17 Term Sheet Clauses to Know During Deal Negotiation

Term sheets can be confusing. Let's shed light on 17 examples of the term language used in these documents so you can be in the know during your next negotiation.

A term sheet is the document that outlines key financial and other terms of a proposed investment between a founder and a finance source. This can also be called a “letter of intent”, “memorandum of understanding” or an “agreement in principal.” It’s the first step in a financing transaction for material of the deal to be negotiated. These comments are focused on angel, venture capital and private equity deals but could come up in more traditional straight debt forms of financing.

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    This article highlights the potential pitfalls that can result in a founder unwittingly losing control and liquidity in their business during their negotiations when seeking funding for their company. 

    Here are some of the basics to review:

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    No. 1: Is the Term Sheet Legally Binding? Generally, no, except for legal liability in the area of confidentiality, exclusivity and costs. The intent here is to define the terms and determine if the deal has the legs to get closed between the parties.

    No. 2: Valuation of Your Business: Realistically value your company’s value based on benchmarks against similar companies. A high valuation may look good on paper, but it will also raise the bar for your performance level if you want to get a future round of funding.

    No. 3: Due Diligence: It’s important that the founder complete a thorough due diligence with whom they will be doing business with. One of the big concerns from venture capital and private equity sources is the founder does not take the time to complete their own due diligence on their long-term partner. Be detailed on how your investors will help your company besides just funding. 

    No. 4: Financial Instrument: There are generally two kinds of equity - stocks including preferred stocks and common stocks.  Convertible debt notes are increasingly being used.

    • Stock Classification- Preferred stock is where the investors can have unique terms and conditions that don’t apply to other classed shareholders and where voting rights tend to be unevenly distributed among common shares.  Preferred stockholders benefit by having their money returned before other shareholders. It also pays a fixed dividend, is callable at any given time and can be converted to common stock at the election of the shareholder.  Common stocks do not have these privileges.

    • Convertible Notes- Convertible notes have become increasingly popular over a straight stock equity structure.  Fundamental difference is that the convertible note is a debt instrument with provisions to convert into equity later.  Convertible notes avoid valuation discussion, are cheaper and faster to negotiate than straight equity. Be aware of the CAP rate, lower discount, interest rate and when the note converts into equity and/or liquidity. These will have impact when the note is converted.

    No. 5: Partner Participation Rights: There are three types, ranging in terms of their economic upside potential to investors. 

    • Non-Participating – Most owner friendly option. The investor must choose between straight liquidation preference or a pro-rata share of all proceeds. 

    • Capped Participation – As the Full (see below), but the total return from liquidation and participation rights is capped at a defined multiple.

    • Full Participation - Most investor friendly. The investor first receives their liquidation preference and then a pro-rata share of any remaining proceeds.

    Determine voting rights for all three types of investors.

    No. 6: Pro-rata Rights: Pro-rata rights provide an option (the right, but not an obligation) for initial investors to invest in future rounds in order to maintain their ownership, which would be diluted otherwise.

    No. 7: Liquidation Preference: Liquidation preferences determine the hierarchy of payout upon a liquidation event, such as a sale or merger of the company.  Liquidation preferences allow investors to define the initial amount and breadth that they are guaranteed as a payout.

    No. 8: Anti-dilution Provisions: This right protects an investor from equity dilution resulting from future issues of stock if the stock is sold at a lower price that what the original investor paid in.  This also adjusts relative ownership percentages to prevent new stock lowering oft the investors’ stake.

    No. 9: Protective Provisions: Protective Provisions grants investors veto rights that they otherwise would be unable to exercise at the board level, due to their percentage stake does not constitute a majority vote. These may include forced discussion such as a company sale, stock issuance to expenses, hiring sign-offs.

    No. 11: Drag Along Rights: This clause allows investors to compel other classes of stock to agree with their voting demands for a liquidation event such as a sale, merger or dissolution.

    No. 12: Right of First Refusal/Right of Co-Sale: Notifies all investors on stocks available to purchase by other investors and requires board approval of all transfers of ownership to help prevent secretive transfers of stock from happening.

    No. 13: Guarantees: If the founder is required to be a guarantor, include specific language as to when and how the guarantor will be taken off the note.

    No. 14: Vesting Schedule: Vesting refers to the process by which shares/equity are earned in a business over time (typically four years or fewer.)   A sudden departure of a founder with vested stock leaves dead-equity on the cap table. This event could have important implications on the effects of the remaining founders and funders.

    No. 15: Liquidation Preference:  Liquidation preferences allow investors to define the initial amount that they are guaranteed as a payout. 

    No. 16: Confidentiality and Non-Compete: These prevent conflicts of interest that could arise when investors try to leverage their portfolio by sharing information or possibly investing in competing businesses. The period of this cover ranges from 2 years to 20 years (as seen in oil and gas deals.) Further, the founder wants the investor to be fully focused on ensuring their business is successful.

    No. 17 Mediation/Arbitration: Unfortunately, some deals do go south.  Disputes arise requiring a third party to intercede. Should this action be needed, make sure this course of action is handled in a jurisdiction most convenient to you. For example - In cases where the opposing party is out of state, you want your case reviewed in your county and state. 

    Marsha L. Powers is a finance and strategic development professional, author, entrepreneur and investor and the founder of Powers Advisors and Shale Capital Resources. She has been a contributing writer on Finance for Crain’s Cleveland Business for nine years. Her management consulting areas of expertise includes finance – ranging from senior debt, government finance programs to private equity, market strategy, operations, marketing communications and economic development.  She’s a recognized award-winning leader with proven strategic direction and leadership to over 1500 companies, from early stage to Fortune 50 companies. You can reach Marsha at (216)965-3633, marsha@powersadvisors.com to learn more about how she can help your company succeed.
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    Next up: Accessing Capital: ECDI
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  • Accessing Capital: ECDI

    Access to capital can be problematic not only for aspiring start-ups but also for established businesses looking to upgrade or expand. Ohio small business owners are fortunate to have access to an incredible resource in the Economic and Community Development Institute (ECDI), a small business educator and statewide SBA lender that expanded its services to Cleveland in 2012.

    Access to capital can be problematic not only for aspiring start-ups but also for established businesses looking to upgrade or expand. Ohio small business owners are fortunate to have access to an incredible resource in the Economic and Community Development Institute (ECDI), a small business educator and statewide SBA lender that expanded its services to Cleveland in 2012.

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    With loans ranging from $500 up to $350,000, ECDI is a top-ranked micro-lender whose mission is to invest in people and businesses. Whether you are in need of new or upgraded equipment, operating costs or some backing to get your entrepreneurial dream off the ground, ECDI may be the answer.

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    For more information about ECDI, their educational classes or a loan application, go to www.ecdi.org.


    TIP: 

    ECDI is holding a Business Information Session in Cleveland at noon on Monday, July 20, to inform prospective ECDI clients about programs to develop, fund, and launch a business. Loan program requirements and procedures will also be discussed. Register at www.ecdi.org/events.


    This article originally appeared in the July 13, 2015, edition of Small Business Matters.


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    Next up: Accounting for the Launch of Your Business
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  • Accounting for the Launch of Your Business

    A lot of work goes into getting a small business off the ground. While finding your niche, developing and executing a business plan, and hitting the sales path hard are all extremely important, entrepreneurs shouldn’t forget about the accounting side of the business. Jim Bonvissuto, president of BIG Financial & Advisory Services, took time recently to answer a few questions related to the initial accounting steps all business owners should keep in mind during the launch of their business.

    A lot of work goes into getting a small business off the ground. While finding your niche, developing and executing a business plan, and hitting the sales path hard are all extremely important, entrepreneurs shouldn’t forget about the accounting side of the business.

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    Jim Bonvissuto, president of BIG Financial & Advisory Services, took time recently to answer a few questions related to the initial accounting steps all business owners should keep in mind during the launch of their business.

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    Question: When an entrepreneur starts a business, what should they do first?

    Bonvissuto: The first step is to consult with a CPA.   It is critical that a business has not only the appropriate accounting methodology in place day 1, but almost more importantly is the tax structure regarding entity selection, business registration, and all the federal, state and local payroll withholding tax registrations be set up properly.  The second step is planning the ongoing management of the accounting and tax reporting/remittance that is required.

    Q: Are there different types of entities and does it matter what type is selected?

    Bonvissuto: A key issue that a start-up business has to answer is what type of organization structure they want to form.  A business can form as an S-Corp., C-Corp., Partnership, Sole Proprietor, and LLC.    Each of these entities have different tax pros and cons.  The LLC structure is not recognized by the IRS and still requires you to file a form with the IRS to determine what type of entity you will be taxed as (S-Corp.,  C-Corp., Partnership, or Sole Proprietor).  The entity selected for tax purposes could impact you personally anywhere from 10% to 35%.

    Q: How does a business owner know when it’s right to outsource accounting, or take care of it in house?

    Bonvissuto: A business owner’s primary focus is the day to day operations and growing the business.  The accounting for the business also needs to be a priority.  If there are not enough hours in the day for the owner to also handle the accounting, or they do not have the expertise in house to do so daily, they should outsource. 

    Q: What common mistakes do new entrepreneurs typically make when it comes to accounting? How can those mistakes be avoided?

    Bonvissuto: New entrepreneurs mistake accounting as only a means to filing a tax return annually in April. Accurate and timely accounting is the key tool to a successful business.  It will provide the business owner the information to make informed strategic decisions in order to avoid issues and sustain profitable growth. A few examples are: avoiding cash timing issues of when to pay bills and collect from customers, determining the best timing of advertising/marketing for a cyclical business, determining ways to increase profitability, determining whether one can afford to expand or rather should be cutting back. If the business owner does not have the accounting expertise and/or the appropriate staff in place, a CPA has the expertise to guide you in the right direction.  

    Want more expert advice? Check out COSE Expert Network, an online forum connecting business owners with creative solutions to the tough questions they face every day.

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    Next up: An Insider's Look at Business Insurance
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  • An Insider's Look at Business Insurance

    Participants were navigated through the state of the business insurance industry, baseline coverages and what companies can do to get the best pricing for their business insurance needs in this informative webinar tailored to small business owners. Scroll down to the bottom of this article to listen to the full presentation and view the slides.

    During a recent COSE’s WebEd Series webinar, presenters Rob Strachan of Strachan Novak Insurance and Tessa Forby of Grange Insurance took a deep dive into the business insurance industry to help small businesses like yours understand their needs and achieve desirable outcomes when it comes to protecting their business.

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    State of the industry

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    According to the presenters, Ohio is one of the cheapest states to buy insurance and is considered a buyer’s market, with agencies activing aggressively to acquire new businesses. As with any industry, the business insurance industry is constantly changing due to the release of new technology. In this case, things like Uber and driverless cars will have an impact on the future of business insurance. Amazon is starting to get into the business insurance market place. All of these things will drastically change the landscape of the market moving forward.

    What is the role of the buyer?

    There are two ways to purchase insurance. Buyers can go directly to an insurance company, or they can get an independent broker or agent who can shop the market. If choosing the latter, buyers should have a face-to-face with their broker to explain important information such as their niche and core capabilities.

    What is the agent’s role?

    An insurance agent is a bridge between the buyer and the insurance company. A good agent should listen carefully to the client’s needs and then proceed to shop out to each insurance company. Agents usually have somewhere between five to 15 different insurance companies that they have relationships with and frequently connect with on behalf of their clients.

    What you need to know before seeking coverage

    When evaluating a business for coverage, there are several things an insurance company wants to see, such as:

    • Pride of ownership, including housekeeping of the space and maintenance of the equipment;
    • protective devices such as sprinklers, central station burglar and/or fire alarm, cameras on property and other safeguards;
    • good record keeping of things like job files, vehicle maintenance, etc;
    • financial stability that proves the company is making money and has capital to put back into the business;
    • experience in the field so that the insurance provider is confident the business knows what they’re doing; and
    • appropriate hiring practices. Do they drug test employees or determine what kind of a driving record they have? How frequently is there turnover within the company?

    And on the other hand, there are of course things an insurance company does not want to see from a potential customer, such as:

    • Inaccurate marketing materials or information that exaggerates the company’s capabilities;
    • lack of prior insurance, which could be an indicator that the company doesn’t truly recognize the need for insurance;
    • late reporting of claims, which could be an indicator that the company was careless in preventing a claim from getting too large;
    • frequently changing carriers or agents, showing a lack of loyalty or that they are trying to avoid something;
    • poor payment history, which might show the company isn’t financially stable or that they don’t acknowledge insurance as being an important part of the business; and
    • Difficult clients who seem like they are not receptive to working with insurance carriers.

    When it comes to insurance, there is always “the fine print,” right? The webinar presenters encourage business owners to understand the small print when it comes to the different types of insurance. Here’s a list of important questions to make sure you’re asking:

    Important question No. 1: If someone else’s equipment is in your care inside your building, does your policy cover their stuff?

    Important question No. 2: Is flood included? What about things like pollution, product recall and professional liability?

    Important question No. 3: What happens if equipment breaks down?

    Important question No. 4: Does it exclude things like pollution, product recall and professional liability?

    Important question No. 5: What is the coverage territory?

    Important question No. 6: Does it include non-owned or hired automobiles? What about towing and rental expenses?

    Important question No. 7: What is the coverage timeframe? How far back will the insurance cover you and will it extend into the future?

    Important question No. 8: Are you covered from a cyber perspective: Viruses, phishing emails, privacy breaches?

    Important question No. 9: In the event that you have to cease business for a period, does it cover business income, extra expenses and the effort you need to get your business going again?

    And a few parting words: Do not look at your insurance as an expense. Instead, view it as an asset. You have someone to do your taxes, a financial advisor and a lawyer, among other professionals on your “team.” Do you have an insurance advisor? A hole is left in your business if you don’t have the proper planning needed when it comes to business insurance. Make sure you find someone who is involved and responsive, and who is not trying to sell you something.

    The full recap of this webinar can be viewed below. Also, be sure to head over to COSE’s Events Page to view other upcoming events that can help your business grow.


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    Next up: COSE Member Capital Advisors, Ltd. Awarded 2016 Best Practices Award by InvestmentNews
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  • COSE Member Capital Advisors, Ltd. Awarded 2016 Best Practices Award by InvestmentNews

    InvestmentNews named COSE member Capital Advisors, Ltd.  as one of 12 winners of the 2016 Best Practices Awards, an important initiative that recognizes the top-performing and most innovative firms in the financial advice industry.  The 12 winners of the InvestmentNews Best Practices Awards were identified through their participation in the 2016 Financial Performance Study of Advisory Firms, and recognized at The Best Practices Award and Workshop at the New York Athletic Club in New York City, on October 18th. 

    InvestmentNews named COSE member Capital Advisors, Ltd.  as one of 12 winners of the 2016 Best Practices Awards, an important initiative that recognizes the top-performing and most innovative firms in the financial advice industry.  The 12 winners of the InvestmentNews Best Practices Awards were identified through their participation in the 2016 Financial Performance Study of Advisory Firms, and recognized at The Best Practices Award and Workshop at the New York Athletic Club in New York City, on October 18th.

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    To identify the 2016 Best Practices Award winners, InvestmentNews Research created composite scores that examined the rate of growth, profitability and productivity levels for all the participants in the 2016 InvestmentNews Financial Performance Study. The firms classified as having “Best Practices” were those who ranked among the top-quartile of all participants; however, a number were selected for extensive qualitative interviews conducted by the InvestmentNews Best Practices Committee, in order to select the 12 winners.

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    “We are honored to be considered amongst some of the finest wealth management firms in the country,” says Neil Waxman, Managing Director, Capital Advisors, Ltd.  “To my mind, recognition of best practice is some of the highest praise we can attain because it confirms what our team works so diligently to achieve: commitment to excellence, prudence, and consistency in bringing to bear a superior level of service to our clients.”

    This is the fourth consecutive year that InvestmentNews has recognized the industry’s top-performing firms as part of the Best Practices program. All of the firms honored have participated in InvestmentNews’ primary benchmarking studies: The Advisers Compensation & Staffing Study, The Financial Performance Study of Advisory Firms and The Adviser Technology Study.

    “The firms that have seen the most growth are those that have been the most strategically managed,” says Mark Bruno, Associate Publisher of InvestmentNews. “Capital Advisors is one of those firms, and its leaders executed on their strategic plans more effectively than most firms in the industry. They are an excellent example of how—and why—professionally run wealth management firms are out-performing and well-positioned for long-term success.”

    InvestmentNews honors Capital Advisors, Ltd. with a 2016 Best Practices Award. 

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    Next up: How to Build Your Business's Financial Gameplan
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  • How to Build Your Business's Financial Gameplan

    With all of the day-to-day business operations entrepreneurs are faced with—product development, human resources issues, and business development to name just a few—it might be easy to lose track of a business’s balance sheet strategy.

    With all of the day-to-day business operations entrepreneurs are faced with—product development, human resources issues, and business development to name just a few—it might be easy to lose track of a business’s balance sheet strategy.

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    “A lot of small business owners don’t understand their business’s costs,” says Brian Alquist, president of business consultancy 1Direction, Inc., in Brecksville. “Consequently, they’re really just focused in on the cash they have at the end of the month.”

    But operating a business requires a much more comprehensive plan than just focusing on what’s left over when the month comes to a close, experts say. It requires detailed thought around the best way to think about setting financial goals and KPIs, access to capital, accounting best practices and more.

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    ‘Build backwards’

    One of the first things an owner needs to do is settle on what the organization’s goals are, says Michael Foss of Foss Business Solutions in Lyndhurst.

    “Build backwards,” he advises. “What are our current expenses? How do I want to grow? What do I need to do to achieve that?” Once those questions are answered, the business owner will begin to be able to form a clear picture of the sales (and gross profit margin) the business needs to obtain to achieve those goals.

    This is where understanding your cash flow comes in, says Rion Safier of Rion Safier Accounting LLC in Beachwood. For a small business, cash flow is king and the company’s budget and cash flow forecast

    “There are companies that don’t have an accounting infrastructure and the business owner is just flying by the seat of their pants and using their bank balance as one of their key drivers,” he says. “That’s not a good way of looking at it. What if your receivables are delayed? Your cash might be depleted. Only looking at the cash balance is not an indicator of the health of a company.”

    Measure effectively

    What businesses should be paying attention to is working capital, or the capital a business uses in its day-to-day operations and calculated as current assets minus current liabilities, Alquist says.

    “That tells me how well they’re really managing the financial aspect of their business on a day-to-day basis,” he says. “If the company has some level of capital invested in the business, I would also look at the ratio of depreciation to expenses. That tells me if they are investing or reinvesting in the business.”

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