What to include in a Term Sheet

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.

The content of this article is based on our personal experience. They do not constitute legal advice and do not replace it. If you have any questions about financing rounds, looking for an investor or company valuation, we are also happy to advise you individually in a personal conversation. Contact us using our contact form or arrange your first free appointment.

The term sheet offers security in planning and counteracts information asymmetries

Bei einem Term Sheet handelt es sich um eine Absichtserklärung, die Gründer und potenzielle Kapitalgeber vor dem eigentlichen Beteiligungsvertrag austauschen. Das Term Sheet bildet einerseits die Bereitschaft der Investoren zur Beteiligung am Unternehmen ab und andererseits den Stand der Verhandlungen und erste juristische Eckpunkte. Im Gegensatz zu einem Vorvertrag resultiert aus dem Term Sheet keine rechtliche Verpflichtung zum Abschluss des Beteiligungsvertrags. Allerdings können aus dem Term Sheet als vorvertragliche Absichtserklärung (letter of intent) dennoch Schadensersatzansprüche der einen Partei gegenüber der anderen (culpa in contrahendo) entstehen; beispielsweise dann, wenn Beratungsleistungen für ein Projekt, dessen Abschluss klar in Aussicht gestellt worden war, in Auftrag gegeben werden, und bei dem eindeutig nachgewiesen werden kann, dass initial keine Absicht zur Realisierung des Projekts bestand. 

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. 

Die meisten Klauseln im Term-Sheet verfolgen das Ziel, das Investitionsrisiko für Investoren zu vermindern

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), spielen Mitverkaufspflichten (Drag along) und -rechte (Tag along) eine essentielle Rolle im Hinblick auf einen künftigen Exit. Diese Regelungen dienen einer sicheren und schnellen Konsensfindung. So kann die Mehrheit der Gesellschafter im Fall eines Drag along die Minderheitsgesellschafter dazu bringen, ihre Geschäftsanteile am Unternehmen zu den gleichen Konditionen wie die Mehrheitsgesellschafter an einen Dritten zu verkaufen. Ebenso räumen sie aber den Minderheitsgesellschaftern das Recht ein, im Zuge eines Tag along ihre Anteile teilweise oder vollständig zu den gleichen Bedingungen wie die Mehrheitsgesellschafter zu verkaufen. Dies erleichtert eine rasche Entscheidungsfindung für die Investoren im Fall eines Exits.

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

Bei einer nicht-anrechenbaren Liquidationspräferenz werden Investoren erneut vorrangig in Höhe ihrer Investition ausbezahlt (bzw. in Höhe des vertraglich vereinbarten Multiplikators). Anschließend nehmen sie an der prozentualen Erlösverteilung unter allen Gesellschaftern in Höhe ihrer Beteiligung am Investment teil. In diesem Fall wird die zu Beginn erhaltene Rückzahlung der Investition also nicht auf den Betrag angerechnet, der im Rahmen der Erlösverteilung zur Ausbezahlung der Beteiligung am Stammkapital nötig ist. Dies kann dazu führen, dass die Investoren letztendlich mehr erhalten, als ihnen nach ihrer prozentualen Beteiligung an der Gesellschaft zusteht. Welche der beiden Optionen gewählt werden sollte, hängt von den individuellen Umständen der Finanzierung, der Gesellschaft, der Investoren sowie der Gründer ab. Eine Liquidationspräferenz sollte jedoch im Optimalfall sowohl die Interessen der Gründer als auch die der Investoren wahren.

Weitere Informationen und Hilfestellungen für die Erstellung des Term Sheets sowie kostenlose Vorlagen lassen sich z.B. auf der Seite des German Standard Setting Institute finden.

A deviation from the term sheet with respect to the participation agreement is sometimes difficult to enforce

Das Term Sheet bildet als vorvertragliche Absichtserklärung die Grundlage zum Abschluss des Beteiligungsvertrags. Die Bausteine des Term Sheets resultieren hierbei aus der Informationsasymmetrie der Investoren vor einer sorgfältigen Prüfung der Geschäftstätigkeit. Ziel der meisten Klauseln ist es also, Kapitalgeber vor der Reduzierung ihrer Beteiligung zu schützen. Gleichzeitig bietet die schriftliche Fixierung der Absichtserklärung Planungssicherheit für die Gründer, auch wenn die Vereinbarung eines Term Sheets keine rechtliche Verpflichtung, wie bei einem Vertrag, zum Abschluss des Gesellschaftervertrags beinhaltet. Es können jedoch trotzdem Schadensersatzansprüche der einen Partei gegenüber der anderen entstehen, und eine Abweichung oder Änderung von im Term Sheet fixierten Klauseln gestaltet sich für den späteren Beteiligungsvertrags nur schwer.

At Trustventure, we advise young companies on financial issues and offer CFO-As-A-Service. Our expertise in questions of corporate finance, planning and controlling creates transparency and security for you and your investors. Reach out to us via our contact form or write to us directly at office@trustventure.de.

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