Posted by Esha Kumar on 1 November 2019
The main point of difference is that, generally, a Term Sheet is not intended to be legally binding while Shareholders Agreements are legally binding.
You often use a Term Sheet to quickly agree on the key commercial terms and then use that as a basis to draft up a more formal Shareholders Agreement.
Depending on what stage your business is at, you may need a Term Sheet or Shareholders Agreement to help govern the terms on which your business will operate.
What Is A Term Sheet?
You may think that a Term Sheet is simply an informal version of a Shareholders Agreement.
However, a Term Sheet can be used as a pre-contractual document for any sort of commercial relationship.
For startups, a Term Sheet is commonly used to set out some brief terms between co-founders and potential investors during capital raising rounds.
This Term Sheet would cover the major aspects of the deal between the founders and investors to minimise any risk of a future misunderstanding and to set the foundation for agreeing to a legally binding document.
The Term Sheet does not have to be a complicated document and, if it is not intended to be legally binding, it provides an out for both the investors and founders if they no longer wish to pursue the relationship.
If A Term Sheet Is Not Binding, Why Might I Need It?
You may be thinking, “what’s the use of getting a Term Sheet drafted up when I will need a binding agreement in the future?”
The reason many startup founders decide to get a Term Sheet drafted is to show investors that the founders know what they want in the deal and are certain of the terms they want to be included.
This is attractive to an investor as it gives them confidence that the founders have done their research and know exactly what they want for the growth of their company.
Another reason you should have a Term Sheet drafted is to ensure there are no disagreements when it comes time to draft more formal arrangements.
It’s also a great way to get an in-principle agreement on the most important terms, before wasting time and money on legal fees to draft up a formal agreement.
A Term Sheet gives you the opportunity to negotiate and ensure all the terms of the deal are agreed upon before you formalise the deal and issue shares to your investors.
When Do I Need A Shareholders Agreement?
If your investors will get shares in your business, it’s a good idea to get a Shareholders Agreement drafted.
You will need to get a Shareholders Agreement drafted once both you and your investors have completed your due diligence and if you wish to go ahead with the deal.
A Term Sheet helps with this process.
This is because it allows both founders and potential investors to complete any checks and ensure all appropriate information has been included in the Term Sheet before a formal Shareholders Agreement is drafted.
Some key things in a Shareholders Agreement include company valuation, investor rights, payment of dividends and options for shareholders.
Investors will typically take the time to complete a thorough background check of the company to ensure that it is worthy of their investment.
Once all the relevant checks are completed and both the founders and investors are ready to formalise the deal, a Shareholders Agreement should be drafted.
Getting A Shareholders Agreement
The importance in the transition from a Term Sheet to a Shareholders Agreement is that the relationship between the founders and investors is now legally binding and investors will now get shares in your company.
You can think of a Shareholders Agreement as a step in the process from getting a Term Sheet drafted to the end stage of formalising the relationship.
To learn more about Shareholders Agreements, you can have a read of our article here.
Generally, a Shareholders Agreement is more lengthy and extensive than a Term Sheet.
It will include all the provisions that were agreed upon in the Term Sheet, as well as other details outlining:
- Your startup’s business operations
- Directors’ duties
- What happens when a shareholder wants to leave
- How disputes are handled
Shareholders Agreements can be quite complex and lengthy documents depending on what terms you want to set out in the agreement.
It’s best to do your research and ensure that your Term Sheet is well agreed upon before you decide to draft and sign a legally binding Shareholders Agreement.
What To Take Away
Depending on what stage your new business is at, you might be looking to get a Term Sheet or Shareholders Agreement drafted.
Both these documents are important to any company and they need to be drafted properly to ensure there are no misunderstandings between shareholders as your company grows.
If you have any questions about whether you need a Term Sheet or Shareholders Agreement or need some help getting one drafted, feel free to drop us a line at firstname.lastname@example.org. We are more than happy to help you out!