What’s the Difference Between Term Sheets and a Shareholder Agreement?

What’s the Difference Between Term Sheets and a Shareholder Agreement?

Startup and small businesses may be unsure of the differences between a Term Sheet and Shareholder Agreements.

The key differentiation is that Term Sheets are not usually legally binding, while Shareholder Agreements tend to be legally binding.

Term Sheets will assist in the earlier stages of a deal, to agree on material commercial terms. Term Sheets will subsequently be used as a foundation for a legally binding Shareholders Agreement draft. 

Based on the stage your business is at, a Term Sheet or a Shareholders Agreement will help govern the key terms on which operations of your business will be conducted. 

What is a Term Sheet?

A Term Sheet is a non-binding document which outlines material terms and conditions of an investment. It establishes a template for more detailed legally binding documents. 

Term Sheets are particularly useful for startups, to lay out and agree upon foundational terms between co-founders and potential investors during capital raising stages. They reduce the likelihood of future disagreement between co-founders and potential investors. 

Usually, a Term Sheet is not a legally binding document and is less complex than other legally binding agreements.

A Term Sheet focuses on the more significant aspects of a deal, without including each minor detail covered in a contract. The more intricate details are included in the longer, legally binding agreements. 

Why Use a Term Sheet If They Are Not Binding?

As a business, you may be asking whether a Term Sheet should really be used since it is a non-binding document and a binding agreement will be needed in the future.  

Regardless of their non-binding status, Term Sheets are nonetheless an important tool to show potential investors what they want to be included in the deal and that they are certain of those terms being included. 

The use of a Term Sheet is also a good sign for investors as it is an indication that the co-founders have conducted their research and are aware of what they need for the growth of the company.

A Term Sheet is beneficial as it enables an agreement to be reached on the important terms of the agreement. This prevents potential time wastage and the incurrence of legal costs, where a formal document is drafted, but no agreement is reached. 

When a Shareholders Agreement Is Needed? 

A shareholders agreement is a contract that governs the business arrangements and relationship between shareholders and a company’s directors. It should detail the various rights, responsibilities and obligations of the shareholders, while also protecting their interests in relation to their particular circumstances. 

A Shareholders Agreement is particularly useful where potential investors are receiving shares in your business. A draft of the agreement should be created upon completion of due diligence by both parties.

A Term Sheet assists with this process as it includes the material terms of the deal. This allows founders and potential investors to undertake checks and ensure all relevant aspects have been included in the Term Sheet, prior to the drafting of a formal Shareholders Agreement. 

Key components of a Shareholders Agreement include:

  • Company valuation 
  • Dividend payments
  • Investor rights 
  • Dispute resolution

It is common for investors to complete an in depth background check of the company, to ensure it is worth their while investing. Following this process, a Shareholders Agreement should be drafted if both parties are ready to make the deal formal. 

Reaching a Shareholders Agreement

Reaching a Shareholders Agreement from the Term Sheet phase is important as it ensures the shareholder-founder relationship is now legally binding and investors will now receive shares in the company. 

Due to its more formal and legally binding nature, a Shareholders agreement is longer and more thorough than a Term Sheet. Further provisions outlined in the Shareholders Agreement may include director duties, business operations and the issuance of new shares. 

Depending on the contents of the agreement, Shareholder Agreements can be complex and lengthy. Ensuring the Term Sheet is unanimously agreed upon prior to drafting and commencing a Shareholders Agreement is recommended, as the agreement is legally binding. 

Key Takeaways 

Term Sheets and Shareholder Agreements are hugely beneficial when a business is attempting to raise capital through new investors. 

Both documents must be accurately drafted and agreed upon by both parties to ensure disagreements between your business and future shareholders are limited. 

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