Understanding termsheets

A Termsheet is a “preliminary” and a “non-binding” document which is signed between the startup and the investor. It outlines the key financial and other terms of a proposed investment.

It is preliminary because Investors use a termSheet to achieve a conditional agreement on key terms (such as valuation andshareholder rights) before the due diligence is carried out. Once the due-diligence is over, the termsheet forms the basis for drafting the two final investment documents – (1) subscription agreement and (2) shareholders agreement. Many times these two final documents can also be clubbed into one.

With the exception of certain clauses (commonly those dealing with confidentiality, exclusivity and sometimes some fees in the event of investment not proceeding ahead) provisions of a termsheet are not usually intended to be legally binding.

A termsheet also usually contains certain conditions which need to be met before the investment is completed and these are known as “conditions precedent”.

 So what is the structure of the termsheet?

A terms sheet can be considered to be made up of 3 layers.

1. In simple terms, the core layer of a term sheet includesnumber related terms. It shall mention the pre and post money valuation of the company. It will cover the number of shares to be allotted to the incoming investor. If the instrument is a convertible note, then it will cover the coupon rate payable, if any.  As ESOP dilutes the shareholding of the investors, this part of the termsheet also covers the agreement on the ESOP pool. For example, the termsheet may state that before the conclusion of the final agreements, the startup will create the ESOP pool and it shall not affect the shareholding of the incoming investor.

One of the key things that is agreed upon in the term sheet is valuation of the company:

(i) Pre-money valuation – the value of the business (and the cash) as offered to the investors before the investment

(ii) Post-money valuation – the value of the business after the new cash has been put into the business; so post money valuation equals pre-money valuation plus the fund raise

2. The second part of the termsheet is a group of clauses that protect the investment directly. These are the set of clauses which protect the investments in a very numerical way.  Most of these clauses are related to the scenario what happens if the business doesn’t do well.

If the business raises further rounds of capital at a lower valuation then this part of the termsheet defines what happens to this set of investors. These are called anti-dilution clauses. Generally speaking, there are two forms of this clause:

(i) Full ratchet: the investor gets the new lower price on his investment amount and is fully protected.

(ii) Weighted average (most commonly used): the investor is partially compensated by taking into account the number of new shares being issued at the lower price

The second set of important clauses that are covered here are the “exit” related rights. Typically, the following rights are covered:

(i) Drag along: typically available to a lead investor or to a significant investor that allows them to “force” other investors to sell their shares along with them.

(ii) Tag along rights: Gives the right to small shareholders to participate in the sale organized by the large shareholders at the same terms

The third very important right that is covered here is liquidation preference.

(i) The liquidation preference defines which investors get paid first when a company is liquidated (typically distress sale but profitable also). Generally preferred shareholders are usually paid back first

(ii) The liquidation preference also defines how much the investor will be paid off for example if an investor has 2x preference that means she will get paid 2 times her investment before the pool of money is made available to other shareholders.

3. The third set of clauses in a termsheet are the ones which protect the investors’ interest indirectly. In an early stage investment, the investor is banking only on the entrepreneur really. The clauses in this group ensure that the investor has some say in the strategy of the company and the founders take care of the interest of the investors. Some of the clauses are:

(i) Voting rights& Board seats – Voting rights are generally attached to the common stock (pro rata basis) to participate on key matters of the company

(ii) Information rights – These ensure that the financial and strategic and financial information of the startup is shared with the investors in a timely and accurate manner.Veto rights – these rights give power to the investors to stop the startup/ founders from taking certain decisions that may affect the investment negatively e.g. raising debt or equity in a down round or selling a brand or selling a part of business

(iii) Restrictive clauses on promoters – for example ensuring that they don’t have a conflicting business or they don’t take higher than a specified salary or the vesting schedule of founder shares.

Once a Term Sheet is issued, next steps include:

1. Legal teams get involved to thrash out the details

2. Investors assess financial reports and audits through an accounting firm

3. Deal proceeds if data checks out; otherwise the terms are renegotiated or the deal is dropped

4. Detailed rights discussion leading to finalization of Share Holders Agreement and subscription agreement.

5. Document signing

6. Transfer of funds

7. Regulatory filings

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About Author : The founder of VCIFY, Puneet Suri, is a veteran of the PE/VC industry. He is an M.B.A. from IIM- Ahmedabad, and has been involved in more than fifty investments across consumer, technology and e-commerce sectors. He is based out of Gurgaon (NCR).

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