After a successful approach, it is important to enter into negotiations and to fix essential rights and obligations contractually in a term sheet. However, since there is an information asymmetry to the detriment of investors prior to extensive due diligence, an immediate and binding contractual fixation harbors great risks. In order to nevertheless record the status of the negotiations in writing and to signal to the founders their willingness to participate in the company, term sheets serve as pre-contractual declarations of intent.
- Term sheets ensure planning security and counteract information asymmetries through mutual obligations.
- Most of the clauses in the term sheet aim to reduce the investment risk for investors, for example through vesting, anti-dilution, drag / tag along and liquidation preferences.
- Although the term sheet does not provide a legal obligation to conclude the participation agreement, the agreed clauses shall be complied with and deviations in the deed of association are difficult to enforce in practice.
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The term sheet offers security in planning and counteracts information asymmetries
A term sheet is a declaration of intent that is exchanged between founders and potential investors prior to the actual participation agreement, on the one hand to signal the willingness of investors to participate in the company and on the other hand to record the status of the negotiations and to define the first legal basics. In contrast to a preliminary agreement, the term sheet does not result in any legal obligation to conclude the participation agreement. However, claims for damages by one party against the other (culpa in contrahendo) can arise from the term sheet as a pre-contractual declaration of intent; For example, when consulting services are commissioned for a project whose completion was clearly promised and for which it can be explicitly demonstrated that there was initially no intention to execute the project.
The purpose of a term sheet is, on the one hand, to create security in planning for the founders and, on the other hand, to define certain components for the participation agreement without legally fixing them before carrying out an extensive due diligence. Prior to due diligence, there is a strong information asymmetry to the detriment of investors. This is due to several facts: firstly, the value of the company can hardly or not at all be calculated before the due diligence, secondly, the founders usually are significantly better informed about the performance of their company, and thirdly, based on experience, founders are more likely to evaluate the economic potential of their company better than non-company investors. Therefore, a direct, binding fixation of the participation agreement results in major risks for investors.
Most of the clauses aim to reduce the investment risk
In order to keep the risks as low as possible, investors therefore often insist on the agreement of the term sheet. This is individually adapted to the business model and the industry of the company as well as the requirements of the founders and the previous shareholders. As a rule, however, the following aspects are included, always with the aim of protecting the capital provider before carrying out a due diligence.
- Investor and Investee: Name and address of both the founders and the investors
- Amount of investment: Type and scope of the investment as well as the amount of the planned participation
- Cap Table: Capital structure of the company before and after the investment
- Vesting: Loss of the founder's shares in the event of early departure from the company
- Anti-Dilution: Protection of investors from dilution in the event of follow-up financing due to an uncertain future company valuation
- Drag along: Obligation to sell shares in the event of an exit option for minority shareholders
- Tag along: Right to jointly sell if other shareholders are interested in selling on the same terms
- Liquidation preference: Priority of exit proceeds between shareholders
- Further clauses: e.g. Activities requiring approval, guarantees, legal obligations, contractual penalties, etc.
- Completion Date Confidentiality: Possibility of agreeing on a term, on confidentiality, on the need to be in writing and inserting the severability clause
Some aspects of the term sheet are not part of a standard contract. It is therefore worth taking a closer look at the clauses marked above.
Vesting: obliges the founders to surrender their shares in the event of early exit from the company
Vesting is a contractual term according to which founders have to transfer their shares in whole or at least partially to the other shareholders, but especially to the investors, usually at their nominal value when they leave the start-up early. This obligation arises from the risk of the investors who, when handing over capital, must trust that the founders will work hard in order for the company to succeed.
In the event of an exit, a distinction is made between a good leaver and a bad leaver. A good leaver leaves the company for autonomous reasons, i.e. as part of an ordinary termination, or at least not due to its own fault (ordinary termination by the start-up). A bad leaver, on the other hand, leaves the company in the course of a termination without notice, for example as a result of a culpable breach of duty.
A vesting period is often set for three years; however, the length of this period varies depending on the contractual agreement. The shares subject to redemption are reduced by 1/36 per month. In reality, however, it is more common to opt for a so-called cliff. According to this option, all business shares of the founders are subject to a possible redemption until the end of the first business year. With the completion of the first year and the associated overcoming of the symbolic cliff, only half of the founders' shares are subject to potential confiscation. The rest of the vesting period then runs normally with a monthly reduction of the shares that are subject to cancellation. The advantage of this option is increased security for the investors, since the founders do not retain a share in the company in the event of an exit within the first year but have to surrender all shares.
Anti-dilution: protects existing shareholders from a reduction of their share value in a down-round
In order to reduce the investment risk, anti-dilution regulations protect against reduction in value of the shares of the existing shareholders. In the case of follow-up financing, which is based on a lower pre-money rating than the post-money rating from the pre-financing, these are intended to protect investors from a reduction in their share value. If the start-up's rating is lower in the following round than in the preliminary round, it is called a down-round. Anti-dilution clauses therefore enable the existing shareholders to increase their participation by taking over or subscribing to new shares at a lower nominal value.
In business practice, there are two ways of achieving protection against dilution: In case of a full ratchet, investors can take over or re-subscribe as many shares in the course of the down-round as they need in order to keep their participation quota from the previous financing round unchanged. However, this security arises at the expense of the founders, who have to lose a great deal of their own shares to keep the existing shareholder’s previous participation quota unchanged. In case of the weighted average, on the other hand, the dilution is intercepted by both the founders and the existing investors by taking into account the total number of shares issued in relation to the number of shares of investors with weighted average protection.
Drag / Tag along: grant jointly selling rights, but also obligations
Since institutional investors are interested in a high increase in the value of their investments and in an exit from the company at a suitable time (see also our our blog post: What venture capitalists look for in a start-up), obligations to sell (drag along) and rights (tag along) play an essential role with regard to a future exit. These regulations serve to ensure that consensus is reached quickly and reliably. In the case of a drag along, the majority of the shareholders can get the minority shareholders to sell their shares in the company to a third party on the same terms as the majority shareholders. However, they also grant the minority shareholders the right to sell part or all of their shares in the course of a tag along under the same conditions as the majority shareholders. This facilitates quick decision-making for investors in the event of an exit.
Liquidation preferences: assure investors priority of their participation in the event of an exit
With regards to the potential event of an exit, investors are interested in agreeing on a liquidation preference. A liquidation preference ensures that the investments held by the investors are given priority over other shareholders. In order to achieve a high return and at the same time to reduce the risk of a non-repayment, investors are usually interested in a liquidation preference in their favor.
Non-participating liquidation preference
Whether the investors exit the company with a profit depends mainly on the design of the preference. There are two possible options: non-participating and participating liquidation preferences. In the first case, investors are given priority in the refund of their investment. In the course of the subsequent distribution of the proceeds by percentage among all shareholders, however, the payment already received will be offset. That way, the investors then only receive the amount that is necessary to pay out their participation in the company's share capital, reduced by the investment that was initially refunded.
Overall, the investors receive a total payment equal to their share in the company’s capital. Thus, a non-participating liquidation preference is considered an insurance policy that reduces the risk of non-repayment of the shares held in the share capital. In order to increase this preference’s appeal, multipliers may be added, which ensure that investors receive double or even triple their investment in the event of an exit before other investors are paid out.
Participating liquidation preference
In the event of a participating liquidation preference, investors will again be paid out in the amount of their investment (or in the amount of the contractually agreed multiplier) prior to other shareholders receiving their refunds. Then, they take part in the subsequent distribution of the proceeds by percentage among all shareholders in the amount of their participation. In this case, the repayment of the investment received at the beginning will not be offset against the amount that is necessary for the distribution of the proceeds to pay out the participation in the share capital. This can result in investors ultimately receiving more than they are entitled to based on their share by percentage in the company. Which of the two options should be chosen depends on the individual circumstances of the financing, the company, the investors and the founders. However, care should be taken to agree on a liquidation preference that safeguards both the interests of the founders and those of the investors.
Further information and assistance for creating the term sheet as well as free templates can be found e.g. on the website of the German Standard Setting Institute.
A deviation from the term sheet with respect to the participation agreement is sometimes difficult to enforce
As a pre-contractual declaration of intent, the term sheet forms the basis for concluding the participation agreement. The components of the term sheet result from the information asymmetry of the investors prior to a careful examination of all business activities. The aim of most clauses is therefore to protect investors from reducing their share value. At the same time, the written fixation of the declaration of intent offers planning security for the founders, even if the agreement of a term sheet does not contain any legal obligation to conclude the participation agreement or deed of association. Nevertheless, claims for damages by one party against the other can arise, and a deviation or change from the clauses set out in the term sheet is difficult to enforce with respect to the participation agreement.
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