Term Sheet

What is a term sheet?

Term sheet (key terms paper) describes the written summary of the essential economic and legal terms on which an investor wants to take a stake in a company. Literally, the term means a sheet of conditions; in German, the usual word is Eckpunktepapier (key points paper). The term sheet is agreed after the first conversations and before the detailed review of the company and is, in its core points, not legally binding. Only individual procedural rules such as exclusivity, confidentiality and allocation of costs are binding.

Term sheets accompany above all equity rounds of growth companies, that is, rounds in which investors receive new shares in return for their payment. The draft is usually presented by the lead investor, who leads the round and takes the largest amount. The term sheet is generally signed by the company, the founders, the existing shareholders whose cooperation is needed for the capital increase, and the lead investor. It is implemented in binding form in the participation agreement, in the shareholders' agreement (the contract of the shareholders among themselves) and in the amended articles of association.

Structure and content of a term sheet

There is no statutory template. Common templates divide the provisions into five groups:

• Key economic terms: investment amount, valuation before the round (pre-money valuation) with its basis of calculation (the number of shares taken as the basis), price per share, number of new shares, split into nominal amount and additional payment into the capital reserve, where applicable payment in instalments (tranches).
• Investors' economic rights: liquidation preference, anti-dilution protection, rights to participate pro rata in future rounds (subscription rights), treatment of existing convertible loans.
• Control and transfer rules: consent reservations, advisory board, information rights, rights of first refusal, tag-along right and drag-along obligation.
• Rules for founders and team: vesting of the founders' shares (their gradual earning over several years), leaver rules for early departure, non-compete clauses, employment contracts and the size of the employee participation programme.
• Procedural rules: exclusivity, confidentiality, costs, timetable, closing conditions, governing law and the specification of which parts are binding.

Legal binding force of the term sheet

The core points are subject to a satisfactory review, approval by the investor's investment committee and the conclusion of the final contracts. No claim to carry out the financing follows from them. If one side breaks off the negotiations, it is liable for fault in pre-contractual dealings (Section 311(2) of the German Civil Code, BGB) only in exceptional cases. For contracts that require notarisation, case law demands a particularly serious breach of the duty of good faith for this.

In a GmbH (German limited liability company), the non-binding nature also has a formal reason. If the term sheet contained a binding obligation to transfer shares, for example through a drag-along obligation or retransfers under leaver rules, it would require notarisation under Section 15(4) of the German Limited Liability Companies Act (GmbHG). As a rule, only the following are agreed as binding:

• Exclusivity: for a set period, the company and founders negotiate with no other capital provider about comparable financing (exclusivity period). Four to eight weeks are common, more for larger rounds.
• Confidentiality: the content of the term sheet and information from the review remain confidential.
• Costs: the company often bears the investor's advisory costs up to a maximum amount on closing; if the round fails, each side usually bears its own.

The economic clauses

Valuation and basis of calculation

A valuation is meaningful only together with its basis of calculation. The term sheet specifies whether the value applies before or after the round and which shares go into the fully diluted base. This base counts all present and already promised future shares: existing shares, allocated and unallocated virtual shares, an increase of the employee pool and the conversion of outstanding convertible loans. Every item that is included in the base before the round lowers the price per share and falls solely on the existing shareholders.

Liquidation preference

The liquidation preference determines the order in which sale proceeds are distributed. The simple, non-participating preference is common: the investor receives the higher of its investment amount and the share of proceeds corresponding to its shareholding percentage. With a participating preference, it receives the investment amount first and in addition participates in the remaining proceeds at its percentage. In a GmbH, the preference is implemented as a proceeds distribution agreement in the shareholders' agreement.

Anti-dilution protection

Anti-dilution protection applies if a later round takes place at a lower price per share (down round). The investor then receives additional shares, in a GmbH usually through a capital increase at nominal value. The weighted average is usual, which measures the adjustment by the size of the new round. Full adjustment to the new price (full ratchet) is the exception.

The control clauses

Control clauses give the investor influence over the management of the company even though the shareholders' meeting in principle decides by a majority of the votes cast (Section 47(1) GmbHG) and the investor does not hold that majority:

• Consent reservations: measures that require the consent of an investor majority (veto rights), typically amendments to the articles of association, capital measures, the sale of material assets, loans above a value threshold, the annual budget and changes to the participation programme.
• Advisory board: an optional body with appointment rights that advises and supervises the management and approves certain measures.
• Information rights: monthly reports, annual financial statements, budget and planning within fixed deadlines, in addition to the right to information and inspection under Section 51a GmbHG.
• Transfer rules: rights of first refusal of co-shareholders, a tag-along right and a drag-along obligation. With the tag-along right, the minority joins a sale by the majority on the same terms; with the drag-along obligation, a qualified majority enforces the sale of all shares.

A short catalogue of structural decisions is market standard. A long catalogue with low value thresholds, by contrast, shifts day-to-day business into approval procedures without the shareholding percentages changing.

From term sheet to contract documentation

1. Review: the investor reviews business model, finances, legal matters, tax and technology (due diligence). Findings flow in as warranties, closing conditions or price adjustments.
2. Drafts and negotiation: the participation agreement, shareholders' agreement, new articles of association and the capital increase resolution are drawn up. Added are provisions that are only sketched in the term sheet, such as the warranty catalogue and liability limits.
3. Notarisation (signing): contracts and resolution are notarised. The resolution requires a majority of three quarters of the votes cast (Section 53(2) GmbHG).
4. Closing: once the closing conditions are met, the investor pays the contribution, and the management files the capital increase with the commercial register. It takes effect on registration (Section 54(3) GmbHG), after which the notary submits an updated list of shareholders.

In practice, six to twelve weeks often lie between the term sheet and notarisation. The duration depends above all on how complete the data room is, that is, the organised collection of all documents for the review.

Worked example: comparing two term sheets economically

A software company receives two term sheets for EUR 5 million each. Offer A states a pre-money valuation of EUR 20 million with a simple, non-participating liquidation preference, offer B states EUR 25 million with a simple, participating preference. There are no further preferences, pools or convertible loans.

• Offer A: post-money valuation 20 + 5 = EUR 25 million, investor's percentage 5 / 25 = 20%
• Offer B: post-money valuation 25 + 5 = EUR 30 million, investor's percentage 5 / 30 = one sixth, around 16.67%
• Sale for EUR 30 million under A: the investor chooses the higher amount of EUR 5 million preference and 20% of EUR 30 million, that is, EUR 6 million. EUR 24 million remains for the other shareholders.
• Sale for EUR 30 million under B: the investor receives EUR 5 million first and one sixth of the remaining EUR 25 million, together around EUR 9.17 million. Around EUR 20.83 million remains for the other shareholders.
• Break-even: at proceeds of EUR 125 million, the investor receives EUR 25 million in both cases, because 20% of 125 = 25 and 5 + (125 minus 5) / 6 = 25.

The EUR 5 million higher valuation in offer B pays off for the existing shareholders only at proceeds above EUR 125 million. That is five times the post-money valuation of offer A; at lower proceeds, offer A is more favourable for them. Term sheets can therefore be compared reliably only through a distribution of proceeds for several sale prices (waterfall analysis).

Distinctions: term sheet, LOI and participation agreement

• LOI: the letter of intent in a company acquisition (M&A) on the purchase price, structure and timetable of an acquisition. If it summarises the purchase terms in bullet points, it is sometimes also called a term sheet there. In a financing round, by contrast, the term sheet describes a stake taken through a capital increase.
• Investment agreement: umbrella term for the entire contract package of the round, into which the key points of the term sheet are transferred.
• Participation agreement: the notarised core of this package. It turns the non-binding key points into enforceable obligations on capital increase, payment and warranties.

Common mistakes

• Open basis of calculation. A valuation without stating whether it applies before or after the round and which shares go into the fully diluted base leaves the investor's percentage open.
• Exclusivity without an end date. A period that renews itself silently or is tied to the completion of the review takes away the company's ability to obtain other offers for an indefinite time.
• Pool without a hiring plan. If the size of the employee pool is set as a flat figure, the existing shareholders bear a dilution for which there is no concrete need.
• Milestones only hinted at. If tranches are tied to targets that are not defined in measurable terms, the dispute over whether they have been met arises only after closing.

Frequently asked questions

Is a term sheet legally binding?

Only in parts. Valuation, size of the stake and the investors' rights are generally agreed as expressly non-binding. Binding are usually exclusivity, confidentiality, allocation of costs and the choice of law and place of jurisdiction for these points.

Must a term sheet for a GmbH be notarised?

No, as long as it contains no binding obligation to transfer shares. Only the participation agreement, shareholders' agreement and capital increase resolution are notarised.

Is there a term sheet template in German?

Yes, but there is no statutory template. Law firms and investors publish templates in German and English, and many lead investors present their own template. Valuation, basis of calculation, preferences and approval catalogue are nevertheless negotiated individually for each round.

Can the investor still change the valuation after signing?

Legally yes, because the valuation is non-binding. In practice this succeeds only with an objective reason, usually a material finding from the review or a marked deviation from the plan in the meantime.

The Roemer Capital view

Where several term sheets are on the table in a mandate, Roemer Capital transfers each offer, with pool, convertible loans and preferences, into the same distribution of proceeds across a range of sale prices. Only on that basis does Roemer Capital discuss with the shareholders which offer is economically preferable.

Before signing, Roemer Capital watches for three points: a fixed end date for exclusivity, a clearly defined basis of calculation and an approval catalogue limited to structural decisions. The legal drafting is handled by the company's law firm. Roemer Capital prepares the figures, coordinates the timetable up to notarisation and takes part in negotiating the economic points.