Whether a financing, merger or other acquisition, or other major transaction, parties often outline the major provisions in a non-binding term sheet or letter of intent. A principle benefit of this approach is to help the parties identify major areas of disagreement early to avoid wasted expense on additional diligence and drafting of the definitive agreements.
Yet, basic misunderstandings persist and result in transactions failing after execution of even a thorough term sheet. Perhaps the most frequent misunderstandings relate to the calculation of to-be-issued equity. Over a period of several weeks, a detailed term sheet was negotiated for a stock-for-stock acquisition. After several rounds of back and forth, the parties agreed that the selling stockholders would receive shares representing 25% of the buyer. In the buyer’s mind, this meant that the selling stockholders would receive 250,000 shares, equaling 25% of the 1,000,000 shares of outstanding buyer stock. The seller, however, thought that the selling stockholders would receive 333,333 shares, equaling 25% of the 1,333,333 shares that would be outstanding following issuance of the shares to the selling stockholders. Only after the buyer embedded a capitalization table into the term sheet in the final iteration did the misunderstanding come to light and the parties went their separate ways.
Such misunderstandings are common in venture capital financings where the assumptions regarding the pre-money capitalization are not always obvious and the management team is often inexperienced when it comes to the jargon of venture capital term sheets.
Avoid these misunderstandings by attaching or embedding pre- and post-money capitalization tables in your term sheets. Both parties will benefit from transparency regarding the key economic provisions of the proposed transaction.
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