Congratulations, you received a term sheet for a financing. That’s a huge vote of confidence and, likely, represents the culmination of many hours of work by Company management. After celebrating, what should you do next?
Most companies, eager to capitalize on the momentum of the deal, want to sign the term sheet right away and move on to closing the transaction. Although that desire is understandable, once a term sheet is signed, a company’s leverage decreases substantially (even if the term sheet is non-binding). There are steps a company can take before signing a term sheet that can make a significant difference in the outcome of a deal, so we always recommend taking the time to consider the following issues before signing a term sheet.
1. Is it important to have a lawyer review a term sheet before signing?
A term sheet by its nature focuses on the most significant business terms and issues in a transaction. As a result, it may seem like there is little need to have an attorney review it — after all, who knows your business better than you do?
However, there are a number of reasons why you should strongly consider having an attorney experienced with investor-backed companies review a financing term sheet before you sign it.
Most term sheets offered by investors have been prepared and reviewed by attorneys for the investors counsel. They are strategically crafted to highlight issues that are important for the investors, and minimize or be silent on issues that are important to the company or its founders. Although it is often easy to react to the words on the page and negotiate those points, it is much harder to recognize what has been left out of the term sheet.
Moreover, even seemingly simple phrases in a term sheet can gloss over or imply a whole array of detailed terms that may not be obvious to a non-lawyer. Although term sheets are typically not binding, it will be difficult for your attorneys to negotiate away something in the final transaction agreements that was referenced in the term sheet, even if obliquely.
Even though involving a lawyer might seem like an extra upfront cost, it could save a lot of trouble and money in the long run, and will almost certainly result in cost savings when it comes time to document the transaction.
2. Will reviewing and/or negotiating a term sheet before signing jeopardize the deal?
Founders are often reluctant to negotiate a term sheet or involve an attorney at the term sheet stage because they fear that it will slow down the process just as momentum is building, or, worse case cause the company to lose the deal.
In reality, taking the time to understand a term sheet and discussing key points with an experienced attorney can help speed up the overall process, by identifying key questions and help a founder prioritize which deal terms to include and negotiate at the term sheet phase versus which deal terms can be left for negotiation later.
Generally speaking, investors don’t issue formal term sheets unless they are serious about moving forward with an investment. As a result, typically there are very few issues that might be identified in a term sheet that would prevent a deal from moving forward. An experienced attorney will be able to provide context for terms that may be non-standard or off-market, as well as practical solutions for helping you and your investor reach an agreement quickly. Ultimately, it’s better to address key issues upfront, to allow a founder to compare different deals or offers, and resolve issues or misunderstanding before a founder is inadvertently locked into bad or unintended terms in the final documents.
3. Can I shop the term sheet with other investors?
Ideally, the Company has been talking to a number of potential investors, trying to find a good fit and the best deal. Now that you have a term sheet, it’s understandable that your first instinct may be to take that term sheet to the other investors you have been talking with to see if they can match or beat the terms. While it’s understandable to believe that the quickest way to get the best deal is to get an auction going, there are several reasons you shouldn’t do that.
First, the term sheet was almost delivered to the Company in confidence. Whether or not you signed a formal NDA with the investor (many won’t), the mutual understanding that the term sheet was being delivered in confidence can create a legally binding obligation and liability.
Second, the venture investment community is a small community and there is reputational risk in sharing a confidential term sheet. If nothing else, the party you show it to will now know that you will not be keeping their term sheet confidential, should they give you one.
So, what can you safely share? Even though you should not share the actual term sheet, it is perfectly OK to share your expectations regarding key business terms like the size of the round and the company valuation. It’s also fine to say that you have a term sheet and that you will need to make a decision soon.
In everything, be careful about what you disclose – often it is better from a negotiation standpoint not to share the exact details of the other offers. You want each party to make its highest and best offer, not just $1 more than the other person. Often the investor’s imagination of what a different investor might have offered will be greater than the actual offer, so disclosing exact amounts can backfire.
4. Can I still grant options after I receive a term sheet?
One question from our previous “10 Things to do Before You Get a Term Sheet” post as whether you can grant options after receiving a term sheet. Unfortunately, the answer is probably “no.”
In order to grant an option, the Board of Directors must determine the exercise price for the option, which, in order to avoid tax penalties and other issues, must be equal to the fair market value of the common stock of the company on the date of grant. As a result, the Board must also make a determination of fair market value, and do so in accordance with the IRS rules regarding company valuations in the context of awards to service providers.
The IRS rules, which have been come to be known as the 409A rules, generally say that a valuation must take into account all known facts that are relevant to valuation, and the IRS has indicated that the receipt of a term sheet (not the later acceptance of a term sheet), is enough that a valuation can no longer be performed without reflecting the transaction and valuation described in the term sheet.
As a result of this position, any 409A valuation that the Company has previously received will no longer be valid once you have received a term sheet, and as a practical matter you won’t be able to get a new valuation until after the round closes or is terminated. Without a valuation, it will be difficult, if not impossible, to grant options.
Therefore, to the extent you expect to receive a term sheet from an investor in the near future, if you wish to grant options at the prevailing 409A valuation you should try to get those options approved by the company’s Board of Directors before you receive the term sheet.
5. How negotiable are term sheets?
Everything is negotiable, but a Company’s success in negotiating a term sheet is, of course, primarily a factor of leverage. Historically, with the investor writing the check and the Company needing the funds, the Investor will have the leverage. If the Company has multiple term sheets, or late-stage discussions with multiple investors, then of course the Company’s leverage will increase substantially.
Regardless of the number of investors, the Company’s leverage is always highest before signing the term sheet and is often nearly eliminated after signing, especially in the typical situation where a term sheet includes a binding no-shop provision. While there are a number of specific terms that are typically negotiated in a term sheet (which we’ll discuss in a separate blog post), at a high level there are several things to keep in mind when reviewing a term sheet.
While some items in the term sheet, like valuation, are pretty simple to understand (higher is generally better for the company) and are certainly negotiable, certain non-financial terms, however, will vary from company to company.
For instance, one important area to focus on is how control for future company decision-making is allocated between the common stockholders, preferred stockholders, board of directors and management. There are a number of ways that this is structured, even within “market,” and this is often tailored specifically to the particular company and investor. Even when a company has no negotiation leverage, it’s critical to understand how control of the company will work post-financing.
Finally, it’s sometimes the case that the investor, rushing to provide a term sheet, will use a “standard” form, or a form from a prior deal, without thought to some of the fine print. That fine print may be critically important to the company and significantly shift control in the company, but it may not be important to the investor. If you don’t ask, you won’t know.
6. Is it OK if the term sheet is non-binding?
Term sheets are historically non-binding, meaning that except for some specific terms that are expressly called out, either party can walk away from the deal at any time without liability. The only typical exception to this is that if the term sheet contains an exclusivity provision (also colloquially known as a “no-shop”) or a confidentiality provision. As is typically for most term sheets issue by sophisticated investors, your term sheet will likely include a binding exclusivity provision, where you agree, after signing a term sheet, that you will not talk with any other potential investor until the term of the exclusivity expires.
Otherwise, most provisions in a term sheet are non-binding on purpose. The primary reason for this is that there are numerous details to be worked out that are not contained in the term sheet, including representations and warranties of the parties, stockholder rights and other matters. Although investors often agree to use “standard forms,” those forms still vary quite widely and have substantial room for negotiation and customization. The term sheet can’t possibly cover all of those terms.
The term sheet stage is also the wrong stage to be negotiating those details. Typically it’s only after a term sheet has been signed that the real due diligence investigation by the investor begins. That is because the investor typically does not engage legal counsel for diligence until that stage. Both parties are going to want to make sure that any significant legal or financial diligence is complete and any issues have been addressed before conducting the final negotiations on the deal points.
Although non-binding, the term sheet does offer significant “moral” authority when it comes to final negotiations. If a term has been discussed in the term sheet, absent a material change in circumstances, it is highly unlikely that term will be changed in the final deal documents.
7. Do I need my board to sign off of a term sheet before signing?
Technically, you usually do not need the Board of Director’s formal approval to sign a term sheet. Having said that, it is a good practice to discuss the terms contained in the term sheet with your board:
- they hopefully have experience that can be useful to you as you evaluate the opportunity;
- they will expect to be kept in the know on something as material as a financing transaction, and
- their approval for the deal will be needed in any event, so you definitely don’t want to agree to something in a term sheet that the Company can’t deliver on later.
The best practice here is to circulate draft term sheets to the board and engage in a discussion with them about the terms. Offer to jump on an informal board call/discussion (have your attorney on the call in case the board members have questions on the legalese), and seek their informal approval (verbal or email) before signing the term sheet. But realize that your attorneys may not document a formal board approval of the term sheet, which is fine.
8. When do I need to set up a data room? What is OK to share with investors before I receive or sign a term sheet?
Although not required prior to signing a term sheet, as part of the financing, the investor’s legal and finance advisors will conduct an extensive review of the Company, including a review of financial statements, accounting records, legal contracts, employment matters, IP matters, tax history, and other industry-specific reviews. That due diligence process typically starts with a lengthy request list from the investor or investor’s counsel AFTER a term sheet is signed, wherein the investor asks for documentation relating to all of these areas in the request list.
To respond to that request, the Company will need to provide copies of numerous documents (practically speaking, nearly every piece of paper the business has generated), organized in a way that will allow the investor to complete their review as quickly as possible. The electronic folders where those documents are uploaded is referred to as the data room and you will need one.
You can use any system for creating the data room, but it is typical to use one of the standard file sharing services such as Box, Dropbox, Sharepoint, or Google Drive. Your attorney may be able to facilitate this, or you may have something else that works, and on rare occasion the investor will provide a system. Generally, however, there is no need to purchase one of the customized data room solutions that are on the market.
It’s never too early to get organized, but often the actual population of documents into the data room will follow the signing of the term sheet.
In addition, in some cases, companies or founders may be asked to provide information before the issuance of a term sheet or before signing of a term sheet. It is typical for companies to share high level financial forecasts, high level past financials, in addition to whatever formal investor pitch deck or other materials the company may have prepared specifically as part of an investor financing raise. Ultimately what a company might share before receiving or signing a term sheet will vary by company and investor, generally its better to avoid sharing information beyond a pitch deck and high level financials until after a term sheet is signed.
9. Do I want to be on Carta or Pulley (or Shareworks)?
We typically recommend that a company use one of the online cap table management systems. They each have their plusses and minuses, but if the company has not previously set one up, the first financing is a good time to do that, and you don’t need to wait until after you have a signed term sheet to get started.
The implementation will take a week or two, depending on how complete the current records are and how complicated the cap table is. They also charge a subscription fee, and you will incur some ongoing costs to maintain it (in the form of attorney’s fees when updates need to be made in connection with stock and option issues), but those costs are typically offset by savings in getting 409A valuations (which are included) and in savings in having your attorney maintain a stock ledger manually, which is much more time intensive.
Implementing an online system will speed up the diligence process and the management of your cap table going forward, and if implemented correctly with appropriate checks and balances, will reduce the likelihood of costly errors. Therefore we recommend a company start the process of onboarding onto an online cap table system before receiving a term sheet.
10. What happens next?
Whether or not you make any changes to the term sheet, or take any other steps outlined here, the receipt of a term sheet is a great time to have a coordination call with your attorney. A financing transaction is a complicated process that involves multiple parties and a number of steps. On average, it takes from 4 to 6 weeks to complete a financing process from the time a term sheet is signed. Meeting with your attorney is a great way to understand what the process will look like and coordinate on roles and responsibilities.
In particular, you should discuss and set expectations around:
- when the financing needs to be completed,
- what specific steps will need to be taken, and who is responsible for each step,
- any external events, such as hiring, press releases, significant commercial or strategic announcements, regulatory approvals or announcements, or other material changes to the business that need to be taken into account,
- whether there will be a need for any specialist or local counsel review to address matters like foreign investment issues (CFIUS), anti-trust issues (HSR), IP issues, tax issues, employment issues, litigation, or issues related to cross-border or multi-national operations; and
- what fees and costs you should expect to incur, and what can you do to reduce those fees, and reduce the chances for surprise.
Having a candid and open discussion at the time you receive a term sheet will help streamline the process, save fees and better plan for a successful fundraising experience.
Inceptiv
Latest posts by Inceptiv (see all)
- Ten Things EVERYONE Should Know about the Corporate Transparency Act (CTA) - November 6, 2024