You need investors to grow your business. With the right fit, both parties reap the benefits of a joint effort to rise to new heights. But how does the legal side of the investment work? Why do you need investment term sheets?

Daniel Dippold, the CEO of EWOR, knows the importance of getting legal documents right. As a successful serial entrepreneur, he shared his expertise with our EWOR Academy students.

In this article, you’ll learn why term sheets are key to securing a good investor and what details they include.

What Are Term Sheets?

Term sheets are documents that lay out the conditions between founders and investors. It’s a pre-contract that you negotiate before signing the shareholder agreement.

Despite being in the realm of legal documents, term sheets are not legally binding. They serve as the foundation for the binding agreement after both parties negotiate the details.

Once you have convinced an investor of your company’s worth, they will send you a term sheet. It’s up to you and your co-founders to negotiate the conditions of the deal and set the cooperation up for success.

Be careful with investors who draft perfect term sheets that favour you, as some of them could later include unfair clauses in the binding shareholder agreement.

Most Common Term Sheets Details

Many free term sheet templates lack some of the most common aspects. So, don’t rely on external help and instead, learn the basics of term sheets yourself to avoid running into legal issues later on..

For templates and more legal information, sign up for the EWOR Platform and gain access to hundreds of resources.

Vesting

One of the most common details in term sheets is vesting agreements. Usually, the founders will vest again for a period of up to 36 months. Since this is an important way to protect the business and increase sustainability, make sure to negotiate the terms with investors in your favour.

Side Activities

Investors will usually discourage you from having other projects on the side. They want to make sure that you avoid side activities and any paid projects.

The reason for this policy is that future shareholders prefer that you focus only on the joint venture

Go all in and be transparent about your side hustles. 

Good and Bad Leaver

This detail specifies how both parties want to handle the vesting and purchase of equity once a shareholder leaves the company. 

The outcome of this policy depends on preferences and circumstances. If it’s a bad leaver event, a clause like this can mean that your shares disappear.

Investors and shareholders pay for the best lawyers who craft creative formulations of clauses like this. Be careful about loopholes and vulnerabilities to protect you in the future if something goes wrong.

Information

Sometimes, investors insist on specific information rights and reporting obligations. The term sheet can include monthly, quarterly, and annual update reports on details that are relevant to shareholders.

Financial updates include profit and loss statements, balance sheets, and cash flows. If you want to learn more about financial statements for investors and pitches, check out Daniel’s introduction to start-up financials.

Tag-Along

Another common detail of term sheets is the so-called tag-along clause. This clause specifies how other investors can co-sell if one investor wants to sell their shares.

If one investor wants to sell their 50%, other investors can sell their smaller shares as well. This system depends on investors’ preferences, but it has a huge impact on your company.

Drag-Along

The so-called drag-along is the opposite of tag-alongs. It defines how investors can be forced to co-sell if a specific amount of shares is sold at once. This usually occurs in the 50-80% equity range.

If you’re looking for an exit, make sure you are the majority shareholder and can force every other shareholder to sell their stocks, too. The clause forces them to sell when a large amount is already up for sale.

The opposite case is true when other shareholders force you to sell your shares, even if you don’t want to. Many founders overlook this term sheet detail and risk losing control over their company in case other shareholders want to sell.

Right of First Refusal (ROFR)

The Right of First Refusal allows shareholders to refuse the sale of shares under certain conditions. 

This common clause prevents shareholders from selling shares to external investors without offering them to their current shareholders first. It’s a fair agreement between co-founders, but it can expand to other shareholders as well. 

Subscription Rights

This detail specifies how existing investors take part in future funding rounds. It’s an agreement that ensures that investors maintain their original share percentages.

Liquidation Preferences

When the shareholders decide to liquidate the company, this policy specifies who gets the money first.

Some investors like to divide their shares into two categories: common and preferred shares. This guarantees that preferred shareholders receive their money before common ones in the case of liquidation.

Down Round Protection

This policy specifies how investors can invest in a down round. Investors want to ensure that they won’t lose their percentages.

In other words, they want a mechanism that forces you to compensate them in shares if you raise another round on a lower valuation.

Voting Rights

Term sheets often include a clause that grants investors specific voting rights within the company. Be mindful of investors that insist on having more voting rights than you. 

Board of Directors

Another detail of investment term sheets involves the board of directors. Some investors want the power to appoint board seats, join the board themselves, or replace managing directors.

Be careful about these policies because investors might exclude you, the founder. Even if they only have 10% equity, they could replace key figures to gain control over your company.

Details like this can turn into ugly legal fights that can cost you your company. Instead of brushing over them, read these clauses with great care to avoid such issues.

The Art of Negotiation

Invest time in mastering the art of negotiation. Avoid common and unnecessary mistakes during the term sheet process by preventing loopholes that can harm you. It’s a tedious process, but it will protect you from suffering losses or losing control over your company.

Trust that you chose the right investors, but also ensure financial and legal security by negotiating good deals.

Good investment term sheets and shareholder agreements are fairly negotiated documents.

Bottom Line

The process of gaining investors involves negotiating investment term sheets before signing any binding agreements. Attention to detail and strong negotiating skills will protect you from dilution and legal issues down the line.

Agree upon fair conditions for the investment deal and keep the most common details in mind.

About the author
EWOR Team

EWOR is a school conceived by Europe’s top professors, entrepreneurs, and industry leaders. We educate and mentor young innovators to launch successful businesses.

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