The Risks of a Term Sheet and the Impact on the Long Form Agreement

What starts as a "non-binding" term sheet often shapes the entire deal. In this piece, we spoke with M&A experts Koen Hoornaert, Laurent Detaille, and Ruben Toelen of Van Olmen & Wynant to unpack the key risks and missteps they see in practice.

General Information

1. What is your name and in which legal areas are you specialized?

Van Olmen & Wynant — we are specialized in, on the one hand, "employment law" and, on the other hand, in "corporate law," with a focus on private M&A transactions, including private equity and venture capital deals.

2. How often do you encounter situations in your practice where entrepreneurs experience problems due to an unclear or poorly formulated term sheet?

Sometimes we are contacted as lawyers only when the signed term sheet is already on the table. In such cases, we often find that the founder has problems understanding (all of) it, has misunderstandings about its binding nature, and has agreed to certain principles and conditions whose impact they cannot assess.

Unclear or poorly formulated passages generally result in them being open to interpretation. Consequently, discussions about them can be reopened in the context of the definitive transaction documentation, which can often cause frustration for founders who have no experience with this.

If you, as an advisor, are only involved at a later stage, it is much more difficult to revisit agreements what is agreed upon from the term sheet, even when it turns out that the founder had misinterpreted or misunderstood these agreements.

Legal Status of the Term Sheet

3. Can you briefly explain why a term sheet is generally not binding? Are there exceptions?

A term sheet is generally not binding; it is a "statement of intent" by parties who are willing to negotiate further based on a certain starting position and under specific conditions. The purpose of this document is to clearly establish the most essential aspects of the transaction prior to drafting the definitive contracts.

Within a term sheet, however, there are some exceptions that are binding due to their nature. This particularly concerns clauses such as confidentiality obligations, exclusivity agreements, and dispute resolution.

Only after obtaining exclusivity will an investor typically be willing to incur due diligence costs. The company however is not allowed to pursue other (equity) opportunities for the duration of the exclusivity period, meaning the shorter the company's runway, the stronger the investor's negotiating position will be after execution of the term sheet.

4. What legal misunderstandings do you often see among entrepreneurs when signing a term sheet?

Some founders incorrectly assume that a term sheet is equivalent to the final contract in terms of legal character.

Others underestimate its importance and think that this document has no legal consequences because of its non-binding nature. The idea is: you are not obligated to do the deal at the end of the day, but if you do the deal, it will be based on the rules of the term sheet. A term sheet creates the expectation that items clearly outlined in it will not be renegotiated at a later stage but will be refined and supplemented where necessary. Often, people underestimate how difficult it is to deviate from clearly defined provisions in a term sheet later without damaging the relationship with the other party.

Pitfalls When Signing a Term Sheet

5. What are the biggest risks of signing a term sheet without legal advice?

The biggest risk is that an entrepreneur signs a term sheet without fully understanding its implications, nor realizing what can be considered market standard. There is therefore information asymmetry.

However, the term sheet of your first round determines how your basic documentation, such as the investment agreement and shareholders' agreement, will look. In practice, the agreements of the first capital equity round will often serve as the basis for subsequent rounds. From a precedent value, that first term sheet is therefore of essential importance. What you give away there, you never get back. It is therefore important to have a good understanding of what is market standard in which phase.

6. Which terms or clauses are often misunderstood by entrepreneurs?

Many founders underestimate the impact of provisions that only become relevant in future (potential) scenarios.

These include, for example:

i. Liquidation preference (the distinction between "non-participating" and "participating"): some founders find it difficult to estimate how this affects a payout upon exit;

ii. Anti-dilution protection (the distinction between "narrow-based" and "broad-based", between "weighted average" and "full ratchet" protection): founders need to understand the impact of this on their dilution in share percentage in case of future "down round";

iii. Leaver provisions: an investor investing in a start-up is actually investing in the team. As soon as your operational role within the company stops, this has an impact on your shareholder position, because in such a case, the investors typically get the right to take over (part of) your shares. It is essential to understand this mechanism well, as well as what is considered market standard in this regard;

iv. Directors and authorities: VC investors, who classically become minority shareholders, will always ask for veto rights at the level of the board of directors and the general meeting. Know that this first list of veto rights in practice is the minimum that you will have to grant to the investors of future rounds;

v. Representations and warranties: we find that the mechanism for potential compensation is often a stumbling block for founders.

7. Can you give a practical example where an entrepreneur suffered adverse consequences from a poorly drafted term sheet?

Some notable examples include, among others:

i. a founder who significantly exposes himself with his entire private assets to compensation towards the investor (founder liability);

ii. a founder who agrees to strict leaver provisions, whereby the investor de facto has the (discretionary) possibility to buy out this founder at any time, sometimes taking into account a large discount.

iii. a founder who accepts a term sheet with a much too favorable liquidation preference for the investor, causing the investor to disproportionately benefit from the exit proceeds, to the detriment of the founders, even in very favorable exit scenarios.

Impact on the Long Form Agreement

8. How much freedom does an entrepreneur still have in negotiations about the definitive agreement if a term sheet has already been signed?

Although a term sheet is not binding, parties are not meant to deviate from the arrangements that have been concluded in it. Much depends on the extent to which the term sheet is detailed and the expectations that parties have. In practice, a strict term sheet can leave little room for further negotiation without risking the deal.

Major deviations in the definitive agreement from the term sheet can be seen as a "reopening of negotiations," which, at best, will lead to delays (which are never in the interest of a company with a limited runway), but may also create distrust between parties and typically leads to (at least) a longer negotiation process.

The number of parties also plays a major role; good contacts with a single investor obviously allow more leeway than when you are sitting at the table with multiple institutional investors.

9. What are the most common conflicts between a term sheet and the eventual long form agreement?

It is never excluded that parties attribute a completely different intention to the same provision in the term sheet. Differences in interpretation are therefore not unusual.

Also a common point of discussion are additions to the long form agreement for matters that are not explicitly included in the term sheet. Certain matters are included in the long form agreement by a party as being market standard while these are not explicitly mentioned in the term sheet. A term sheet is by definition not all-encompassing.

10. How can a poorly formulated term sheet weaken an entrepreneur's position in later negotiations?

When a founder is not legally assisted in the term sheet phase, in practice, the investor's lawyer will also draft the contracts. A poorly formulated or vague term sheet leaves much room for the investor to structure the final contracts to their advantage.

Advice and Best Practices

11. What would be your most important advice to entrepreneurs who sign a term sheet without legal assistance?

The best advice is not to sign any term sheet without seeking (at least high level) legal advice. A term sheet can be seen as the foundation of the transaction, on which — figuratively speaking — the rest of the transaction rests.

Know that a potential professional investor has extensive market knowledge and expertise themselves and on top of that is always assisted by advisors specialized in the matter. Make sure you can effectively reduce the information gap by talking to other founders, but also by seeking legal advice.

12. Are there specific clauses or agreements that should always be well-defined in a term sheet to avoid later conflicts?

Below are the most important ones:

i. Valuation, investment amount, and cap table: A term sheet typically mentions the (maximum) investment amount as well as the pre- or post-money value of the company. These concepts impact the ultimate dilution of the founders. Also pay attention when setting up an ESOP pool, and who bears that dilution. The following formulations can indeed make an important difference in the cap table:

• "investment of 2 million EUR at a pre-money valuation of 10 million EUR, followed by the issuance of a 10% ESOP". In this case, you give away 2/12th of the cap table and the dilution for the ESOP is borne pro rata by the founders and the investors;

• "investment of 2 million EUR at a post-money valuation of 12 million EUR, including an available ESOP pool of 10%". In this case, the issuance of the ESOP is already factored into the valuation, causing only the founders to undergo the dilution.

ii. Liquidation preference: Ensure that you can assess in a clear and transparent manner how the proceeds of an exit are distributed.

iii. Dilution and future financing rounds: Despite often seeming merely hypothetical, this impacts the future percentages in the shareholding (and consequently impacts control and proceeds).

iv. Governance: Special attention should be paid to decision-making at director and shareholder level and composition of the governing body. What can you as a founder decide independently and in what does the investor have a say.

v. Exit strategies and transfer restrictions of shares ("drag along", "tag along"): An investor may have a different exit horizon than the founder(s).

vi. Leaver provisions: Extremely important. In certain cases, you can be forced — after having been active for years — to transfer your shares in the company to the investor, at a predetermined valuation. Ensure that this is only possible in clearly defined cases.

vii. Exclusivity: How long are you not allowed to speak with other interested parties (with the exception of parties that would participate in the round).

viii. Conditions precedent: What additionally needs to happen before the investment will actually take place.

13. What red flags should be recognized before the term sheet is signed?

As a founder, in the first instance, the biggest "red flags" are the provisions that you don't (fully) understand, or whose concrete impact you cannot assess. When certain things are written so cumbersomely with excessive legal language or are substantiated with so many assumptions that there is too much interpretation/room for maneuvering.

On the other hand, you should pay attention to provisions that you feel could have a substantial impact on your position within the company.

Examples of these are:

i. Provisions that can force you to transfer your shares (leaver provisions);

ii. Provisions that de facto give the investor complete control over the company (governance);

iii. Provisions that lead to a (far-reaching) dilution of your shareholding;

iv. Provisions that allow the vast majority of any (exit) proceeds to flow to the investor;

v. Too long exclusivity provision period (an investor knows that your runway is limited in time, and the longer the exclusivity, the greater their power becomes in the negotiations);

vi. Unreasonable personal liability (representations and warranties).

14. How can entrepreneurs seek legal advice in a cost-effective way when drafting or evaluating a term sheet?

Use specialized networks, accelerators, or incubators that sometimes offer free legal advice; work with a law firm with whom you can establish a long-term trust relationship.

Final Question

15. What lesson about term sheets would you like to impart to young entrepreneurs (and lawyers who assist them) who are about to close their first major deal?

Bringing a first external financier on board in the capital of the company is placing a first puzzle piece in a completely new chapter. This puzzle piece, to which all further pieces need to connect, largely determines your future position in the company.

A term sheet, although in principle not binding, lays the foundations for a definitive agreement, whereby a well-thought-out term sheet can make the difference between a successful collaboration and a poor business decision.