Term Sheets and Operating Agreements

These highlights are from the “Term Sheets and Operating Agreements” Startup Fundamentals webinar presented on May 8, 2024 by Alexa Steinberg, corporate attorney at Greenberg Glusker LLP. The on-demand version is available on the WFN website here. The webinar is designed for entrepreneurs and startup founders aiming to demystify the complexities of term sheets, letters of intent (LOIs) and operating agreements. Whether you're in the midst of fundraising, negotiating partnerships, or laying the groundwork for your company's future, understanding these critical documents is essential.

What is a Term Sheet?

A Term Sheet is a preliminary agreement that will be replaced by a final form agreement. It serves as a bridge between initial negotiations and a formal, legally binding agreement. The term sheet provides a brief, yet comprehensive overview of the fundamental aspects of the proposed transaction; a summary of points.

Term Sheets Create MOMENTUM

A Term Sheet presents an opportunity:

• Kick start to negotiations

• Lets the other side know you are serious without having to throw good money after what potentially could be bad

• Allows parties to get on the same page and highlights any potential undefined issues or undiscussed terms

• Enables parties to resolve problems before becoming emotionally and financially entrenched in a position

What Terms to Include

• Overview of the deal – What is this agreement about? Who are the parties? What responsibilities are being created for each party?

• Legal transaction structure – What is the definitive agreement? What does the process look like?

• Term – How long is this agreement going to last?

• Payment Terms – Who is paying whom? How much? When? Is there an escrow?

• Exclusivity – The prohibition on negotiating with others. When does that expire?

• Confidentiality – incorporation of an existing NDA

• Conditions to close – such as a financing contingency

• Deadlines and Other Terms – Any additional obligations each of the parties may have (no-hire, non-compete, etc.). When does the definitive agreement need to be signed?

Non-Binding Nature

In general, Term Sheets are Non-Binding. The purpose of a Term Sheet is to come to an agreement on major terms and to allow the parties to begin the negotiations and due diligence period (if the deals calls for such). However, typically provisions of exclusivity, confidentiality, and no-hire are binding.

Problems & Solutions

Problem: A contracting party can use almost any excuse for renegotiating the terms of a transaction after the Terms Sheet has been signed.

Solution: Define as many terms as possible when you have the maximum amount of leverage.

Problem: The longer the exclusivity period, the lower your negotiating leverage. Most exclusivity periods range from one to three months.

Solution: Keep exclusivity periods as short as possible. Include milestones to continue to be granted exclusivity.

Operating Agreements

An Operating Agreement defines the business's financial and functional decisions and the roles, responsibilities, and liabilities. It establishes how decisions are made, how profits are shared, and how members will be paid.

WHY should you have one?

• Members have agreed upon rules and procedures they can refer to in the event of a conflict

• Prevent being at the mercy of state statutes, which can be vague, confusing, subject to change and may not match the members’ intentions.

How is your LLC managed?

Member Managed vs. Manager Managed

• Member managed means all members have a voice but there are possible stumbling blocks when dealing with silent members who are not actively involved in the business and really don’t understand the nature of the business.

• Manager managed centralizes decision-making authority but may cause conflict with members who disagree with decisions.

What is in an Operating Agreement?

It includes the LLC name and address, agent for service of process, name and address of each member of the LLC, amount of capital contribution of each member, classes of units and the rights of each class, and how members can transfer equity.

Tax Treatment

You will need to choose a tax treatment: sole proprietor, partnership, C Corporation, or S Corporation.

Distribution of Profits and Authority

How to distribute profits to members

• Create a waterfall

• Allows freedom as to when and how to make distributions based on your opinion as manager

If you are manager of an LLC, define scope of authority

• What can a manager do without requiring member consent?

• Founding member/manager should have broadest scope of authority

What items require member approval?

• What percentage?

• When is unanimity required?

Permitted and Not Permitted Transfers

Transfers of ownership (membership interests):

• Permitted Transfers

  • Transfers to your living trust or to your company

  • Such permitted transfers require no approvals

• Not Permitted Transfers

  • Sale of membership interest to third party

• Requires approvals

• Other members have first right to purchase interests of the transferring member before being sold to third party (Right of First Refusal)

• Price determined by other members or appraisals

• Do you want third party to have any right to vote as a member?  What rights does a transferring member have?

• New members get only profit distribution rights

• No additional rights without member approval

Disclaimer

NOTE: These materials are for informational purposes only and not for the purpose of providing legal advice. You should contact your attorney to obtain advice with respect to any particular issue or problem. Use of and access to these materials does not create an attorney-client relationship between Greenberg Glusker and you. Any opinions expressed in these materials or any presentation regarding these materials, are the opinions of the individual author and may not reflect the opinions of the firm or any other individual attorney. The information contained in these materials is time-sensitive. Content may be correct when published and later become obsolete or incorrect. Greenberg Glusker expressly disclaims all implied warranties. © 2024 Greenberg Glusker.

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