What is a "term sheet"?
A term sheet is a document that outlines the basic terms and conditions of a business deal, typically an investment or acquisition. It is commonly used in venture capital (VC) funding and mergers and acquisitions (M&A) to lay the groundwork for a more detailed, binding contract. The term sheet serves as a roadmap for negotiations between the parties involved, establishing mutual understanding on key financial, legal, and operational aspects. A term sheet signals the parties' intent to proceed with the deal and provides clarity on the expectations, rights, and obligations of each side.
A term sheet is generally considered a non-binding document, but there are certain provisions that can be legally binding. For example, confidentiality clauses are often binding, requiring both parties to keep the details of the transaction private. Similarly, exclusivity or no-shop clauses may be binding, preventing the target company from soliciting or negotiating with other potential investors or buyers while the term sheet is in effect. These binding provisions help protect the integrity of the negotiation process and ensure that both parties remain committed to working toward a final agreement. It's important to clarify which terms are binding in the term sheet to avoid potential disputes later in the process.
In venture capital, a term sheet sets out the key terms for an investment in a startup or growing company. It is often the first formal document exchanged between the founders and potential investors. .
In the context of mergers and acquisitions, a term sheet outlines the basic structure of the deal, such as whether the acquisition will be structured as an asset purchase, merger or a stock purchase, the proposed purchase price, and other critical deal points.
While term sheets can vary significantly depending on the deal type and the parties involved, there are several key terms that should be covered in each scenario.
Key Terms in a Venture Capital Term Sheet:
- Valuation: The pre-money valuation of the company, which determines the value of the business before new investment is made.
- Investment Amount: The amount of capital that the investors will provide and how it will be allocated among the investors..
- Equity Ownership: The percentage of ownership the investors will receive in exchange for their investment.
- Liquidation Preference: Tje order in which investors get paid in the event of a liquidation or sale of the company, ensuring that they are paid before common stock shareholders.
- Board Composition: Determines how the board of directors will be structured, including how many seats investors will have and how many will be held by founders or independent board members.
- Anti-Dilution Protection: Protects investors from dilution of their ownership if the company issues additional shares at a lower price in the future.
- Voting Rights: Outlines the rights investors have in decision-making processes, including any veto rights they may hold over certain actions such as sale of the company.
- Vesting Schedule for Founders: Specifies the timeline over which founders earn their shares, often tying ownership to continued employment with the company.
- Drag-Along and Tag-Along Rights: Provides investors with the ability to force or join a sale of the company under certain conditions, ensuring that minority shareholders can be included in a sale.
For example, in a typical Series A round, an investor might agree to provide $5 million for 25% ownership of the startup, with a 1x liquidation preference, meaning the investor will be entitled to at least the original investment amount in the event of liquidation.
Key Terms in an M&A Term Sheet:
- Purchase Price: The total amount the buyer will pay to acquire the target company, including any contingencies like earnouts or performance-based payouts.
- Deal Structure: Whether the deal will be structured as a stock purchase, asset purchase, or merger, each of which has different legal and tax implications.
- Payment Method: Details whether the purchase price will be paid in cash, stock, or a combination of both.
- Earnouts: If applicable, specifies the conditions under which additional payments will be made, often tied to achieving certain financial or operational milestones post-closing.
- Closing Conditions: Lists the conditions that must be satisfied before the transaction can close, such as regulatory approvals or the successful completion of due diligence.
- Representations and Warranties: Statements made by both parties regarding the state of the business being sold, which serve to ensure that both sides have full knowledge of the company’s financial, legal, and operational condition.
- Escrow and Indemnification: Specifies any portion of the purchase price to be held in escrow to cover potential post-closing liabilities and outlines the indemnification obligations of each party.
- Non-Compete and Non-Solicitation Agreements: Provisions that prevent the seller from competing with the buyer or soliciting employees after the transaction is completed.
- Termination Provisions: Conditions under which either party can terminate the agreement, typically related to failure to meet certain deadlines or conditions.
For example, in a $100 million acquisition deal, the term sheet might specify that $80 million will be paid upfront in cash, while $20 million is tied to the acquired company meeting certain revenue targets over the next two years.
Examples:
In venture capital, a famous example of a term sheet is the Sequoia Capital investment in WhatsApp. The term sheet for WhatsApp's early funding rounds outlined the terms under which Sequoia would invest, ultimately helping the messaging platform grow to the point where it was acquired by Facebook for $19 billion.
In M&A, the Disney acquisition of Pixar involved a complex term sheet outlining the $7.4 billion purchase price, paid in Disney stock, along with representations and warranties about Pixar’s intellectual property and creative pipeline.
In conclusion, a term sheet is an essential document in both venture capital and M&A transactions. It provides clarity on key terms and sets the stage for more detailed agreements, helping both parties navigate complex negotiations with a clear understanding of the deal structure. Whether it's an investor funding a startup or a company acquiring another, a well-drafted term sheet can help prevent misunderstandings and streamline the path to a final agreement.
For more information, see A Guide to Venture Capital Financings for Startups and How to Negotiate a Business Acquisition Letter of Intent.
