Your investor has sent the term sheet back signed, with a counter-offer on the valuation. Your co-founder wants to know whether you should now pay for the full shareholder agreement, and your accountant is asking what the document actually commits you to. This is the point where founders routinely pay for the wrong document, or the right document at the wrong time, and the mistake usually comes down to not understanding what each document is for.
The decision is not really term sheet versus shareholder agreement, because for most priced capital raises you will use both, in that order. A term sheet is a short, generally non-binding document that records the key commercial terms of the proposed investment. A shareholder agreement is a binding contract that governs the ongoing relationship between the shareholders and the company once the investment happens. There is also a third set of rules already in the picture that founders tend to forget: under s 134 of the Corporations Act 2001 (Cth), a company's internal management is governed by statutory replaceable rules, a constitution, or a combination of both, and your shareholder agreement will have to sit alongside whatever default regime already applies to your company.
What to weigh up before you commit to a document
Five factors separate founders who spend their legal budget well from founders who do not. They are the stage of the deal, the purpose of each document, how binding each one is, what each one has to cover, and who ends up bound by what the law already provides.
Where you are in the deal
A term sheet belongs at the front of a deal, when the parties have agreed in principle on price and structure but nothing has been verified or documented. It lets both sides test whether a deal is realistic before spending money on lawyers and due diligence. If the parties discover at that point that they are not aligned on the valuation or the structure, the cost of finding out is a few pages of paper rather than a full drafting exercise.
A shareholder agreement belongs at the back of the deal, once the commercial terms are settled, the due diligence is complete and the shares are about to be issued. Drafting one before the commercial terms are agreed is usually wasted work: if the deal falls over, so does the document, and the legal fees are gone. The usual sequence for a priced round is term sheet first, then due diligence, then the binding documents, which normally means a subscription agreement for the share issue and a shareholder agreement for the ongoing relationship, and often a new or amended constitution at the same time.
There is one situation where a shareholder agreement is needed with no external investor at all. Co-founders taking shares in their own company can use one to govern their relationship from day one, covering vesting, share transfers and what happens if one of them leaves. In that scenario you can skip the term sheet entirely and go straight to the binding document, because there is no external deal to align on. Similarly, some very early rounds are structured as convertible notes, which delay the valuation question; in that case the shareholder agreement usually arrives later, when the notes convert into shares and the investors become shareholders.
What each document is for
A term sheet is a negotiating tool. It sets out the material commercial terms of the investment so both parties can see, on one or two pages, whether they are aligned: the valuation, the amount being invested, the class of shares being issued, the board seats being offered and the key conditions on the deal. It is a summary of the deal the parties intend to make, not the deal itself, and it is deliberately short so that disagreements surface early and cheaply.
A shareholder agreement is the operating contract for the shareholder relationship. It sets out the rights and obligations of the shareholders and, where the company is signed as a party, the obligations of the company towards them. Where the term sheet records what the parties intend to agree, the shareholder agreement is what the parties actually agree to be bound by. It is normally a much longer document, because it has to work as a set of rules for a relationship that will run for years, through new share issues, exits and disputes. If you are unsure whether you need one, the test is simple: once someone other than the founders owns shares, there are relationships to govern, and the shareholder agreement is the document that governs them.
How binding each document really is
The usual position is that a term sheet is not legally binding. That does not mean nothing in it binds. It is common for term sheets to carve out specific clauses that are binding from signing: a confidentiality clause, an exclusivity or no-shop clause that stops the founders negotiating with other investors for a period, and sometimes a costs or break-fee provision. Those carve-outs need to be expressed clearly, with wording such as subject to contract or non-binding except as stated. If the document is silent, the whole thing will generally be treated as a statement of intentions rather than a contract, and parties should not assume that a signed term sheet commits anyone to invest.
A shareholder agreement is a contract, and it binds the parties to it in the usual way. Breach of its terms can be enforced, and the usual contractual remedies apply. The same is true, separately, of the company's constitution and replaceable rules, because s 140 of the Corporations Act 2001 (Cth) gives them effect as a contract between the company and its members, and between the members themselves. When founders negotiate the term sheet, the question to keep asking is which of its clauses will survive into the binding documents, because it is those clauses, not the term sheet itself, that the other side will be able to enforce.
In short form, the two options line up like this:
- Option A: term sheet: Generally non-binding apart from expressly identified carve-outs such as confidentiality, exclusivity and break fees. Short, quick and inexpensive to prepare, and useful for testing alignment before money is spent.
- Option B: shareholder agreement: A binding contract between the shareholders and usually the company, enforceable on breach. Longer, more expensive and normally drafted after the commercial terms are agreed.
What each document has to cover
A term sheet should cover the commercial terms that would be costly to change later. It is not the place for every detail of the deal, but it should capture the terms that drive the economics and the control of the company:
- Valuation: the pre-money valuation and the price per share
- Investment: the amount being invested and the class of shares to be issued
- Rights: the special rights attached to the new shares, such as board representation, information rights and anti-dilution protection
- Conditions: the key conditions of the deal, including due diligence and any required investor or board approvals
- Exclusivity: the period during which the founders will not negotiate with other investors
- Confidentiality: the protection of the company's information during the process
A shareholder agreement covers the rules of the relationship after the investment, and it is where the details that never fit on a term sheet actually live:
- Share transfers: pre-emption rights over existing shares and the process for approving transfers to new holders
- Exit rights: drag-along and tag-along rights that govern how shares can be sold together on an exit
- Governance: director appointment rights, board composition and how deadlocks are resolved
- Dividends: how and when profits are distributed to shareholders
- Funding: what happens if the company needs more capital and existing shareholders do not participate
- Disputes: the agreed dispute resolution process, often mediation followed by arbitration or litigation
Who is bound, and what the law already provides
A term sheet binds only the parties that sign it, and only as to its binding carve-outs. A shareholder agreement binds the shareholders who are parties to it, and the company if it is joined as a party, which it usually is. One point founders often miss is that a shareholder agreement only binds the people who signed it, so when new investors join later they are usually asked to sign an accession or adherence deed to bring themselves into the agreement, otherwise the original shareholders could find themselves bound to a group that has changed around them.
The less obvious point is that your company already has a governance regime whether or not you sign anything. Under s 134 of the Corporations Act 2001 (Cth), a company's internal management may be governed by the Act's replaceable rules, by a constitution, or by a combination of both. Replaceable rules apply automatically to companies registered after 1 July 1998, unless the constitution displaces them under s 135. One example is s 254D, which requires the directors of a proprietary company to offer new shares to existing shareholders first. That pre-emption default may be exactly what your founders want, or it may get in the way of the deal you have agreed with an investor, and it only changes if the constitution or the shareholder agreement deals with it.
The practical point is that a shareholder agreement is not drafted on a blank page. It has to work alongside the replaceable rules and any constitution, and it is common for the agreement to be designed to prevail over inconsistent default rules. This is one of the areas where a generic template can quietly leave you with a rule you did not intend, which is why the interaction between the three layers is worth checking with a lawyer rather than assuming the template covers it.
How an Artificer Legal practitioner helps you make the call
Founders tend to involve lawyers at one of two points: when the term sheet arrives, or when the shareholder agreement is ready to sign. The first is cheaper and usually the better choice, because it is far easier to change a term in a two-page document than to unpick it once it is drafted into a binding agreement.
At the term sheet stage, an Artificer Legal practitioner can mark up the document so the binding carve-outs are clear, check the commercial terms against what the company actually needs, and flag the terms that will be expensive to unwind later, such as board control, vesting and anti-dilution. We can also stress-test the assumptions behind the deal, including whether the investor's standard terms are actually standard, and model what each clause means for the founders' control of the company, so you are negotiating with a clear picture of the downside as well as the upside.
At the shareholder agreement stage, we draft the agreement so it is aligned with the company's constitution and the replaceable rules, make sure the company is properly joined as a party, and check the interaction between the agreement, the subscription documents and the share issue itself. If investors join later, we prepare the accession documents that keep the agreement binding on the whole group. The aim is that by the time the money lands, the documents reflect the deal you actually agreed, not the deal the templates assumed.
The term sheet is a map, not the commitment
The mistake that costs founders most is treating the term sheet as though it were the investment. Because the document is generally non-binding, the investor is not committed to invest until the binding documents are signed, and founders who stop fundraising, hire staff or pay for a full shareholder agreement on the strength of a term sheet can find themselves exposed if the deal collapses. The term sheet's real value is different: it forces the parties to agree the commercial terms before money is spent on lawyers and due diligence, so the binding documents are drafted once, against terms everyone has already accepted.
To recap: a term sheet is a short, generally non-binding document that records the material commercial terms of a proposed investment and precedes the binding documents; a shareholder agreement is a binding contract that governs the ongoing relationship between shareholders and the company; and both sit alongside the default governance regime the Corporations Act already provides, including the replaceable rules and any constitution. Most priced capital raises use both documents in sequence, with a lawyer involved at the term sheet stage to protect the commercial terms before the binding agreement is drafted.