Term Sheets and the Hook, Line, and Sinker Fallacy

 

Saurabh Nathany explains Term Sheets.

Are you a startup founder? Have you received a Term Sheet? 

It’s very exciting when you’ve built your product (or sometimes it’s still in the works), pitched before investors, and now an investor wants to invest!

Let’s assume the investor wants to invest in direct equity. We call such an investment round a “Priced Round”, meaning, securities issued at a particular price. Priced rounds (as opposed to SAFE or Convertible Note rounds) typically begin with an investor sending you a Term Sheet containing terms based on which they will invest. 

You will be tempted to sign (and frankly, I would too!)

But hold on! Proceed with the utmost care!

Unless you are experienced enough to understand all the terms, please avoid signing the Term Sheet without having your advisor review and confirm the terms with you.

Two big reasons for this:

1. Non-Binding but (Ironically) Non-Negotiable:

Term Sheets contain investment terms in a bullet-point fashion, whereas Investment Agreements contain the longer form versions of the terms. Each is specifically designed that way. 

The terms you agree to at the Term Sheet level will eventually need to be incorporated into the Investment Agreement.

And while Term Sheets say they are non-binding, really the non-binding aspect of them is the obligation of the investor to invest. So, after signing a Term Sheet, if an investor backs out, they cannot be sued because their obligation to invest was not binding.

But if the investor proceeds to invest, unless the terms are very one-sided, the provisions of the Term Sheet will find their way into the Investment Agreement. Investment Agreements are the binding agreements in contrast to Term Sheets. In an Investment Agreement, the investor agrees to invest a certain amount of money at a certain price per share. All parties are aware of how many shares each investor would eventually get. 

This is why, however impatient you may be to sign the dotted line, you should always have an attorney, or someone well versed with the nature of Term Sheets, review and advise you. 

Investors should give you at least two to three days to review and revert. During this time, you should ensure you fully understand the terms contained in the Term Sheet and their implications.

2. Multiple Investors:

Where the investment round size is big (in excess of $5M), and the company is pursuing multiple VCs, sometimes multiple Term Sheets will be received that may be in conflict with each other. For example, the Term Sheet of VC Fund 1 may require that post-closing, the company have at least two investor directors, one of which is assigned and allocated to VC Fund 1. On the contrary, the Term Sheet of VC Fund 2 may require that post-closing, the company have only one investor director that is allocated to VC Fund 2.

The earlier these conflicting points are discussed and agreed upon, the quicker the parties will be able to close the financing transaction otherwise investors may end up either not agreeing with each other and one withdrawing its offer to invest or both investors may team up to negotiate against the company. 

To avoid this, it may be best to have a single Term Sheet executed by all the VC investors combining the terms of each. 

Now, let’s assume the inevitable:

You’ve signed a bad Term Sheet that contains some very onerous terms.

The following are the steps you may consider proceeding with:

  1. Discuss with your legal counsel and understand the implications of the egregious terms.

  2. Understand which terms are worth fighting for and which you can let go of.

  3. Prepare a strategy where you go to the investor with a bucket full of deviations from the Term Sheet. (Ideally, your bucket list should contain two or three key terms you should fight tooth and nail for.)

  4. Before your legal counsel begins preparing the Investment Agreement, set up a call with the investor (no lawyers at this time, please) to explain why some terms won’t work from a business standpoint. (Ideally, you should discuss with your lawyer regarding positioning some points in a certain way over others).

Although this is more like damage control after the fact, this is one of the best mitigation approaches for you as a founder. 

Over the next few weeks, I will share specific terms in a Term Sheet that are onerous and must be avoided at all costs.

So, stay tuned…

Disclaimer: the blogs on this website are for informational purpose only and are not intended to provide legal advice.

 
Samantha Gee