The Term Sheet
In today’s guest article by Dr. Nikolaus Uhl, LL.M., a specialist lawyer for commercial and corporate law and partner at GreenGate Partners Rechtsanwaltsgesellschaft mbH & Co. KG, the Term Sheet is examined as a crucial component of financing negotiations.
Dr. Uhl elucidates the function, structure, and legal significance of a term sheet, highlighting why this seemingly informal step can be pivotal to the success of an investment.
Despite all positive discussions and verbal agreements, the first steps toward an investment or financing round should be taken with care. In most cases, after the initial exchange of information with potential partners, it is advisable to record the key data of the intended transaction in a preliminary document – the so-called term sheet. Through the term sheet, the parties declare their intention to enter into a contract and affirm the seriousness of the endeavor. It serves as the foundation for the agreements to be concluded later and should therefore be negotiated with appropriate diligence. Furthermore, the execution of a term sheet carries a psychological effect that should not be underestimated.
Negotiations surrounding the term sheet should be used by all parties to clarify all relevant issues at an early stage. Transparency and openness during this phase can have a positive impact on the further course of discussions and on the investment process as a whole.
The selection and involvement of suitable advisors should take place at the latest during the drafting and negotiation of the term sheet. This is the only way to ensure that the individual intentions are effectively and professionally translated into the final agreements. Mistakes in the term sheet are usually difficult to correct in the subsequent contracts.
1. Purpose and Distinctions
While not legally mandatory, drafting a term sheet is highly recommended, especially in complex negotiations involving multiple parties or extended timelines.
The primary goal of a term sheet is to outline the key economic and legal parameters of the intended investment and collaboration.
An advantage of a term sheet is that it allows parties to assess early on whether their interests align, potentially avoiding protracted and unproductive negotiations. Conversely, signing a term sheet can significantly propel the process forward, increasing the likelihood of a successful agreement.
The optimal time to finalize a term sheet is after initial negotiations when there’s a serious intent to proceed with financing, but details remain to be clarified. The term sheet typically marks the transition to due diligence and formal contract negotiations.
Alternative documents, such as letters of intent or preliminary agreements, may serve similar purposes but differ in binding nature and scope. The choice depends on the parties’ intentions, negotiation stage, and desired level of commitment.
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Since a term sheet generally contains declarations of intent without formal obligations to transfer shares, no specific legal formalities are required. Nonetheless, a written agreement is advisable for clarity and future reference.
2. Legal Nature and Binding Effect
A term sheet is typically non-binding. However, certain provisions—such as confidentiality, exclusivity, cost allocations, and penalties—are often explicitly stated as binding.
For investors, exclusivity clauses are crucial to prevent the company or shareholders from engaging in parallel negotiations with other potential investors. Cost provisions should specify whether the investor will be reimbursed for due diligence and contract preparation expenses, and whether a break-up fee applies if negotiations are terminated. It’s important to note that even without such clauses, arbitrary termination of negotiations may lead to liability for damages.
Additional terms may be declared binding, especially when specific economic points or special rights are intended to be included in the final agreement.
Although there’s no legal obligation to incorporate the term sheet’s contents into the final contract, the document holds significant weight in negotiations. Refusing to adopt agreed-upon terms or introducing new, unaddressed points can erode trust and potentially jeopardize the entire financing round.
3. Contents
A term sheet should encompass essential provisions for both parties, including:
- Investment amount and structure
- Securing overall financing
- Company valuation and potential revaluation
It’s crucial to avoid overloading the document; standard terms need not be included, and specific issues shouldn’t be overly detailed.
Generally, terms not included in the term sheet are unlikely to appear in the final agreement, and those that are included are difficult to renegotiate later.
Common topics addressed include:
- Form of financing (e.g., capital increase or mezzanine financing)
- Conversion rights of loans into equity
- Disbursement of funds contingent on milestones
- Distribution of proceeds in case of share or asset sale
- Investor consent rights for shareholder resolutions and management actions
- Anti-dilution protections
- Pre-emption and co-sale rights, as well as drag-along obligations
- Information rights
If the investor is expected to provide advisory or other support, it’s advisable to address related matters in the term sheet. Strategic plans should also be included to facilitate their integration into subsequent agreements.
For founders involved in multiple ventures, a clause may be included requiring them to focus their entrepreneurial efforts on the company in question.
Additional provisions can reference industry-standard terms, provided they are genuinely customary and not unexpected. For instance, clauses regarding intellectual property rights can be mentioned, ensuring the company has access to essential assets for its operations and growth.
4. Conclusion
In complex or large-scale transactions, it’s imperative to establish a clear yet concise term sheet with all involved parties. From the outset, treat its provisions as binding and negotiate accordingly—later deviations can jeopardize the entire process.
Clearly articulate and document your expectations early on, before incurring further costs for due diligence and contract negotiations.