Private Equity Term Sheet: Typical Terms and Conditions

09 Aug 2018·In Investment Terms

You’re considering an equity investment in a private company with exciting prospects…  Great, but do you really know what your “equity” investment in the company will get you? 

Investment characteristics of one type of private equity investment can be very, very different from another.  This guide can help you understand better what’s being offered to you. 

There are 5 basic questions you must quickly address from the onset 

Question #1 – Is this equity publicly registered or private?  Just to make sure … the following is about a private investment that is not registered with the Securities Exchange Commission and, therefore, does not enjoy some of the investor protections inherent in public registration. 

Question #2 – Is preferred equity or common equity being offered?  Preferred equity can have all sorts of investor benefits relative to common equity, in particular, liquidation preference if the company’s business fails and ends up having to sell its assets. 

Question #3 – Voting rights … majority or minority?  Most equity carries voting rights for important decisions the Issuer must make (like selling the business), but not all.  If you get voting rights and are in the minority (as most venture investment is), you should be looking for special terms which protect you as a minority investor (see below). 

Question #4 – Is Company management motivated to run the business for the benefit of equity investors?  All sorts of decisions will be made in running the business after you invest, and you likely won’t be able to influence very many of them.  Do key managers win big when you win as an equity investor? 

Question #5 – Is this a Limited Liability Company (an “LLC”), a C Corporation or an S Corporation, and in what state is it registered?  We’re getting into the legal weeds, but it has an impact on a number of factors: the special protections you should be looking for (S corporations have virtually none); whether you are getting shares, membership interests, units, etc. as the security for your investment; how the investment affects your taxes (LLCs and S Corps are “pass-throughs”); and which state’s laws govern the investment (Delaware is the most commonly used state for incorporation). 

A Summary of Terms (often called a Term Sheet) like the one described below, should be created and agreed to before you make an equity investment in a private business.  This document is the simplest way for the investor and issuer to understand the deal they are making, and the Term Sheet will be the basis upon which the other closing documents are drafted.  We strongly encourage you to retain legal counsel specializing in private finance when negotiating a Term Sheet and reviewing Closing Documents.  

Since a common equity investment usually has no special rights relative to other, previously issued, common equity, the following will emphasize terms associated with preferred equity, indicated by a (P), which is usually only available to preferred equity investors. 

SUMMARY OF TERMS

Borrower Name 

Amount ($) offered to Investors 

Basic equity terms – Common or Series of Preferred, preferred dividend (if any) 

Offering Terms:

Issuer:This states the legal name and location of the Issuer, which all closing documents should reference exactly. It may also describe the Company’s primary activity and summarizes the demand for the product / service.
Securities Offered:A description of the type of securities being offered, e.g., Common or Preferred Membership Interests (if an LLC), type of Preferred (e.g., Convertible, redeemable or participating) and for older companies which Series is now being offered (typically lettered as A, B, C, etc.). Different Series of preferred can have different terms relative to each other which must be considered before making an investment.

If a Preferred Offering, it will describe what the Investors should expect in the way of a Preferred Return through a Distribution Waterfall describing the manner that Issuer distributions to equity investors are treated (e.g., first to Preferred then to Common). Furthermore, it will define controlling Issuer documents, such as an Operating Agreement for an LLC or the Articles of Incorporation for a C Corp. You should read and reconcile the Summary of Terms to the language contained within these documents.
Offering Amount:How much is being offered for investment within this Series or Class of equity.
Pre-Money Valuation:The equity value of the business that is claimed by the Issuer before additional capital is raised through the Offering. This value is the basis for determining the share price assigned to the new equity, which is calculated by dividing the Pre-Money Valuation by the sum of all outstanding equity, options to purchase equity and equity resulting from outstanding convertible securities (also known as the fully diluted capitalization). The sum of the Pre-money Valuation and the amount of capital raised through the Offering is the Post-money Valuation.
Preferred Return on Investment (P):Specifies a minimum return on the preferred equity, e.g., a 6% Cumulative Annual Return on invested capital. This would also define when the Distributions would be made (quarterly, typically) and how they are authorized by the Board of Directors.
Preferred Return of Capital (P):Specifies the manner in which the funds originally invested by the preferred equity investor are treated in distributions (Dividends), relative to other preferred investors and to common equity investor’s.
Automatic Redemption & Automatic Conversion (P):Identifies circumstances in which time holder of preferred equity is compelled, at the election of the investor, to either present the investment for redemption or to convert to common equity.
Redemption Rights (P):Preferred equity for venture stage investment usually entitles the investor to a redemption right (a form of put) five years from the date of investment at a valuation that, at a minimum, is the amount of funds originally invested plus any accrued preferred dividends. If the company has not grown to the point it either has amassed sufficient cash resources or it cannot borrow the necessary funds, this redemption can be deferred by the Issuer until it has the necessary financial resources to pay the amounts needed.
Use of Proceeds:This outlines how the proceeds of the capital raise will be used by the Issuer. Use of funds usually will include paying fees and expenses associated with the Offering.
Investor Qualification:Defines which Investors are eligible to participate in the Offering, such as a requirement that they meet the “Accredited Investor” definition within SEC Regulation D, Rule 501. (CFG’s investments are sold only to Accredited Investors).
Minimum “Subscription Amount”Defines the minimum investment amount each Investor must commit to participate in the Offering.
Escrow:If there is a minimum total issuance amount specified by the Issuer for the Offering (a Min/Max Offering), an Escrow account must be established at a bank providing escrow services for investors as fiduciary. This bank will be the Escrow Agent for the Offering. Until the minimum amount has been raised, Investors’ funds will be held in safekeeping by the Escrow Agent before being released to the Issuer. If the minimum has not been raised by the termination of the Offering, funds are returned to Investors.
Board of Directors:This clause defines the size of the Board of Directors (or Managers) and how they are to be selected. It is common for preferred investors to have a designated number of seats on the Board who only they elect as their representatives. Board Committees are also defined (e.g., an Audit Committee or a Compensation Committee) and whether the Investors will be represented on each committee, generally with special voting rights on the Committees.
Voting Rights (P) Specifies the voting rights of the equity being offered. Voting is typically pro-rata to share ownership with Preferred Investors voting with common on an As If Converted basis as well as within the preferred equity class when its approval is designated for certain major strategic events affecting the Issuer, such as a sale of the business to a third party or initial public Offering.
Registration Rights & Lock-up Restrictions (P):Provides that the equity held by preferred equity investors will receive registration with newly issued public shares at the time of an initial public Offering. Though the shares are thereafter registered, there will usually be a 6 month or longer lock-up assigned to the shares that restricts public trading of these shares during this period to avoid downward pricing pressure on the freely trading public shares.
Information Rights:A private equity Investor should have ongoing access to financial and other information about the Company’s performance, usually on a quarterly and annual basis.
Preemptive Rights (P):Provides new investors with a “first right of refusal” to invest in a subsequent equity financing in an amount relative to their ownership in the Issuer.
Co-Sale/Tag-Along Rights (P):Protects minority shareholders. This right enables Preferred Investors to sell their shares alongside certain other selling Shareholders (usually 5% or greater holders of the Issuer’s outstanding shares) in a potential private transaction to a third party, on the same terms, and in proportion to their relative ownership in the Issuer to the seller.
Drag-Along Rights:Protects the Shareholders holding a majority of the Issuer’s equity. This enables the Issuer to pursue certain strategic transactions, such as a sale of the Company, if approved by a majority (or possibly super-majority) of all shareholders. Minority shareholders are forced to join the transaction on the same price and terms as other selling shareholders. The percent necessary to “trigger” Drag-Along Rights often is as high as 75% approval for the transaction in question.
Anti-Dilution Protection (P):This clause protects the Investor from equity “Dilution” if a subsequent issue of equity is at a lower price than what is being paid in the current Offering. All such protection effectively awards more equity to protected investors, though “Weighted Average Dilution Protection” only provides a proportionate level of protection while “Full Ratchet Dilution Protection” lowers the Investor’s share price to that established for the subsequent, lower-priced round of equity financing.
Fees and Expenses:Fees can include a Success Fee to a Placement Agent, legal fees and other miscellaneous closing costs. A Placement Agent may also receive shares or warrants to purchase equity interests in the Company.
Offering Period:The Company should designate a date for the Offering to be completed, often with a 60-day extension option by the Issuer.

The Summary of Terms specifies the rights and other terms of an equity security being issued.  It summarizes what a potential Investor should expect from the investment.  Once an Investor has indicated interest in the Offering, and Closing Documents have been crafted, these are forwarded to the investor for subscription in the Offering. 

For information about terms that usually apply to debt investments, please see Debt Private Placement Term Sheet: Typical Investment Terms and Conditions.”