Highlights
- A Term Sheet is a non-binding agreement between an investor and a company. It is similar to a letter of intent or a memorandum of understanding
- Certain terminology and features are common in all Term Sheets
- A Term Sheet ensures that all parties are on the same page regarding the investment
Access to adequate funding is a concern for most entrepreneurs. Identifying the right type of financing you need (e.g., grants, loans or equity), given the stage of your business is only the first step. The next step is to start the conversation with investors who can provide that type and amount of investment. When you deal with banks, individuals or institutional investors, a document that comes up often is the ‘Term Sheet’.
A Term Sheet is an agreement between an investor/financial partner and a company that lays out the basic conditions for investment. The document details what each party is expected to contribute to the transaction and outlines what is expected to happen over the course of the investment. The Term Sheet will also lay out what value the investor has placed on the company based on investment type and amount. It is like a letter of intent (LOI) or a memorandum of understanding (MOU). The conditions in a Term Sheet are agreed on via negotiations between the company and the investor.
Types of Term Sheets: Initial vs Final
At the start of a conversation about a potential investment, the investor presents an initial Term Sheet that, largely, is non-binding. There are some binding terms regarding confidentiality, who bears the transaction costs and a pre-emption period, as explained below. This means that most of the contents of the Term Sheet are conditional on the confirmation of certain assumptions that will be made through further investigation into the state of the company (due diligence). It is not a legal promise to invest, and all parties can cancel the agreement at any time.
If after due diligence both parties want to continue with the transaction, the investor will present a final Term Sheet that will act as a summary of the legally binding detailed agreements that will have to be signed before funds can be released.
Term Sheets may differ based on the investor and the stage of the investment, but there are some similar features and terms that will always appear. Below are some common sections in a typical Term Sheet, and some areas where things may be different depending on the type of investor.
Investment Terms: This is usually the first section of the Term Sheet. It would typically include a description of the investor and company, the amount to be invested and whether it will be a debt or equity investment. If the investor makes investments in different currencies, the currency for the transaction will also be included.
This section could include the use of funds as well as how and when funds would be disbursed to the company.
Equity Terms/Debt Terms: The Equity and/or Debt Terms section lays out the investor’s valuation of your company and outlines certain terms and conditions for investment. This section also highlights a number of shareholder agreement terms that the investor would like to make known. These would typically cover conditions about board representation, what should happen if your company seeks to raise more funds in the future, and shareholder rights.
Valuation: There are a variety of ways to determine the value of your company but usually an investor will present valuation as a multiple of EBITDA (your calculated earnings before depreciation and amortisation, taxes and interest payments) e.g., 5x EBITDA, or as a multiple of net assets (the company’s total assets minus its total liabilities).
In an equity investment, the valuation determines the percentage of the company the investor will own after investment and usually, a post investment share allocation table is also included. If it is a debt investment, the valuation would cover the value of the collateral to be used in securing the debt, or the value of the equivalent equity share if the debt will be converted to equity at a later stage of the investment.
In a venture capital (VC) fund Term Sheet, valuation is expressed in terms of pre-money and post-money values. The pre-money valuation is the company’s valuation before the new investment. The post-money valuation is simply equal to the pre-money valuation plus the amount of the new investment.
Exit Provision: The Equity/Debt Terms section also includes provisions for the investor’s exit. The most common provisions are the Call provision and the Put provision
- Call Provision: The call provision allows for the company to buy back shares from the investor at a pre-determined valuation provided certain financial targets are met. The company here has the right to ‘call’ on the investor to sell a percentage of their shares.
- Put Provision: The put provision allows for the investor to give the company right of first refusal when it wants to sell its shares. This means that the investor ‘puts’ the choice and offer of buying the shares in front of the company first, before marketing to a third party.
Anti-dilution and Liquidation Preference: In situations where the investor receives preference shares (the holder of a preferred share receives a fixed dividend from the company, and has priority when it comes to sharing profits over other equity shareholders), the Term Sheet might include anti-dilution and liquidation preference terms. The anti-dilution terms provide protection against dilution so that the investment value and shareholder stake remain the same in subsequent third-party investments into the company, while liquidation preference terms state that in the event of a sale, proceeds will be paid back to the investor first before other shareholders.
Board representation: A private equity (PE) investor would usually want the right to appoint 1 or 2 board members and would also require that they have representation on key board committees such as the audit, compensation or strategy committees. Having a say in the decision-making process at the company makes investors feel more confident about funding a business. All investors have a duty of care toward their investors’ money and seek to mitigate risk and ensure maximum returns with such governance changes.
Additional Funding Raises: For an investor, an additional funding raise can be an opportunity or a worry. Every investor wants an opportunity to earn returns on their investment, so ‘tag-along’ and/or ‘drag-along’ rights might be included in the Term Sheet to ensure those opportunities.
- Tag-along rights give a minority shareholder the right (but not the obligation) to sell their shares for the same price and terms as a majority shareholder. So, in the event of an exit share sale by a majority shareholder, minority shareholders would have the same price and terms.
- Drag-along rights are designed for when an offer is made to buy the company. If a specified percentage of shareholders want to sell, then all shareholders would be made to sell at that price. This is on the assumption that buyers would want to buy the whole company.
Legally Binding Terms: The final section of the Term Sheet explains general investment terms like representations and warrants, audit and reporting obligations, and transaction and due diligence costs. Some notable terms include:
Pre-emption Period: The company agrees to give the investor pre-emptive rights for a period (usually 120 days from the date of signing the Term Sheet) with respect to the company issuing or agreeing to another financial instrument from a third party that would prevent the completion of the investment. This means that the company must give the investor the right to match or offer a similar financial instrument before they go with the third party. Typically, the Term Sheet will provide for exceptions such as grants or short-term working capital facilities.
Representations and warrants: The investor would usually require that the company makes certain representations and provides some warrantees. The representations are usually to say that the company is registered and in good standing under the laws of the country it is registered in; that it is free and clear of any legal entanglements or litigations, and that it follows international anti-money laundering and ESG guidelines. The existing shareholders are also required to make similar representations. The company also provides warranties that the company’s financials are true and fair, and that there are no legal or financial issues involving the company.
Audit and Reporting Obligations: The company commits to providing audited accounts and to submit to audits at the request of the investor. The company also commits to providing quarterly or monthly reports on its financial performance. These commitments give comfort to an investor that attention is being paid to the financial health of the company.
Transaction and Diligence Costs: The investor stipulates who bears liability for costs incurred in conducting company due diligence as part of the assessment process before investment, as well as cost associated with processing the investment after the final approval.
In a nutshell, the Term Sheet is a document to ensure that both the company and the investor are on the same page before further steps are taken in the investment process. Indeed, a Term Sheet is a positive indication that an investor is interested in providing funds to your company! Since the Term Sheet considers the concerns and obligations of both parties, it is quite important that at least one person on your team can actively influence its creation.
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About the Fund Manager
Injaro Investment Advisors Limited is an investment advisory firm licensed by the Ghana Securities & Exchange Commission, and is part of an international fund management group that manages investments across Sub-Saharan Africa. Injaro has expertise in the areas of private capital, corporate finance advisory, asset management, management consulting and project management.
