If you are building a business and looking for outside investment, you will likely hear about term sheets and preferred stock or preferred equity. These documents can feel confusing, but they are the roadmap for your funding. Understanding these basics helps founders stay in control during negotiations.
What is a term sheet and why does it matter?
A term sheet is a short document that outlines the main business points of an investment opportunity or transaction. Founders use it, often with the help of counsel, before lawyers write the long, final contracts.
You should know that a term sheet can be a mixed document. Often some parts, such as the company’s proposed enterprise value, do not legally bind either party and can change. However, if the term sheet is signed by the parties, some parts can be legally binding on both sides. These usually include exclusivity (you cannot talk to other investors for a while) and confidentiality (disclosed information, including the existence of the negotiations, must be kept secret).
A terms sheet helps align the parties on big issues early. This can save time and money on legal fees later.
What you will see in a term sheet
Term sheets for a preferred investment focus on how much control the founders keep and how investors get paid. Founders should pay close attention to these categories to ensure they align with long-term goals. These include:
- Investment amount and timing: The total cash the investor gives the company.
- Valuation: What the company is worth before new money comes in.
- Preferential Return or Dividends: This is an amount paid to the preferred owners first, before common or other equity owners are paid.
- Liquidation preference: This is an amount paid to the preferred owners on sale or shut down of the company.
- Voting rights: This explains the extent of investors’ say in business decisions.
- Other rights: Rights of first refusal, board seats, information rights, protection against dilution, registration rights, pre-emptive rights, and other rights are often negotiated.
These six pillars represent the core of the financial relationship between you and your new partners. It is helpful to involve counsel early on to help identify issues and protect founders. Once both sides settle these points, the legal teams will draft and negotiate final agreements.
Why the law matters
Both federal and state laws regulate the issuance of equity to investors. The laws are similar, but not identical, from state to state. In Texas for example, businesses must follow the Texas Business Organizations Code. This law sets the rules for how a business issues different classes or series of equity. Often, filings are required with the states where the company is formed and where investors reside.
Speaking with a lawyer early may ensure your binding clauses do not trap you. They may help you understand the technical language so you can grow your business with confidence.