WHAT IS A TERM SHEET IN PRIVATE EQUITY? TYPICAL TERMS AND CONDITIONS IN A PRIVATE EQUITY TERM SHEET OR OFFER LETTER
Following the review and discussion of the business plan, initial investigation and enquiries, and negotiations on capital structure and other terms, and provided that the private equity firm is keen to do a deal with you, the private equity firm will send you an offer letter or term sheet. This sets out the general terms of the proposal, subject to the outcome of the formal due diligence process and other enquiries and the conclusion of the negotiations. The term sheet, without being legally binding on either party, demonstrates the investor’s commitment to management’s business plan and shows that serious consideration is being given to making an investment. The term sheet represents the private equity firm’s preferred terms and not necessarily and indeed, unlikely at this early stage in negotiations, your preferred terms.
The private equity firm may change the terms as the due diligence process and negotiations progress, for example, adjustments to the overall valuation, refinement of ratchets etc. The terms in the term sheet will be incorporated into the shareholders’ agreement at the end of the negotiation process. It is better for the term sheet to be as detailed and unambiguous as possible so that there are no surprises when the eventual shareholder’s agreement has been drafted for you to sign. You can obtain an example of an indicative term sheet from the BVCA.
Whilst there are no standard term sheets you can expect that the term sheet will cover the following areas all of which are briefly described below:
- amount to be invested, instruments (eg. convertible preferred shares), valuation, capital structure;
- liquidation preferences, dividend rights, conversion rights, anti-dilution protection, redemption rights, lock-ups, pre-emption rights;
- board composition, consent rights, information rights;
- warranties, vesting, option pool, milestones;
- confidentiality, exclusivity, fees, conditions precedent.
Areas covered by the term sheet
1. Amount to be invested
The term sheet will set out the amount that the private equity firm is to invest in the company, the format in which the investment is to be made, eg. convertible preference shares, and the number and price of the shares.
2. Instruments/ Securities Offered
A description of the type of securities being offered, e.g., Common or Preferred Membership Interests (if an LLC), type of Preferred (e.g., Convertible, redeemable or participating) and, for older companies, which Series is now being offered (typically lettered as A, B, C, etc.). Different Series of preferred can have different terms relative to each other which must be considered before making an investment in a new Series.
The valuation (pre-money) should be firmly buttoned down in the term sheet. The pre-money valuation is the value of the business or company before the particular finance raising round has been completed.
4. Capital structure
The capital structure should be shown in the final term sheet both before and after the private equity firm’s investment, on a fully diluted basis, including all share options.
5. Use of the funds
This outlines how the proceeds from this financing will be used by the Issuer. Fees, such as a Placement Agent Fee, and other expenses, such as legal, which are associated with the Offering, should also be identified.
6. Liquidation preferences
These are the right of the preference shareholder to receive before any other shareholders cash that is available in the event of the company being liquidated or indeed sold, as in a trade sale, or achieving an IPO. The private equity investor may express that he requires a multiple of his original investment in these situations.
7. Preferred return on investments
Specifies a minimum return on the preferred equity, e.g., a xx% Cumulative Annual Return on invested capital. This would also define when the Distributions are to be made (typically quarterly) and how they are authorized by the Board of Directors.
8. Dividend rights
The right to receive dividends may be cumulative or non-cumulative. If cumulative the dividend due to the preference shareholder accrues even if the company does not have adequate distributable reserves to be able to pay a dividend when it is due. The accumulated dividends then become payable to the private equity firm in the event of a liquidation occurrence as above. Non-cumulative dividends are not accrued if the company does not have distributable reserves to pay them.
9. Conversion rights
Preference shareholders usually have the right to convert their shares into ordinary shares, for example in the event of an IPO. They will do this only if it is a ‘qualifying’ IPO where above a certain minimum amount of capital is raised at above a minimum stock price. This protects preferred shareholders converting from preferred shares to ordinary shares in connection with an IPO that is too small or has no meaningful public market or liquidity for the shareholder.
10. Anti-dilution provisions
Anti-dilution provisions protect the preferred shareholder from dilution resulting from later issues of shares, in connection with subsequent financing round, at a lower price than the private equity investor originally paid (known as a ‘down round’). Anti-dilution provisions in their most aggressive form are set up such that the lower share price of the later share issue is applied to the original, higher-priced shares and the investor’s shareholding is adjusted as if he had invested at this lower price.
11. Redemption rights
Redemption rights require the founder or management team to buy back the private equity investor’s shares by a specific date. These rights are used if the business does not generate the growth required by the investor to give him his required capital gain. A multiple of what the private equity firm invested may be required to be paid back to the firm.
12. Lock ups
Lock-ups specify how soon after a flotation the management team and the private equity investor can sell their shares, which is important in making the shares attractive to public investors at the time of the IPO.
13. Pre-emption rights
Pre-emption rights apply when a company proposes to issue new shares and existing shareholders, such as the private equity investor, have the right to be offered a pro-rata part of the new shares before they are offered to a new shareholder in a way that does not dilute the original private equity shareholder. In relation to sales of existing shares, similar rights require a shareholder wishing to sell shares to offer them first to existing shareholders before being able to transfer them to outsiders.
14. Board composition
The private equity firm has the right to have a seat on the board of directors.
15. Consent rights
Consent rights give the private equity firm the right of veto over a whole range of areas even though the private equity firm may not have a majority of the shares with voting rights. Such areas could include the recruitment of new members of the management team, purchase of new equipment, corporate mergers and acquisitions, expansion overseas or into new markets, future finance raisings, issue of stock options, borrowing levels and the sale or flotation of the company. The private equity investor may set limits over which he wants the right of veto, for example, new equipment purchases greater than $250,000 or borrowing limits greater than $500,000.
16. Information rights
Information rights will require the company to provide the private equity firm with copies of the monthly management accounts (including budget versus actual comparisons and explanation of variances), updated monthly cash flow forecasts, audited annual accounts, annual strategic plan and budget etc.
The term sheet may require the management team to warrant certain information which the private equity firm is relying on in arriving at its investment decision. You will need to negotiate, with your lawyer involved, the nature, extent and limit of these warranties and what happens if they are breached in terms of indemnification (if the value of the company is reduced in the event of a breach of warranty you may have to compensate the investor for the reduction in value) or contractual damages (if it can be argued that the shareholders have suffered no loss you might not have to pay the private equity firm in connection with the breach).
The private equity firm may require the shareholder founders or management or other key employees to remain working with the company for a minimum term before they can realise the rights over all the options or all the shares ascribed to them. The shares are considered vested when an employee can leave his job, yet maintain ownership of the shares or exercise his options to obtain the shares with no consequences.
If there is a minimum total issuance amount specified by the Issuer for the Offering (a Min/Max Offering), an Escrow account must be established at a bank providing escrow services for investors as fiduciary. This bank will be the Escrow Agent for the Offering. Until the minimum amount has been raised, Investors’ funds are held in safekeeping by the Escrow Agent before being released to the Issuer. If the minimum has not been raised by the termination of the Offering, funds are returned to Investors.
The percentage of equity shares reserved for new options for existing and future employees should also be set out in the term sheet. This will affect the valuation of the company.
Milestones are often used to set goals that the management team have to reach before additional tranches of capital are put into the company by the investor, management salaries are reviewed or share options are granted.
The term sheet will contain a clause on confidentiality, ie. that both the investor and the founder /the management team will keep the fact that discussions are progressing between them confidential as well as agreeing not to divulge any information supplied.
The private equity firm may want to include an exclusivity clause in the term sheet preventing you from talking with other private equity firms about investing in your proposition for a specified period of time, usually, the period that the various due diligence exercises are carried out.
The term sheet will set out the basis on which the professional fees of the investor’s accountants, lawyers and other due diligence providers are to be paid. In addition, some private equity firms may charge a fee for doing the transaction (deal fee) and, post-investment, some private equity firms may charge the company for monitoring their own investment by taking a fee for the provision of non-executive directors appointed to the board.
25. Conditions precedent
Conditions precedent included in the term sheet include details on what has to happen between the term sheet being signed and the completion of the investment. This will include the satisfactory completion of the due diligence process and the completion of the various legal agreements, including the shareholder’s agreement and the warranties and indemnities documentation. Conditions precedent may also specify that you must do certain other things during this period, such as securing the contract with the major customer that you have informed the private equity firm is in process.
All of the above areas included in the term sheet are negotiable. The term sheet is only binding as regards exclusivity, confidentiality and fees. The term sheet will go on to form the basis of the final legally binding investment agreements.
- Gender Smart Investing: a growing opportunity
- Areas to cover in your business plan
- The advantages of private equity over senior debt
- Stages of venture capital funding
- World’s top 10 private equity firms
- Private Equity Investment Strategies
- Top sources for startup funding
- Leveraged Buyouts
- Private Equity
- Mezzanine Financing
About the author
Dileep K Nair
Mr Dileep is currently the managing partner of Unifinn Capital Global and an advisor to the investment banking and corporate finance world. He is a mentor, entrepreneur, business advisor and investment banking expert with an overall 19 years of experience in investment banking, retail banking and corporate finance and business management. He handled a wide range of corporate finance transactions, including private equity funding, private debt, venture capital, angel investing, M&A, LBO etc worldwide.