What Is a Term Sheet?
A term sheet is a nonbinding agreement that shows the basic terms and conditions of an investment. The term sheet serves as a template and basis for more detailed, legally binding documents. Once the parties involved reach an agreement on the details laid out in the term sheet, a binding agreement or contract that conforms to the term sheet details is drawn up.
- A term sheet is a nonbinding agreement outlining the basic terms and conditions under which an investment will be made.
- Term sheets are most often associated with start-ups. Entrepreneurs find that this document is crucial to attracting investors, such as venture capitalists (VC) with capital to fund enterprises.
- The company valuation, investment amount, percentage stake, voting rights, liquidation preference, anti-dilutive provisions, and investor commitment are some items that should be spelled out in the term sheet.
- Term sheets are also used for mergers, acquisitions, and long-term debt (i.e. commercial real estate development).
- Term sheets are non-binding, though may often require an upfront good faith deposit or other indicator of evidence that both parties intend to carry out an executed full agreement.
Understanding Term Sheets
The term sheet should cover the significant aspects of a deal without detailing every minor contingency covered by a binding contract. The term sheet essentially lays the groundwork for ensuring that the parties involved in a business transaction agree on most major aspects. The term sheet reduces the likelihood of a misunderstanding or unnecessary dispute. Additionally, the term sheet ensures that expensive legal charges involved in drawing up a binding agreement or contract are not incurred prematurely.
All term sheets contain information on the assets, initial purchase price including any contingencies that may affect the price, a timeframe for a response, and other salient information.
Term sheets are most often associated with startups. Entrepreneurs find this document crucial for investors, often venture capitalists (VC), who may offer capital to fund startups.
A term sheet used as part of a merger or attempted acquisition would typically contain information regarding the initial purchase price offer, the preferred payment method, and the assets included in the deal. The term sheet may also contain information regarding what, if anything, is excluded from the deal or any items that may be considered requirements by one or both parties.
What's Included In a Term Sheet
The details to be included in a term sheet are highly dependent on the agreement at hand. What is included in a angel investment, early funding investment term sheet will be substantially different than what's included in a commercial real estate development term sheet.
Regarding an investment term sheet, commonly included details are:
- Nonbinding Terms. Neither party is legally obligated to abide by whatever is outlined on the term sheet.
- Company valuations, investment amounts, the percentage of stakes, and anti-dilutive provisions should be spelled out clearly.
- Voting rights. Startups seeking funding are usually at the mercy of VCs who want to maximize their investment return. This can result in the investor asking for and obtaining a disproportionate influence on the company's direction.
- Liquidation preference. The term sheet should state how the proceeds of a sale will be distributed between the entrepreneur and the investors.
- Investor commitment. The term sheet should state how long the investor is required to remain vested.
Regarding debt agreements, commonly included details are:
- Economic details. This includes the term, loan size, interest rate, and other financial matters common to debt.
- Risk mitigation preferences. The lender will often require specific conditions be met or specific information be provided on a recurring, timely manner.
- Extension rights. The borrower is often allowed to extend a loan, but the term sheet identifies the conditions and cost of extension.
- Due diligence at closing. As part of the term sheet, the lender may stipulate what they require when the loan agreement is drafted. This can include a list of requirements the borrower must prepare to be approved for the loan.
A term sheet may be signed by both parties to formally signify that each side has agreed to the terms and that each team's legal council may proceed with drafting a formal agreement.
Terms Found In a Term Sheet
Term sheets often have standardized language that is commonly and widely accepted by both parties. Here are some specific terms or phrases found in two different types of term sheets.
Investment Term Sheets
Valuation (Pre-Money & Post-Money): Investors may want to see the pre-money valuation and post-money valuation before an official investment agreement is drafted. This valuation information should be based on what the valuation is before the investment is made as well as the value of the company including the new investment.
Valuation Cap: The valuation cap is the value when convertible notes become eligible to covert into equity. Often an important negotiation point, this figure must be discussed early between the two parties to understand a fair point for the start-up to engage in a proper valuation and what protection is fair for the investor.
Drag Alone Clause: Investors may want guarantees that minority stakeholders will follow the guidance of majority stakeholders. A drag along clause requires that smaller investors lead larger investors in business decisions.
Dividends: Investors may want upfront clarity on what net income distributions they will be entitled to. In addition to clarifying the dollar amounts, investors may want to know the timing (i.e. monthly, quarterly, or annual).
Liquidation Preference: Investors may want to know the order in which owners are paid out in the event the company gets sold. This is important to investors as it reduces investment risk.
Voting Rights; Investors may be interested in the say they have over the operations of the company. This may be an agreement on the number of votes the investor receives or any restrictions on matters in which they are not eligible to vote in.
Pro-Rata Rights: Investors may want to better understand their rights for future rounds of investing. For example, depending on their current investment, they may be entitled to the right of first offer for an investment offering in the future. On the other hand, there may be penalties for investors that decide to not partake in future rounds of investing.
No-Shop Agreement: Investors may want protection from other investors or other investment rounds. A no-shop agreement outlines the terms that restrict the company from taking investment money from other people for a specific period of time.
Loan Term Sheet
Loan Amount: Borrowers are obviously pursuing a specific amount of funds to borrow. This term may be a fixed dollar amount, subject to LTV metrics, or subject to DSCR and NOI calculations.
Guaranty: Borrowers may be required to indicate what legal entity with more established credit may vouch for the debt and be held liable in the event that the direct company defaults.
Interest Rate: Depending on the loan, these terms may widely vary. For long-term loans, the interest rate may include a fixed spread rate in addition to a variable rate (i.e. one-month term SOFR).
Term: Borrowers must understand when the loan is fully payable or due. For open lines of credit or development loans, this is the period in which the loan is assessed interest but principal payments may not be due.
Collateral: Borrowers may have to post collateral to substantiate value in the event that they default on a loan. This is often the underlying asset that is supported by the debt, and the lender often stipulates whether they require having the first deed of trust.
Financial Covenants: Borrowers may have to substantiate financial health to a lender. This includes providing externally certified financial statements, guarantee statements, or other financial records that are in accordance with covenants agreed to with the lender.
Loan Costs: In addition to interest assessments, a lender may require an annual administration fee or a one-time loan closing fee. For very large loans, these expenses may be material, and the lender should take care in reviewing what upfront costs must be paid before any loan proceeds are distributed.
Tips for Writing a Term Sheet
Every term sheet will vary, as the parties, conditions, situation, and agreement will rarely be repeated. Still, there are broad tips to drafting a term sheet that apply to nearly every situation:
- Summarize the Conditions. At the beginning of the term sheet, draft a summary that identifies the overall purpose of the agreement and intended outcome. This includes specifically addressing the project (i.e. Seed A funding of Company XYZ or Residential Development of 254 units in Los Angeles, CA). Identify each of the legal parties to be involved.
- State Binding/Non-Binding Terms. A term sheet should explicitly state expectations regarding whether the agreement is binding or non-binding. This is often listed early in the term sheet.
- List the Terms. Though straightforward, understand that a term sheet is the first piece of formal transparent information the opposing party may receive. Though the term sheet should not be the full list of details in the agreement, be mindful to provide enough information to entice the other party without being too overwhelming with details. The term sheet should cover the primary, most important aspects of a deal with the understanding that the minor aspects can be sorted out later.
- State Timeframes. Though the term sheet is non-binding, it should still come with an expiration date that requires the opposing party to take action by a certain time. This will not only encourage participation and action on the term letter but also ensure the terms of the deal do not become stale and unfavorable if held open for too long.
- Encourage Feedback. Consider distributing a Word document version of the term sheet that tracks changes. It would be ideal if the first draft of the term sheet was a complete meeting of the minds with no further changes. Realistically, this is rarely achieved. Though you must ensure the other party does not make changes without tracking, tracking changes allows each side to easily identify the areas not yet in agreement.
A company will often solicit multiple term sheets and compare the terms across bidders. It will then likely move forward with the term sheet that is most favorable, though it may decide to negotiate with anyone that submit a term sheet.
Similar Documents to Term Sheets
A term sheet may seem similar to a letter of intent (LOI) when the action is predominately one-sided, as in acquisitions, or a working document to serve as a jumping-off point for more intensive negotiations. The main difference between an LOI and a term sheet is stylistic; the former is written as a formal letter while the latter is composed of bullet points outlining the terms.
Although term sheets are distinct from LOI and memorandums of understanding (MOU), the three documents are often referred to interchangeably because they accomplish similar goals and contain similar information.
Example of a Term Sheet
In 2021, the New York City Department of Housing Preservation & Development released a term sheet regarding its Supportive Housing Loan Program. The program was intended to offer low-interest loans to support the development of supporting houses with on-site social services.
The term sheet outlines what entities are eligible for these low-interest loans, what tenants quality for the on-site social services requirement, the loan amount, loan terms, as well as construction requirements. At the end of the term sheet, the department's contact information is shown so interested parties that agree to these terms can communicate with the NYC Office of Development.
What Are the Key Points of a Term Sheet?
A term sheet often covers four main categories: the deal economics, the investor rights, the governance and oversight, and the exit terms. A term sheet must communicate enough terms to be insightful for the investor without being a complete set of terms that still need to be negotiated
Who Prepares a Term Sheet?
Depending on the financial instrument, different parties may be the one to prepare the term sheet. For seed round investments, investors often provide a term sheet when offering their private investment. For loans, lending institution will often provide a term sheet to prospective borrowers.
Is a Term Sheet Legally Binding?
Term sheets evidence serious intent but are generally not legally binding. A company may sign a term sheet to agree to the terms of the instrument. However, for example, a separate loan agreement must be signed to be legally binding; a company is not under contract for the loan even if it agrees to a term sheet.
What Is a Term Sheet Format?
A term sheet may take many different forms. In general, it must outline the economic transaction agreed to by the parties. These transactions may range from mergers, acquisitions, loans, joint ventures, or commercial real estate transactions. The format of each term sheet must be tailored to each specific type of instrument.
The Bottom Line
A term sheet is a document that evidences serious intent between two parties that often signals the beginning of a transaction. This term sheet is the first step for the two parties to begin agreeing to how the deal will be structured. Though term sheets are often not binding, they may require a good faith deposit to be held in escrow that indicates expectation of a future deal to be agreed upon.