Entrepreneurs Need Term Sheets

According to Forbes, “The term sheet is one of the most critical documents an entrepreneur can ever design or sign.”  A term sheet is a document that results from initial negotiations between the business owner and potential investors prior to selling your stock to outside investors.  It is a non-binding contract document, so it is easy to think that it can be changed without consequences, however, it is the beginning point, resulting from initial negotiations, where both parties map out their risks and obligations. 

Both parties are free to back out of the agreement without any obligation, but if one party decides to change the agreed upon terms, it will cause the other party to have to fully reconsider his position on the offer to buy or sell the stock.

Consider your terms carefully.  A term sheet is your opportunity to lay out your proposal for all the critical items that will make the deal worthwhile to you.  If you overlook essential aspects in the beginning, it will be very difficult to add them in later.  It is wise to evaluate ways to optimize such things as option pools, liquidation and participation, dividends, protective provisions, and controlling rights before you ever begin negotiations.  The term sheet is the documented results of your negotiations, not the beginning points of negotiation.

Forbes further points out that “Just as founders don’t want difficult or greedy investors on board, investors don’t want hassle or founders that only want to take the money and run. The term sheet should facilitate a win-win for both sides.”  It is a waste of everyone’s time to try to negotiate terms that are so unfavorable to one of the parties, that he will end up walking away from the deal before it is ever executed.  Consider ahead of time the difference between where you can give in and where you have to draw the line.

It is important to think ahead about issues that are not currently pressing, but will raise serious problems in the future, if not properly negotiated.  For example, restrictive debt financing terms might prevent you from getting needed funds when bankruptcy is looming.  Giving away a controlling stake in the company may be a subtle sign that you will be replaced after the investors feel more comfortable in running the business.  Limitations on future fundraising or projections for too quick of a turnaround may predict that investors are looking for a quick exit, leaving you with investors not of your choice.

As a final word of advice, you can protect yourself and maximize your negotiations by following these three tips:  “1) Make the most of your term sheet; 2) Hire the right lawyer; and 3) Know the difference between the terms of preferred and common stockholders.”  The attorneys at Wilson, Bradshaw and Cao, LLP, have more than 70 years of combined experience in securities law and can maximize your application for going public and conducting your negotiations for optimal results. 

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