Term Sheet - Explained
What is a Term Sheet?
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Table of ContentsWhat is a Term Sheet?How is a Term Sheet Used? Term Sheet Common FeaturesRed Flags in a Term SheetBenefits of Term SheetThe Disadvantages of a Term SheetAcademic Research on Term Sheets
What is a Term Sheet?
A term sheet is a document which outlines the basic terms and conditions under which a business or an investment should operate. The term sheet is usually non-binding because it is not a final agreement signed by the signatories. It is a setting that only outlines what should be executed in the future. It is used by the legal counsel to guide them in the preparation of the final agreement of which after it has been negotiated and signed by the concerned signatories, it becomes an official binding document.
How is a Term Sheet Used?
A term sheet can also be defined as a business transaction proposal by concerned parties. It is a reference document for which the parties refer to when drafting the ultimate agreement or business acquisition. It lays a foundation for ensuring that the parties involved in a business deal come to a consensus on the important aspects of the contract. It is a working document that serves as a starting point for more extensive negotiations and then to a binding agreement. It helps the concerned persons to be aware of what to expect, which they will not accept and what they want out of the term sheet.
Term Sheet Common Features
The term sheet offers a summary of the terms and condition being negotiated or presented by the parties. It points out any basic information on the important points of the deal agreement. The most common features include the following:
- Information concerning the identification of the parties.
- Type of security (collateral) being offered.
- Shares and purchase price on the table.
- Methods of payment to be used.
- Assets involved in the pact.
- Time frame agreed upon by both parties to accept and respond.
- The process to be followed when executing the deal.
- Anything that has been excluded in the contract or any item that may be considered a necessity by either one or both parties.
- Terms offered in case of liquidation (closing conditions)
- Rights, privileges, preferences restriction and obligations of each party.
Red Flags in a Term Sheet
As a business owner, there are many indicators in the term sheet that will help you know whether or not the potential investor is worth striking a deal with. A good term sheet will always have terms that benefit both parties at the end of the day. It should endeavor to ensure that every party emerges a winner in the deal. The following specifications in a term sheet should be a flag raiser that you are in for a raw deal:
- When in the investor is asking for a huge control of your business shares. This is clear that the investor is out to replace you as the sole owner of your business. In this case, the deal is not favorable and you should avoid it.
- When the investors terms are likely to limit future fundraising for your business. When the terms regarding sourcing fund seem limited, then it is probably not a good deal.
- When you notice that the debt financing and convertible note terms are harsh and that could lead you to bankruptcy.
- When the investors are in for a short-term investment with no clear expectations or timelines. This should be an indicator that the intentions of the investor are not known and he or she may be out to spoil your business and then leave.
Benefits of Term Sheet
It helps the parties involved to avoid misunderstanding when negotiating through the agreement. The concerned parties will be guided by what is outlined in the term sheet to negotiate further their deal. It acts as a memorandum of understanding that ensures that the parties involved read from the same page during the negotiation process. This makes the negotiation process smooth and with minimal disagreements. Since the term sheet is non-binding, you are able to demonstrate your commitment or seriousness about the deal without being tied to a deal and without risking too much. The term sheet guides the legal counsel when drafting the agreement. He is able to know what to include in the agreement document and what not. It helps him or her to come up with a clear and concise agreement that meets the expectations of both parties It speeds up the process. When you have a term sheet, it saves you the time of spelling out the long-term references since they are already there on a term sheet. It strengthens or stabilizes a transaction. Though the term sheet has no binding requirement, by signing on the term sheet, may prompt both parties to have some sense of commitment. That sense of commitment will ensure that they live up to their words.
The Disadvantages of a Term Sheet
A term sheet can make you land into an unexpected lawsuit. This may happen when you unintentionally create a binding obligation through your wording but instead to help you in negotiating, but instead, it turns out to be accidentally binding. If this happens and things, then you might find yourself facing legal consequences. As much as term sheet is not supposed to be binding, there are two provisions in the term sheet that will always remain binding to both parties. Any party who violates this provision will lead to him or her being sued for breach of contract. These provisions are:
Confidentiality Terms - A term sheet always has a clause that specifies terms of confidentiality regarding sensitive information of a targeted company. The clause protects the companys information from being shared to a third party by the investor. A third party, in this case, is any person who is not part of the pact. Each party is, therefore, supposed to observe discretion.
No-Shop Provision - This provision is provided in the term sheet to protect the investor. It prohibits the target company from searching for another investor with any third party for a specific time. This protects the investor to ensure that he or she does not waste his or her time and resources with a target company that is already looking for an alternative investor.
- Term sheet discloses your intentions in advance, and this may weaken your negotiation position. This may work to the advantage of the other party during negotiation since he or she already knows what your terms are.
- Creating a term sheet may be expensive. This is because to come up with a comprehensive term sheet, you will need to involve a number of professionals to do the drafting for you. They will in exchange want to paid service fees. The total cost may be high.
- Term sheet can lead to parties pull out of the deal. This is because since most details about the contract are highlighted early in the term sheet. If one party or both parties dont like what is in the document, he or she may back off even before even starting the negotiation.
Academic Research on Term Sheets