How to Read an Investor’s Term Sheet

AdobeStock_278805688-300x200Term sheets are, by design, made to be simple. They are supposed to give a general overview of a proposed investment in very broad terms. Despite this, a term sheet can contain provisions that could create complications for your business in the future. An experienced investment lawyer can help you fully understand the implications of all term sheet provisions in order to protect your business from future problems.

Investment Amount

The amount to be invested is usually the most important provision of a term sheet. Many investors, especially new investors, get distracted by the overall amount of the proposed investment, which can distract an entrepreneur from other important investment terms. The investment could be contingent on the business being valued above a set amount. It could come in installments. The installments could also be contingent on the business meeting certain goals by certain dates. Business owners must thoroughly understand the terms of any such contingencies and how they could impair the company’s ability to secure the full amount of the proposed investment.

The investment amount will also be accompanied by a capitalization table. This table is a descriptive tool that shows the ownership interest of each involved party. Founders, employees, and investors should each appear on the table with a detailed breakdown of their equity interest in the business, including common stock, preferred stock, stock options, and any other equity issued in the business. Pay careful attention to the composition of each party’s ownership interest, especially any changes that the investor proposes to the composition of equity interest in the business.

Anti-Dilution Clauses

In order to allow for more investors or more employee equity in the future, some businesses end up diluting the value of initial equity interests given to founders and employees. Investors generally want to protect their ownership interest from this possibility in order to secure their investment. As a result, anti-dilution clauses are common in term sheets that are prepared by investors. This does not have to be a deal breaker. So long as the business plans allow for the protection of the investor’s equity without dilution, the anti-dilution clause can still be part of a workable term sheet. But anti-dilution clauses do put some limits on the options a business has for raising capital in the future. If you need the flexibility to sell as much equity in the business as possible, an anti-dilution clause could impair that ability. Consult with a lawyer about the effects of an anti-dilution clause. If the provision does not work with your future business plans, there may be alternative ways to protect the investor’s equity interest.

The Right California Startup Counsel for All Entrepreneurs

Getting a term sheet is an exciting prospect for any new business owner. Term sheets do, however, have important legal provisions that could impair your future rights to control, manage or fund your business. Be sure you understand the implications of a term sheet before agreeing to any finance terms. Call (408) 441-7500 to schedule a consultation with one of the experienced California corporate lawyers at Structure Law Group.