Navigating a term sheet for the first time can be a daunting process. In this article, Caveat private equity specialist Panel Member, Sarah Lawrence, answers some of the most common questions asked by entrepreneurs.
What is a term sheet?
- A term sheet is a summary of the key commercial and legal terms upon which an investor proposes to invest in your business.
- It is essentially a longer and more formal version of the principles of the deal that you would have been discussing with the investor to date.
- A term sheet may also sometimes be known as a ‘heads of terms’, a ‘heads of agreement’, a ‘memorandum of agreement’ or a ‘memorandum of understanding’.
- A term sheet on its own is not sufficient to underpin the actual transaction. The more complete legal documents required to give effect to the transaction are often referred to as the ‘comprehensive agreements’. However, the term sheet is used as the basis upon which the comprehensive agreements are drafted.
What are the key things to look for in a term sheet, as an entrepreneur?
To put it broadly, you need to make sure that all the key elements of the deal that you have been discussing with the investor, are covered in the term sheet. For example:
- The amount of the investment, the form of the investment (debt versus equity), and the timing of the investment;
- The authorised purpose of the investment (eg: working capital, or for the purchase of equipment);
- The form of the investment (debt or equity, or both). In this regard, consider the following:
- Debt is a loan to the company that must be repaid.
- Debt will probably bear interest. Ensure the interest rate and terms are what has been discussed.
- Check whether the repayment terms are what has been discussed – Are they realistic for the company based on your cash-flow projections?
- Investors will frequently ask for security for monies lent. This could take the form of personal suretyships from the entrepreneurs, or a pledge of the shares in the company or, if the company has assets such as equipment or IP, a pledge of the assets.
- Because debt must be repaid, taking an investment in the form of debt affects the company’s balance sheet, and may reduce the chance of the company getting further loans from other parties in the future.
- Equity is essentially money paid to the company in exchange for shares in the company.
- This money is not repayable by the company.
- Issuing shares to the investor, however, means that the investor will obtain the rights that go along with those shares – voting rights and dividend rights.
- It usually also means that the rights of the existing shareholders (typically the entrepreneurs themselves) are diluted, because now they are sharing control of the company with the investor.
- Investor rights: If the investment takes the form of an equity investment, the investor will obtain certain rights as a matter of law. However, investors frequently want additional rights over and above those which attach to their shareholding, and this is regardless of whether they invest by way of equity or by way of debt. For example:
- veto rights on certain decisions;
- information rights, such as monthly management accounts, access to the books, monthly update meetings;
- board seats/board voting; and
- employment agreements and restraints for the entrepreneurs.
- The term sheet may also contain provisions around a ‘fundraising fee’ and a ‘break fee’. If the deal falls through, the entrepreneurs or the company may become liable to pay a break fee to the investor as compensation for the money and time they’ve spent on the deal to date. Be certain that you understand and are happy with the circumstances in which a break fee would become payable.
What are the risks associated with signing a term sheet?
- Because the term sheet is used as a basis for drafting the comprehensive agreements, it is important that entrepreneurs are completely comfortable with the content of the term sheet. Attempting at a later stage to re-negotiate things that have already been accepted in the term sheet will cause the investor frustration and may put the relationship on a bad footing before the comprehensive agreements have even been signed.
- Don’t be afraid to challenge or negotiate the term sheet. Investors will respect you more if you engage with the document and thrash the issues out early on in the process, rather than staying quiet and then only raising concerns much further down the line.
- Major risks can arise when a business is not ready for the investor scrutiny which usually comes after the signing of a term sheet, but before the deal is finally closed. Ensure that your business is prepared for the due diligence investigation that the investor will want to undertake. Do not try to hide company problems or issues from the investor – they will come to light later, and the deal may then collapse and the break fee become payable.
Are there any risks that pop up in the South African context specifically?
- The only thing that springs to mind here, is that occasionally investors (especially smaller or inexperienced investors) try to transplant investment structures from other jurisdictions (such as the US) into the South African context, because they are considered simpler.
- An example is the SAFE – simple agreement for future equity:
- Whilst there is nothing illegal or problematic about using a SAFE in a South African context, they can have unforeseen consequences which create a lot more complexity than would have been created had a simple equity or debt investment structure been utilised.
- If an investor proposes a SAFE, I suggest getting an attorney to look at it and to tease out what the effects of that SAFE will be further down the line.
What are the things that you as an entrepreneur should pro-actively add to the term sheet before finalising with the investor?
- During your discussions with the investor, they will likely have promised you all sorts of things (aside from the monetary investment), such as business development support and the like. Make sure that everything they have promised you is reflected in the term sheet as part of their obligations towards your company.
- Ensure that the term sheet contains a confidentiality clause, and that it goes both ways – you are going to be sharing a lot of information about your business and your ideas with the investor, and they need to keep this confidential.
- If there is an exclusivity or a non-circumvention clause in the term sheet, ensure that it is subject to a time horizon. If the deal does fall through, you want to be able to approach other investors at some point in the future. You should only be precluded from approaching other investors for as long as you are negotiating with the investor with whom you have signed the term sheet.
What is your advice to entrepreneurs who are looking to negotiate a term sheet?
- Always bear in mind that an investor is acting with its own best interests at heart. Don’t be blinded by flattery or the amount of money they are prepared to invest. The money is not coming for free.
- Before you read the term sheet that an investor sends you, jot down on a separate piece of paper all the aspects of the deal as you understand it from discussions to date – both what they have promised you, and what you have promised them. Sometimes when we read a document, it causes us to focus on what is there and we forget about the things that it doesn’t say.
- Read the term sheet a couple of times before you start commenting on it. Be sure you understand every single clause. Don’t be shy to ask the investor (or even better, your attorney) to clarify the meaning of clauses you are not clear on. Do not be tempted to gloss over things or assume that it’ll probably all be ok.
- Do not avoid negotiating or changing the wording of clauses because you are scared of offending or annoying the investor. They will be a lot more annoyed if you start backing out on things three months later, once the draft comprehensive agreements are on the table.
- Although your business is precious to you, avoid taking an emotional, defensive or entitled tone when making comments on the term sheet or discussing it with the investor. Your tone and manner make a big impression on the investor and their attorneys. Keep it professional and respectful, or the investor and their attorneys could become negatively pre-disposed to you.
Sarah has a BA from Stellenbosch and a BA Hons and LLB from UCT. She was admitted as an attorney in early 2010 after having completed her articles at ENS. She worked as an associate in ENS’ corporate commercial department for two years, before leaving to focus on her commercial practice. Sarah joined Caveat in 2012 and specialises in M&A work.