Oh Sheet! 5 Critical Issues for Your Next Financing Term Sheet

How Much do you Know about a Financing Term Sheet?

You are in the early stage of the financing process for your company. A non-disclosure agreement has been executed, and you have started initial discussions with an interested investor, perhaps with a peek behind the curtain to assess the value of your venture. It is now time for your company to either initiate or entertain a funding proposal. You know the proposal will take the form of a term sheet, but how much do you really know about a term sheet beyond that?

The term sheet, also known as a letter of intent (LOI) or memorandum of understanding (MOU), is a critical tool to advance your company’s financing. You may have the opportunity to prepare your own term sheet for an early stage financing, which commonly involves friends and family or initial seed investors. However, when it comes to later-stage and venture financings, when you’re dealing with more sophisticated investors, you’re more likely to receive the term sheet from the investors for review and negotiation.

Regardless of the source of the term sheet, the potential threat of giving away more of the farm (e.g. ownership, control, and operational flexibility) than you intended is both real and frightening, whether it results from inexperience or letting a fox into the henhouse.

So, what do you need to understand and look out for when you are preparing or reviewing a term sheet? To keep you and your financing efforts on track, we’ve identified five key issues that you should understand before your next financing term sheet becomes your next nightmare:

Five Key Issues to Know Before Your Next Term Sheet:

1. The term sheet is an initial deal barometer

A term sheet is more than just an outline of the major terms of a financing proposal. It is a gauge of the atmosphere surrounding the investment transaction as a whole. How the investor responds to the deal presented and the negotiations thereafter provide strong signals regarding its business approach, a level of fairness and operational control going forward. In this way, the term sheet acts as a valuable bellwether, revealing if the investor is on board with your vision. This tip-off can save you precious time and resources by opting out of a deal before you get into a full-blown agreement, which may be difficult to extract yourself from somewhere down the road.

2. The terms are generally not binding…

Speaking of the pain of extraction, the beauty of a term sheet is that, while it provides an outline for the financing, the terms are generally not binding (except when they are – more on that below). In fact, the terms of the financing are subject to change depending on the results of the investor’s due diligence investigation and the financial condition of your company. The bad news is that, over time, the terms typically only improve for the investor. Although the outline for the financing presented in the term sheet is not set in stone, it creates a structure that provides little leeway for your company to negotiate more favorable terms. It therefore, is important that you ensure that any terms that are particularly important to you are included in the term sheet, so that they are on the table from the outset.

3. Except for those provisions that are binding…

For the most part, term sheets are non-binding, but there are a few common binding provisions built into term sheets that are designed to, among other things, help keep the parties honest and on track to complete the deal:

• Confidentiality: Unless there is a stand-alone non-disclosure agreement, the parties are generally required to maintain the confidentiality of the terms and conditions set forth in the term sheet, as well as any information shared during discussions and due diligence. The bottom line is that the investor does not want the company to use the term sheet to shop for another investor, and the company does not want the investor to share with others its confidential information or the terms of the deal the investors were able to orchestrate.
• Governing Law and Dispute Resolution: This clause establishes the venue, governing law, and method of dispute resolution that will apply should a disagreement arise between the parties, in particular relating to those binding provisions.
• Expenses: Expense provisions typically involve two scenarios: (1) the investor requires that the company pay its legal and other related fees and costs for the financing, regardless of whether the deal goes through; or (2) each party is responsible for its own fees and costs. The most important thing to remember is that, if there is an expense provision, you need to make sure that there is a cap on the fees in order to avoid sticker shock should a financing fall through.
• Exclusivity: An “exclusivity” or “no-shop” provision prohibits the company from soliciting offers for financing from other investors for a set period of time during a financing negotiation. Violation of this provision can bring an abrupt end to negotiations and, in limited cases, the infliction of a termination fee or other legal hammers. In this manner, exclusivity gives teeth to a term sheet, but those teeth can cut both ways. While investors want to make sure that they are not wasting their time on a deal that may be snatched up by someone else, due to the countdown nature of this provision, it also encourages the investor to move quickly and efficiently in conducting its due diligence, so as not to lose the opportunity to another interested party.

4. The no-shop period is not siesta time

You should not fall asleep while the investor is conducting its due diligence during the no-shop period. This is the time to keep your eyes wide open. Calendar your no-shop deadline and make sure that you and your team comply with the restrictive provisions of the term sheet. During this time, continue to conduct your business in good faith and provide the investor with the information and updates needed to complete its due diligence.

Be very mindful of the power of the no-shop provision as a source of negotiation leverage as the deal progresses. This leverage may shift as the end of the no-shop period nears, depending on the financial situation of your company and the investor’s desire to close the financing. For example, if the investor suspects that you are in financial dire straits and believes you have no other financing options, then the investor can try to draw out the closing to the end of the no-shop period (or beyond) and whittle you down to get better terms. Other times, the investor may ask the company to extend the no-shop period to allow it additional time to complete due diligence, vet the company or raise money for itself to fund the investment.

As a general rule, keep the exclusivity period to 30 days (if possible) and don’t extend beyond that. If you have to, only grant short extensions if the investor has demonstrated good faith efforts to move forward with the deal and you’re satisfied with the terms. If you give investors too much rope, then they can and will use it to their advantage.

5. Seek expert advice when creating your term sheet

It is easy to feel like a real wheeler-dealer when it comes to negotiating your term sheet, but pace yourself, cowboy. We have said it before, and we will say it again, whether this is your first or fifteenth time at the rodeo, you always should get professional advice when crafting or negotiating a term sheet. Unless term sheets are a regular part of your day job, hand the reins over to the experts for which they are. Legal and financial advisors’ familiarity with these documents allows them to identify quickly potential perks and pitfalls in proposed terms, as well as to provide invaluable insight into negotiating the best possible deal for your company. Term sheets set the tone for your financing, and once you’ve agreed to something, it’s hard to pull that back. Professional counsel can help you avoid ineffective negotiations that may leave you boxed in by the “golden rule” – “he who has the gold rules.”

To have a term sheet in hand from an interested investor is an exciting opportunity to take your company to the next level. You are now armed with enough insight to approach your next term sheet as a guide to negotiate a fair deal or walk away from a bad fit, hopefully with the wisdom of experienced counsel to guide you to the right decision. And don’t forget: When it comes to startup funding, you need to “give a sheet” about your term sheet.

By the way, term sheets are such an integral piece of the startup journey that we’ve hosted our Tacos and Term Sheets webinars and workshops to help educate entrepreneurs about various term sheets that they will encounter along the way. Check out our recent term sheet webinars and sign up for our next workshop!

Related Content

Want to learn even more about funding your company? These blog posts are a great place to start:

• Finders/Weepers
• Financing Fundamentals: Equity Funding, Convertible Debt & Dilution
• Due Diligence: Is your startup investor ready?
• 6 Investor Questions You Need to Answer to Raise Money
• Convertible note term sheet – Explained
• Venture Capital Attorney – 7 Interview Questions To Ask A Prospective Lawyer

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