This post explains what an investor should expect to see in a terms sheet for buying shares in a private company in Australia.
What is a terms sheet?
A terms sheet is a short form agreement that sets out the key terms of a proposed transaction. A terms sheet is usually signed once an investor is in a position to make an indicative offer, before the commencement of due diligence.
A terms sheet is sometimes referred to as heads of agreement, a non-binding indicative offer (or 'NBIO') or 'memorandum of understanding'.
Is a terms sheet binding?
This will depend on the wording of the document. Usqually, most (but not all) of a terms sheet will be non-binding. Specifically:
- any terms that relate to the process of the negotiations will normally be binding. These include provisions about confidentiality, exclusivity and any agreement between the parties to continue negotiating in good faith;
- any terms that relate to the substantive terms of the proposed transaction will be non-binding. An agreement about the price is an example.
The purpose of a terms sheet is not to bind the parties to a particular transaction. It is merely to provide each party with confidence that a deal is capable of being done on terms that they are comfortable with, subject to the completion of due diligence and the conclusion of final negotiations.
A binding term is a term that gives rise to enforceable rights and obligations. That is, if one party breaches a binding obligation, this may give rise to a legal remedy that may be enforced through the courts.
What binding terms should be included in a terms sheet?
If you are an investor, you can expect to see the following binding provisions in a terms sheet:
- Confidentiality. The parties would usually agree to keep the terms of the proposed transaction confidential. (It is also normal for confidentiality to be covered in a non disclosure agreement that is signed before any sensitive information is released to the investor.)
- Due diligence. Where the investor intends to conduct due diligence, there will normally be a binding obligation on the company or vendor to provide access to information and to respond to the investor's inquiries in good faith. A terms sheet will normally expressly state that any final agreement between the parties remains subject to the outcomes of the investor's due diligence investigations.
- Exclusivity. If you are seeking to negotiate with the company (or vendor) on an exclusive basis, this should be addressed. This is more common where the investor is buying the entire company or a substantial stake in it. An exclusive arrangement will give you comfort that you can continue spending time, effort and money on the transaction in the knowledge that you should not be gazumped by another bidder at the last minute.
- Good faith negotiations. A terms sheet will often contain a provision requiring the parties to negotiate in good faith. This does not mean that the parties are committed to reaching an agreement. It simply means that the parties will continue to work honestly and ethically, albeit on arm's length terms, with the shared aim of hopefully signing binding transaction documents.
- Costs. Most of the time, the parties will agree to bear their own costs in connection with the transaction. In some cases an investor (such as a private equity firm) may seek to have some or all of their costs reimbursed by the company.
- Effect of the document. The parties' agreement that some parts of the document will be binding, and that others will not, is normally expressed to be a binding part of the agreement.
- Governing law. Because some parts of a terms sheet will be binding, it is normal for a terms sheet to identify the law that will apply to the terms sheet (eg NSW law or Victorian law). There will also usually be a statement by the parties that they submit to the jurisdiction of specific courts (eg NSW or Victoria). This is to ensure that if a dispute does emerge - for example, in relation to the unauthorised use or disclosure of confidential information - the parties know where that dispute will be heard, and which law will apply.
What non-binding terms should be included in a terms sheet?
This will depend on the transaction concerned, and it can vary significantly between transactions. In broad terms, a terms sheet will normally identify:
- Nature of the transaction. The terms sheet will describe how the transaction is intended to be structured (ie by way of share sale or share issue, as opposed to a convertible note or some other arrangement). The terms sheet will usually identify the number (or percentage) of shares to be sold or issued. Where shares are to be issued, the terms sheet will often include a pre-investment cap table and a post-investment cap table, so that there is no confusion around valuation issues (whether the valuation is 'pre-money' or 'post-money') or what, precisely, the investor can expect to receive for their investment.
- Time for completion. The terms sheet will often express a shared desire to complete the transaction by a particular date.
- Purchase price or level of investment. Often the purchase price will be expressed as a specific figure. Sometimes the terms sheet might indicate a range of figures, or alternatively explain how the price is intended to be calculated (for example, by reference to an agreed valuation or valuation methodology).
- Anti-dilution protections. Where shares are being issued, and where it is likely that the company will be seeking to raise further capital in the future, it is not uncommon for the investor to seek specific protections against dilution, and for this to be reflected in the terms sheet.
- Conditions. Conditions refer to things that must be done before the investor is required to complete the investment. One example is the execution of final transaction documents, such as a share sale agreement or share subscription agreement. Where the investment relates to the purchase of an entire company, there will normally be a condition that all existing security interests be discharged by completion, so that the company is sold on a 'debt free' basis. Where the investor will be joining other shareholders in the company, there will usually be a requirement that the investor signs a shareholders agreement (and if the investor will become a significant shareholder, the investor may require changes to the shareholders agreement as a related condition. Learn more about key protections for investors in shareholders agreements here). There is essentially no limit on the types of conditions that can be included in a terms sheet. If there is something important to the investor that needs to be done before it will be willing to complete the transaction, this would normally be incorporated into the document.
- Common 'standard' terms. It is normal for an investor to expect the transaction documents to contain a variety of warranties in their favour. This expectation is normally reflected in the terms sheet. (You can learn about warranties in a share purchase agreement here.) There may be other 'standard' terms that relate to particular types of transactions, and these would also be mentioned.
- Other significant commercial terms. Related to the point above, there may be other commercial terms that are important to the investor.
How detailed should a terms sheet be?
There are two schools of thought on this question.
On the one hand, a detailed terms sheet will ensure there is alignment between the parties at an early stage of the transaction, therefore reducing the scope for disagreements at a later stage in the process. The parties will need to negotiate the detail of the transaction at some point, so in one sense there may be no harm in starting early.
On the other hand, the negotiation of a more detailed terms sheet will involve more time and expense, potentially for no benefit given that (1) the commercial terms will remain non-binding and (2) the transaction will remain subject to the outcomes of due diligence. Because there will usually be a significant imbalance in the amount of information available to the parties (as a result of the investor not having conducted any detailed due diligence), there may be little utility in the parties becoming tied up in detail at an early stage in the process.
Normally it is not difficult for the parties to find an agreeable balance. The outcome is usually that both parties are able to express, at least in general terms, the items that are most important to them, and agree to defer some of the detailed negotiation until later.
Who prepares the terms sheet?
This will vary depending on the nature of the transaction. For example, where the transaction involves:
- a fundraising round involving multiple investors, the terms sheet would normally be prepared by the company;
- a large investment by a single investor, the terms sheet (or 'non-binding indicative offer') would typically be prepared by the investor; and
- the purchase or sale of an entire company, although the terms sheet could be prepared by either party, it is not uncommon for the investor/buyer to propose the first draft.