally, the attorneys for these companies) will argue for “materiality qualifiers,” meaning that the restriction only applies if it produces a “material” effect on the company. The challenge, of course, is that no one really knows what “material” means in this context, so even trying to soften the effects of these protective provisions nevertheless exposes the company to risk.
- Drag-Along Rights
A drag-along agreement provides a subset of investors the ability to force, or “drag along,” all of the other investors and founders to conduct a sale of the company, regardless of how anyone else, including the other investors and founders, feel about the transaction.
Drag-along rights matter most when things are falling apart. When things are crashing, investors may want out in order to preserve their money. Founders, however, may have different thoughts. Considering the enormous amount of sweat equity invested, founders are often reluctant to sell a company for a price that generates a small profit or even produces a loss. Founders are more likely to ride out the downturn, rather than cut their losses and move forward.
Before seeking to raise outside capital, be sure to understand what term sheets are and how the terms will impact your company. A term sheet could cause lasting damage, or set up your company for long-term success.
If you seek guidance from an attorney in starting your business or seeking venture capital, please contact Simms Showers, LLP, located in Leesburg, Virginia, at KDW@simmsshowerslaw.com or HRS@simmsshowerslaw.com or call 703.771.4671.
Feld, B., & Mendelson, J. (2017). Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist. New York, NY: John Wiley & Sons.
Wilmerding, A. (2001). Term Sheets & Valuations: An Inside Look at the Intricacies of Term Sheets & Valuations. Aspatore.
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