Investment Term Sheets: All You Need to Know

?What is an Investment Term Sheet and when might one be used?

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An Investment Term Sheet is a non-legally binding agreement between an Investor and a company. It sets out the main terms under which the Investor will invest in the company and what they expect in return, for example shares in the company or interest. Once the parties agree on the terms set out in the Term Sheet, a legally binding Investment Agreement incorporating those terms will be drawn up.

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A Term Sheet is commonly used by Start-up Businesses as it is an effective way for them to attract Investors and raise funds for their new business. As Term Sheets provide an overview of the important points agreed on by the parties, they make clear both the company and Investor’s intentions and expectations at an early stage, after which they can decide if the terms are suitable for them and if they want to go forward with the investment. This helps to avoid misunderstandings and the potential for disputes in the long run.

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?What are the key terms to include in an Investment Term Sheet between an Investor and a Start-up Business?

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Investors will consider it riskier to invest in Start-up Businesses, as they have little to no trading history, and it would be harder to estimate their future profits. Therefore, Investors will have greater negotiating power as to the key terms to be included in the Term Sheet, as there is a greater risk attached to their investment.

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Some of the key terms to be included in the Term Sheet are:

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1. Company valuation- The value of the company before the investments will be made.

2. Capitalisation table- This table should set out the current issued shares, the shares to be issued to the Investors, and the price per share based on the company valuation.

3. Investment amount- The amount each Investor will invest in the company.

4. Security- this is what the Investor will get in return for investing in the company. For example, they may be getting shares in the company and/or earning interest on their investment amount.

5. Board of Directors- Where Investors are investing in Start-up Businesses, in return they may want control over certain decision-making and the management of the company. Therefore, the Term Sheet should set out which Investors, if any, will be given a seat on the Board.

6. Voting Rights- The Term Sheet should set out which matters require the approval of majority shareholders. Investors that have voting rights attached to their shares will have a right to vote on these decisions.

7. Dividends- Investors will want to know the proportion of the company’s profits they will be entitled to, and how this will be paid to them (monthly, quarterly, or annually).

8. Pre-emption Rights- This is the right of the Investor to minimise or prevent the dilution of their shareholding in the company. This right is generally activated when the company issues new shares. In such a case, the Investor would be entitled to a ‘right of first offer’- meaning the company would have to offer the new shares to these Investors first. If the existing Investors don’t wish to purchase these shares, the company can then offer them to third parties.

9. Drag-along Rights- Investors would want to include a drag-along provision in the Term Sheet and in the subsequent Investment Agreement to protect their investment in the company. This provision would mean that where more than 50% of the shareholding in the company is acquired by a third-party, the minority shareholders will have to sell their shares to the same third-party under the same terms and conditions.

10. Tag-along Rights- Similarly, including a tag-along right in the Term Sheet and subsequent Investment Agreement would give minority shareholders the right to sell their shares to a buyer at the same price offered to majority shareholders thereby safeguarding the interests of minority shareholders.

11. Anti-dilution- Dilution occurs when a company issues new shares in future funding rounds at a lower price than current Investors paid for their shares, resulting in the percentage of the shares owned by existing shareholders going down i.e. ‘diluting’. Investors will want the Term Sheet to include anti-dilution provisions to ensure their share percentage of the company is maintained, thereby protecting their investment.

12. Employee Share Option Plans (ESOP)- These are schemes set up by companies rewarding their employees with shares in the company. Investors will want to know if any ESOP scheme will be set up by the company, as it can alter the share structure of the company.

13. Expiry- The Term Sheet should specify the date it will expire on if not signed by the parties by then.

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?What should Start-Up Businesses be mindful of?

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As Start-up Businesses will have less negotiating power as to the terms of the investment, there are points they should be mindful of before signing a binding agreement.

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1. Final Agreement- Start-up Businesses must keep in mind that Term Sheets are not legally binding, and the Investors are not bound to make any investments at the point of signing, unless otherwise stated. This is because the Investors will want to do their due diligence before finalising any agreement. Start-up Businesses should therefore hold off on increasing expenses at this point, especially if these are being made in anticipation of theinvestment payments coming through. ?

2. Board of Directors- Start-up Businesses should be wary of Investors that want a seat on the Board, as Directors are responsible for the running and management of the day-to-day operations of the company. The founders of the Start-up Business may not want Investors to have such control in the company, especially at this early stage.

3. Future rounds- Start-up Businesses should be wary of Investors wanting to include terms that prevent them from raising funds in the future from other Investors.

?Overall, Term Sheets serve as a good basis for both Investors and Start-up Businesses to see if they agree on the important terms of an investment before wasting time, resources, and costs on drawing up a binding agreement, only to realise that the transaction doesn’t work for them. Starting with a Term Sheet allows the parties to negotiate and agree on the most important terms before deciding if entering into a binding agreement works for them.

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Having a good Term Sheet that provides for both the Investor and Start-up Business’s needs can result in a successful investment benefiting both parties.

For advice on Terms Sheets and Investment related documents please do not hesitate to reach out to us at [email protected] .