Term Sheet

What is a Term Sheet?

The term sheet is usually a non-binding agreement that contains all the essential points related to the investment like capitalization and valuation, stake to be acquired, conversion rights, asset sale, etc.

  • Private equity identifies a target company, goes through the business model, studies the business plan, performs due diligence, and then does the necessary discussions & negotiations before deciding on the target company.
  • The term sheet comes into the picture after a Private equity fund has decided to get into an agreement with Target Company. A term sheet is the first step of the transaction between the Private Equity fund & the Target Company. It has all the essential & critical points of the agreement.
Term Sheet

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Source: Term Sheet (wallstreetmojo.com)

List of Provisions in the Term Sheet

Below is the list of term sheet provisions, including Binding Provisions and Basic Provisions

Binding Provisions in the Term Sheet

A term sheet is not a legally binding document. However, certain sections of the Term sheet are legally binding.

#1 – Confidentiality Terms

The term sheet has this clause wherein the sensitive information about the target company is protected from being shared by the PE Fund to third parties.

Term Sheet - Confidentiality

#2 – “No- Shop” Provision

This term sheet clause is to protect the PE Funds. In this clause, the target company is prohibited from searching for any other financing with any third party for a specific time. This provision helps PE Funds to save their time as well as their money by not getting involved in due diligence or negotiations with target companies who are already talking to other potential investors.

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Basic Provisions in the Term Sheet

#1 – Type of Security Offered

The most important & essential provision of the term sheet is the type of security offered – equity, preference shares, warrants, etc., and the price per share of that security. It is the initial deal term, which is determined between the PE fund & Target Company.

Term Sheet - Shareholding Pattern

#2 – Capitalization & Valuation

The next part under the basic term sheet provision is Capitalization & Valuation.  This clause decides the price per share for the Target Company. As preferred stocks have more attractive terms, so they are preferred over equity by the Private equity investors.

Term Sheet - Post Money

This term sheet clause also provides the information on pre-money & post-money valuationsPost-money ValuationsThe term "post-money valuation" refers to determining the value of a firm after it has received a capital injunction. In basic terms, post-money valuation is the process of determining the worth of a company after increasing its capital flow. As a result, post-fund infusion valuation indicates the company's worth at any point in time.read more of the company. Pre-money valuation is the valuation based on the number of shares outstanding before the financing is done. Whereas, post-money valuation is based on the number of shares that will be outstanding post financing.

When PE funds make an investment, it shall analyze its investment based on “as a converted basis.” As the name applies, “As-converted” is the number of shares that are outstanding plus the number of shares that would be outstanding when warrants and options of the target company are exercised, and convertible securitiesConvertible SecuritiesConvertible securities are securities or investments (preferred stocks or convertible bonds) that can be easily converted into a different form, such as shares of an entity's common stock, and are typically issued by entities to raise money. In most cases, the entity has complete control over when the conversion occurs.read more are converted by the holders.

#3 – Dividend Rights

After capitalization, the Term sheet would have a clause about the Dividend rights under basic provisions. It deals with the dividends to be paid. Dividends are paid either on a cumulative basis or a noncumulative basis.

Term Sheet - Dividends

Since Target companies are either start-ups or mid-level companies, so they hardly give any dividends.  Investors prefer cumulative dividendsCumulative DividendsA cumulative dividend is a promise of paying a fixed percentage of earnings to the preferred shareholders. If the company cannot pay the dividend within the pre-decided date, then the dividend gets accumulated and is paid in the future. Cumulative dividend = Preferred dividend rate * Preferred share par valueread more, so the dividends keep accumulating and will be accounted for when preferred stocks are converted into common stock. This provision is essential as it decides how much of common stock will go to preferred stockholders in the event of a liquidation.

#4 – Liquidation Preference

Post Dividends, term sheet, has the provision on Liquidation preferences. Preferred stockholders receive preference over common stock in case of liquidation.

Term Sheet - Liquidation Preference

Generally, liquidation preferencesLiquidation PreferencesLiquidation preference is a clause that states the order of payment from the realization of assets in case of liquidation. It usually protects secured debt, trade creditors, other liabilities, and then preference and equity share holders.read more would be equal to the amount invested. However, at times, it would be a multiple of the amount invested. This multiple can be in the range of 3 to 5 times of the amount invested.

The target company should carefully understand the liquidation provisions before making a deal with the PE fund. It is so as a low valued company then on liquidationLiquidationLiquidation is the process of winding up a business or a segment of the business by selling off its assets. The amount realized by this is used to pay off the creditors and all other liabilities of the business in a specific order.read more, the common stockholders would get minuscule proceeds.

#5 – Conversion Rights

Conversion rights would be the next basic provision covered in the Term Sheet. This term sheet provision gives the Investor the right to convert to common stock. Investors rarely utilize this right in normal conditions as the preferred stock has more value than the common stock at the time of liquidation.

Investors convert their preferred stock into common stock before sale, merger, or IPO of Target Company. Generally, when the company plans for an IPO, preferred stocks are automatically converted to common stock as underwritersUnderwritersThe underwriters take the financial risk of their client in return of a financial fee. Market Makers like financial institution and large banks ensure that there is enough amount of liquidity in the market by ensuring that enough trading volume is there.read more do not prefer taking multiple classes of stock to the public.

#6 – Anti-Dilution Provisions

After the conversion rights term sheet provides a clause for Anti-Dilution under the basic provision. This clause is inserted in the term sheet as a protection measure. The clause protects the PE fund in the future if the company sells additional shares for subsequent financing at a price below the per-share price paid by investors.

Anti Dilution

These provisions are such that if the subsequent financing happens at a lower price, then the conversion price of all shares purchased at a higher price is adjusted downward. It is done in such a way that the percentage ownership of investors is maintained. It results in previous investors getting more shares and diluting ownership of other holders who do not have price protection.

#7 – Board of Directors

Under basic provisions, term sheet also have a clause on the Board of DirectorsBoard Of DirectorsBoard of Directors (BOD) refers to a corporate body comprising a group of elected people who represent the interest of a company’s stockholders. The board forms the top layer of the hierarchy and focuses on ensuring that the company efficiently achieves its goals. read more.  This clause deals with the number of directors that would be on the Board, from the investor side. Generally, a clause is added wherein if the required milestones are not achieved in the stipulated time or if any pre-defined negative event occurs, the Investor shall have the majority of directors on the Board.

Target company and its founder should carefully study the structure of the board as will have to deal with the board when making any major corporate decisions.

Board of Directors

Many times a board representative from the investor group is more of a positive than negative. It is so as it can give a brilliant direction, particularly if the group has industry-specific experience.

The term sheet would also have a provision on Information rights. Investors would require companies to provide “information rights.”  These are ideally information related to financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more, strategic plans, forecasts of the target company.

#8- Redemption Clause

Sometimes basic term sheet provision also contains the Redemption clause. This clause provides the PE fund with liquidity. The provision is that the company is required to buy back the shares when it has the financial resources to do so.

Redemption will generally only be considered when the company has become profitable, but there are no opportunities for liquidity through a sale, IPO, or recapitalizationRecapitalizationA recapitalization is a method of restructuring the ratios of various capital-generating modes, such as debt, equity, and preference shares, based on WACC and other company requirements, such as desired control level.read more.

Some other provisions that are part of basic provisions are Transfer restrictions, preemptive rights, rights of first refusal, Tag along & drag along with provisions

#9- Transfer Restrictions

Transfer restrictions are restrictions placed on transferability. These term sheet restrictions are placed to ensure that shares are not sold to a party that the company does not want as their shareholders.

#10 – Pre-emptive rights

Pre-emptive rights are those rights that give the shareholders a right to purchase new securities if any issued by the company. This term sheet provision is included in the term sheet so that investors can retain their relative percentage of total outstanding shares.

Pre Emptive Rights

#11- Rights of the first refusal

Rights of first refusal are those rights wherein it is compulsory for the founders of the target company & the other shareholders to offer their shares first to the company or preferred shareholders. They can go to the third party only after refusal from the company or preferred shareholders.

Right of First Refusal

#12 – Tag along & drag along with provisions

If the sale to the third party goes to advanced stages of negotiation, then Tag along rightsTag Along RightsTag-Along Rights is an agreement that lays out the terms and conditions to protect minority shareholders from being left out if the majority shareholder decides to sell its stake, allowing minority shareholders to sell their shares at the same valuation as the majority shareholders.read more give the PE fund the right to sell their shares too on a pro-rata basis.

Tag Along

Under drag-along rightsDrag-along RightsDrag-along rights refer to an agreement clause whereby the majority shareholder has the right to compel the minority stakeholder to participate in the company's sale at the time of merger or acquisition.read more, investors who have a specified percentage of shares (generally majority) and who have identified a third party as a buyer are required to include other shareholders to participate. In this scenario, minority shareholders are forced to participate. This term sheet provision helps in the sale of the company if favorable terms exist even if other shareholders do not favor the sale.

Additional Provisions

If the transaction between the PE fund and the target company is that of leveraged buyout Leveraged Buyout LBO (Leveraged Buyout) analysis helps in determining the maximum value that a financial buyer could pay for the target company and the amount of debt that needs to be raised along with financial considerations like the present and future free cash flows of the target company, equity investors required hurdle rates and interest rates, financing structure and banking agreements that lenders require.read moreor recapitalization, such transactions will have a debt component. A general provision included is that any purchase made of management’s stock and/or new equity shall be financed, using the cash flow of the companyCash Flow Of The CompanyCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more to back the debt.

LBO and recapitalization give the advantage to the founders of the target company as well as option holders to receive a substantial dividendDividendDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more and retain ownership at the same time. They can also remain actively involved in the management of the company in the future. Apart from this, the company shall receive additional capital for growth in the future.

#1 – Earnout Provision

Additionally, the term sheet has an Earnout provision wherein founders & other shareholders receive additional payments based on the future performance of the businesses sold. So if they are able to reach a specified target, goal, specified earnings multiple, or a certain level of profitability, then they qualify for earnoutEarnoutEarnout refers to a contractual clause whereby the business seller will be liable to receive an excess future compensation in the form of a percentage of earnings, owing to the condition that the business attains a particular financial goal.read more. Earnout provisions are quite common in LBO & recapitalization transactions.

The inclusion of such term sheet provision reflects a reasonable expectation from an investor that the company is able to reach a point where it has made itself financially attractive. Obviously, the risk of proving so under this provision lies with the management of the target company.

Therefore, as a target company, earnout provisions should meticulously be studied and carefully negotiated with the PE fund. One of the provisions in earnout is that the management shall be entitled to the same only when they remain with the company for a specific time period, else they are forfeited. So the target company should accept the provision only if it plans to be with the company until the specified time.

However, it’s not easier for the management as it is highly probable that differences may arrive between founders & the team brought in by the PE fund investor or when the Investor becomes too interfering in the day-to-day affairs of the target company’s business.

Additional term sheet provisions would include miscellaneous details such as fees to pay to Investor’s accountant, lawyers, experts carrying out the due diligence process, etc.

#2 – Conditions Precedent

Additional term sheet provisions also include Conditions precedent

Conditions precedent that is included in the term sheet would include information on what has to happen between the time from when the term sheet is signed and till the completion of the investment.

This term sheet provision would include

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This article has been a guide to Term Sheets. Here we discuss what is term sheet, list of term sheet clauses, including binding and basic provisions, along with practical examples. You may learn more about Private Equity from the following articles –

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Comments

  1. Joseph M Perez says

    Very informative thank you

    Joseph M PEREZ

    • Dheeraj Vaidya says

      thanks Joseph!

  2. Guillermo A. Marioni says

    Hey there, Dheeraj! Thanks a lot for this awesome and incredibly professional content-analysis!
    I am going to read each key point thoroughly later, with more time.

    • Dheeraj Vaidya says

      thanks Guillermo!

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