The Term Sheet
(fifth of a series)

By Frank Demmler

In past weeks we’ve looked at why investor’s want to say, “No,” to your business plan; how they will approach the valuation of your business, if you avoid that, “No;” that deals are negotiated with percents, but they’re structured with shares; and that the arithmetic used to quantify a deal can be tricky.

With that as a foundation, we’re now ready to take a look at how a deal actually gets done. Probably the most significant step in the process is the receipt of a term sheet from an investor. Today we’ll take a look at what the term sheet is.

Definition

A term sheet is a relatively short document that an investor prepares for presentation to the company in which the investor states the investment that he is willing to make in the company. This document is usually 5-8 pages in length.

Textbook Definition

“The term sheet reflects an agreed-on valuation, and sets out the amount of the investment that is to be made, as well as the ownership claims the investor receives in exchange for the investment. In addition, the term sheet may identify some of the options, rights, and responsibilities of each party.” (Entrepreneurial Finance, 2^nd Edition, Smith & Smith, John Wiley & Sons, Inc., 2004)

Practical Meaning

While the term sheet is important, and what it contains requires a great deal of study and consideration, perhaps the most important aspect of a term sheet is that it is the first real, dependable indication that the investor is actually interested in investing. Until the preparation and presentation of a term sheet, the investor has likely indicated one, or all of the following, to the entrepreneur when probed about the investor’s willingness to invest:

• “It’s under review.”
• “We’re interested.”
• “We’re doing diligence.”

All of these appear to be positive, and the first-time entrepreneur is likely to interpret them as such. At the same time, they don’t really say anything, and may really mean, “It’s in the stack with all the other business plans that I haven’t had time to get to.” In other words, talk is cheap, but you need a term sheet to know that the investor is serious. [Note: I hate the word, “interest,” in entrepreneurial settings. When an entrepreneur tells me that a customer or investor is “interested,” I get very nervous. “Interest” doesn’t mean anything in this context. Has the customer issued a purchase order? Has the investor given you a term sheet? Those are meaningful. Interest is not.]

Where It Fits in the Deal Process

Let’s take a look how an investment opportunity may proceed through an investor’s process of making deals. The numbers in brackets are my estimates of how many businesses, out of 100, make it to each succeeding step. By the way, as a practical matter, it is not at unusual for this process to take 8-10 months for the successful firm.

1. Receive & screen business plan [100]

2. Review business plan [20]

3. Bring in management team to present [15]

4. Due diligence [10]

5. Evaluation of opportunity [6]

6. Internal partners meeting [5]

7. Term sheet [3]

8. In-depth due diligence [2]

9. Legal documentation [1]

10. Funding [1]

We’ll save the dynamics of this flow and what you can do to improve your chance of making it through all of these steps for a future column. The key thing here for the entrepreneur to appreciate is that the term sheet step is the first one in which the investment firm has decided that it has an intent to invest, if the terms of the deal can be agreed upon.

Purpose: Investment of Capital for a Security Interest in the Company

The first-time entrepreneur may think that the transaction to be completed between the company and investor is a simple exchange of cash for some number of shares of stock in the company. A deal, though, is much more complicated and complex than that. A term sheet is likely to address at least the following:

• Amount of the investment
• Type of security being purchased
• The pre- and post-financing values of the company, including the capitalization table and the role, if any, of an option pool [Note: see last week’s column for important considerations about how an option pool can affect how a deal is valued.]
• Definitions and assumptions
• Rights, preferences, privileges, restrictions, and obligations
• Board of Directors
• Representations and warranties
• Negative covenants
• Positive covenants
• Remedial action clauses
• Agreements with the founders and key management

We will look at some of the key provisions in a future column. The key thing here is that the scale and scope of these transactions is very broad and many considerations come into play.

The term sheet is intended to reflect the desires and concerns of the participating parties in a way that is mutually agreed upon. Assuming that it is successfully negotiated, it is then turned over to the attorneys to craft the legal documents. The eight-page term sheet is then converted to 300 or more pages of legalese in at least four legal documents [Warning: I am not an attorney]:

• Amended and restated articles of incorporation,
• Amended by-laws of the corporation,
• Securities purchase agreement, and
• Shareholders agreement.

Advice for the Entrepreneur

• Securing an investment is a complicated and involved process.
• Don’t try to take short cuts.
• You need to understand what is involved.
• Securing a term sheet from an investor comes after you have passed through a number of key decision points by the potential investor. At each point, the decision is “No” or “Maybe.” Your goal is to avoid the “No” and get a “Maybe” at each step along the way, until you get a “Yes” at the last step, and close on your financing.
• Securing a written term sheet from an investor is an extraordinarily important accomplishment in the fund raising process.

Next week we will look at the deal from the perspectives of the entrepreneur and the investor and see how a term sheet addresses their concerns and desires.

Frank Demmler (fd0n@andrew.cmu.edu) is Adjunct Teaching Professor of Entrepreneurship at the Donald H. Jones Center for Entrepreneurship at Carnegie Mellon University. (http://web.gsia.cmu.edu/display_faculty.aspx?id=168)