Startup
Basic term sheet terms and principles that are important know
New entrepreneurs quite quickly encounter a document known as a term sheet, and it seems that no one calls it by any Hebrew name, such as “document of conditions”, “document of transaction conditions” or “document of principles”, but rather by the English term.
Apart from the use of said term in a foreign language, which is also used by purely Israeli investors investing in Israeli companies, many of the terms used in this document are unfamiliar to entrepreneurs who have not yet experienced the fundraising process.
For the purpose of this article, we will briefly review the most important principles and terms that appear in this type of transaction document.
The party that drafts and proposes the document is the potential investor in the company. The investor will submit this document to the company after conducting business and technology evaluations and coming to the conclusion that he is interested in investing in the said company.
The document will detail the terms under which the investor will agree to invest in the company. Investment in the company will always be subject to due diligence tests conducted by the investor and his consultants on the technological level, the intellectual property level, the accounting level and the legal level, and anything else the investor might wish to examine before making the investment.
The document will first describe the company’s current capital structure, before the investment, and will include a capitalization table describing the types of shares, the shareholders, the numbers of shares held by each and entitlement to options, if any were assigned.
After this come the proposed investment amount and a breakdown of the company’s value before the investment.
Next will be detailed the types of shares to be issued to the investor (ordinary shares, preferred shares, etc.), the number of shares that will be allocated with respect to the investment and the price per share and the investor’s holdings after making the investment, on a fully diluted basis, that is, after taking into account all the shares and options already allocated to others, other than the investor. An additional post-investment capitalization table will be attached.
The investor will sometimes reserve an option to make an additional investment at an investment amount to be defined, at the original investment price or perhaps at some additional cost over the original investment.
Sometimes this term sheet will state that the investment will be made in stages or over a certain period of time, and sometimes the transfer of each portion of the total investment amount will be subject to the company’s achievement of certain milestones – be they technological milestones or certain minimum sales quotas or any other condition that accompanies the investment.
The term sheet will detail the use of proceeds by the company, which will usually be detailed in a business plan attached to the term sheet.
Certain investors will agree with the company to provide consulting or management services to the company, and this type of agreement will be signed along with the investment agreement, and the company will pay the investor a separate payment for these services.
The document will detail the conditions of the option plan that will be developed for the company’s managers, employees and consultants, as well as the number of shares that will be retained for this plan.
If the investor receives preferred shares, then the preferential conditions granted to the investor and attached to these shares, such as the right to receive his investment back in the form of a dividend, with or without interest, with or without a premium, before other shareholders receive dividends from the company (dividend preference); voting rights, the terms and dates when the preferred shares convert to ordinary shares; what happens when the company merges into another company or is acquired by another company; what happens if the company is liquidated (liquidation preference); whether the investor is protected from dilution when additional investments are made in the company (anti-dilution) and more.
The investor will retain veto rights with respect to all of the company’s main decisions (restrictive provision), such as: changes to the articles of association, changes in the nature of the company’s business activities, changes in the share capital and capital allocations, making investments exceeding a certain threshold, changes in the signing rights on behalf of the company, merging with or being acquired by another company, and more, and more, limited only by the imagination of the investor and his attorney.
The document will detail the options granted to the investor and the other shareholders in the company against a reduction of their holdings in the company, such as pre-emptive rights; the right of first refusal in case of a sale by a shareholder; the right to join the sale by a shareholder (come along or co-sale); requiring the founders/inventors not to sell their shares for a certain minimal time to be determined.
In addition, the term sheet will determine the manner of voting in the general assembly and the board of directors, as well as the composition of the board of directors. It is important to note the legal quorum required for convening a general meeting or board meeting, so that a certain group cannot “hijack” a decision in the absence of another group.
The investor will demand and receive the right to review documents from the company’s accounting system, quarterly and annual financial reports (information rights), the right to visit the company and inspect its offices and plants, etc. These rights are especially important for an investor who does not receive a seat on the board of directors with his investment (as directors receive all of these rights automatically).
A term that is not at all familiar to new entrepreneurs and which is of great importance to investors is “registration rights”, i.e. the right to register the shares for trading. When a company offers its shares to the public, the party receiving the money raised from the public is the company. The shareholders do not receive anything, and therefore the event does not constitute an “exit” from the investors’ point of view, unless their shares were also registered for trading. In a first offering, it is rare for the investment bank to agree to register the shares of the shareholders for trading (unless the company is extremely successful and promising). Later, however, when the company has already raised funds and wants to make another public offering, shareholders can register their shares for trading as well (subject to the limitations of the law in the country in which the offering is made), and investors therefore place special emphasis on the issue of registering their shares for trading, whether by piggyback or demand rights – more about that in a separate article.
It is important to emphasize that the term sheet does not constitute a binding contract for any of the parties. That being said, the document does express the parties’ desire to make the investment according to the terms detailed therein, and the principles of good faith do apply to the negotiations between the parties and to the actual execution of the investment. If the investor discovers (or says that he has discovered) as part of his examinations findings that could affect the value of the company, then it is possible that the investor will demand to alter the terms of the investment.
Almost always, investors do demand that the company not conduct parallel negotiations with other parties after the date on which the term sheet was signed and all as long as the due diligence is being carried out by the investor (no shop). The company must also undertake to continue to conduct its business normally as long as the investment has not been closed.
During the period of time that the investor conducts his examinations, the legal advisors of the parties will draft a detailed legal agreement, within a specified period of time, which will include the terms of the term sheet and the legal terms that usually apply to agreements of this type. If the defined period of time has transpired and the investment has not been made, and the deadline has not been extended, the term sheet will automatically expired.