A term sheet is a letter of intent provided by a private equity firm to a target business. The purpose of the term sheet, apart from articulating an interest in the target, is twofold: 1) to outline the proposed terms of the transaction, and 2) to apply an indicative value to the transaction. The term sheet is rarely legally binding; it acts more as a letter of good faith between the parties. If all of the terms become agreed, the term sheet forms the basis for more detailed documentation, such as a redrafted Shareholders Agreement or Certificate of Incorporation.

It is important to keep cognisant of the affect a term sheet will have on existing documentation. Generally, if a term within the term sheet differs from an existing term between shareholders, then the expectation is that the new term from the term sheet will replace the existing term. Business owners, or other parties considering the transaction, need to understand that the term sheet becomes the proxy for the terms of the relationship and may affect their control over the business in the future.

The process of negotiating a term sheet, like most negotiations, is all about pushing and pulling. For each clause there will be wording that puts it in favour of the private equity firm, wording that puts it in favour of the potential investee, and wording that provides a relatively neutral position. It is rare that all clauses are written from a neutral position because different parties feel differently about different issues. So typically, parties will enter negotiations and attempt to have the issues they are most sensitive to written to favour their cause.

Term sheets have varied degrees of complexity, usually based on the stage of discussions and agreements already made in principle. Very simple term sheets where the private equity firm is in a weaker position may only include a few clauses outlining the valuation, deal structure and exclusivity. More advanced discussions may result in a term sheet with 15+ clauses and may discuss concepts such as right of first refusal, drag along rights, conversion rules, etc. In later posts I’ll discuss some of these concepts in more detail.