Understanding Investor Term Sheets

Congratulations! You’ve successfully pitched to an investor, and they’ve agreed to invest in your company. What comes next? Usually an investor will send you a term sheet (also known as heads of terms), outlining the key terms of the proposed investment.

Generally, term sheets are not legally binding – you will need to enter into a subscription agreement (possibly along with other documents) with your investor to create the contractual obligation on them to actually send you the money. However, terms sheets are used to clearly and simply set out the main commercial terms of the investment, so it is important to ensure you understand what you’re agreeing to!

We strongly recommend you speak to a lawyer once you receive your investor’s term sheet, but below is an overview of the main points in a term sheet, and what to watch out for.

1. Investment Amount

It may be an obvious point, but it’s important to clearly state how much money the investor is committing to your company, as well as any timing or conditions attached to the payment.

2. Company Valuation

Pre-money valuation = how much the company is worth before the investor’s money is received.

Post-money valuation = the value of the company after the investment has been received (being the pre-money valuation plus the investment amount).

The value of your company will determine what proportion of it will be owed by the investor once you have received their investment. Sometimes a term sheet may specify the pre-money valuation, or the term sheet may simply state what percentage of your company the investor will receive for their investment, and from this you can calculate the pre- and post-money valuation.

The company valuation is a point of negotiation with the investor, as they usually want to receive as much equity as reasonably possible for their investment.  Therefore, it is important to have a clear understanding, and justification, for what you consider the valuation to be, to ensure you don’t give away any more of your company than you have to!

Once the pre-money valuation is known, the share price, and therefore the actual number of shares to be issued to the investor, can also be calculated. Whilst not usually included in the term sheet, it is crucial to have clarity on your current equity ownership/capitalisation, as this will determine the share price (usually calculated as pre-money valuation divided by current share capital).

3. Type of Shares

The term sheet will specify whether the investor will receive ordinary shares or preference shares. Ordinary shares will typically be the same class of shares that are currently held by the founders and any early investors (such as family and friends). It is usually in the founders’ interests to issue ordinary shares to investors. However, some investors, particularly VC funds, will request preference shares, which means you have to create a new class of shares which rank above the ordinary shares when it comes to distributing sale proceeds on an exit. If preference shares are to be issued to the investors, the term sheet will set out the liquidity preference (which is usually 1x non-participating). We go into detail on the difference between ordinary shares and preference shares, and participating and non-participating preference shares here.

4. (S)EIS relief

If your investors are eligible for (S)EIS relief, it may be a condition of the investment that your company obtains advance assurance from HMRC that it is able to offer (S)EIS relief to its investors.

5. Anti-Dilution Protection

Sometimes investors will request anti-dilution, or down-round, protection to protect them from the risk of their shares being diluted if the company issues new shares at a lower price than the price they paid. If this is not requested by an investor, do not offer it! Anti-dilution protection is not compatible with (S)EIS relief, so if investors are seeking (S)EIS relief, they cannot also have anti-dilution protection.

6. Board Seat

It is common for institutional investors, such as VC funds, to require a seat on your board of directors as a condition of their investment. This gives them oversight and influence over major corporate decisions. It is recommended that this right to a board seat is contingent on the investor holding a minimum percentage of shares.

7. Investor Consent Matters

In addition to a seat on the board, investors may also require veto rights or special voting rights on key company decisions, such as issuing new shares, incurring debt, or selling the company. These are common for institutional investors, but try to keep this list to a minimum.

8. Founder Vesting

To align the founders’ interests with the company’s long-term success and to incentivise founders to remain with the company until exit, investors sometimes request a vesting schedule for founders’ shares. Typically, this requires founders to “earn” their shares over a fixed period (e.g., 4 years) meaning if they leave the company before the end of this period, they may be required to transfer some of their shares back to the company. Again, if this is not requested by investors, do not offer it!

9. Employee Share Option Pool

A share option pool is the pot of shares that may be allowed to employees/team members in the future (e.g., under an EMI plan, or other share incentive scheme). The creation of a new employee share option pool, or increase to an existing share option pool, is often included in a term sheet. Investors typically prefer to have the option pool created (or increased) pre-investment so it dilutes existing shareholders, but does not dilute the incoming investors.

10. Confidentiality and Exclusivity

To protect the investor’s time and resources during the negotiation period, the term sheet may include an exclusivity clause which restricts the company from having discussions with other potential investors for a fixed period. This gives the investor has a fair chance to close the deal without the company negotiating with any other investors in parallel.

The term sheet is usually often subject to confidentiality, meaning neither the investor or the company can discuss the terms with anyone else (except legal advisors).

Even though a term sheet is usually non-binding in general, the terms regarding confidentiality and exclusivity are usually legally binding.

11. Costs/Fees

If the investor requires the company to pay the investor’s legal fees for the investment, this will usually be included in the term sheet, and ideally would be subject to a fee cap. In addition, the investor may charge certain other fees as a condition of the investment, such as board fees (if the investor is getting a board seat), or other ongoing monitoring fees. If these are not requested, do not offer!

Conclusion

Understanding the main terms of an investor term sheet is critical for both founders and investors. While most of the terms are non-binding, they serve as the framework for the final, legally binding documents. By fully comprehending the implications of each term, parties can negotiate with confidence and ensure that their interests are safeguarded.

At Lennon Legal, we advise clients on all aspects of raising finance, from navigating the complexities of term sheets to closing the deal. Our goal is to help you secure the most favourable terms while building lasting relationships between investors and founders. If you are considering a funding round please get in touch.