Why Use the Impact Term Sheet?
The growing consensus that positive impact aligns with good business
There is increasing acknowledgement that success in business shouldn’t be measured in purely financial terms. Over the last 20 years or so, we’ve seen increasing acknowledgment that a company’s long-term success must take into account externalities in terms of risks to stakeholders – including the environment and nature. This is reflected not only in academic literature but also statutes (for example, s. 172 of the UK Companies Act 2006) and regulations, particularly at the European level.
Some economists (Alex Edmans, author of Grow the Pie, for example) have even argued that pursuing positive impacts for relevant stakeholders may also help to increase a company’s own revenues, and create greater long-term value for shareholders.
New technologies and projects aim to address some of the most pressing environmental and social issues of our time, while also mitigating risks for businesses. These include physical climate and transition risks. All of these new ventures require funding in order to scale.
Why “traditional” structures are not enough
When multiple funders with multiple targets, and without a stake in a venture’s mission, gain control and impose “traditional” governance structures, there’s a risk that mission will become lost or diluted. Traditional governance structures were developed solely to protect financial returns. And they can mean that a venture is unable to live up to its impact potential.
When the Legal Innovation for Sustainable Investments (LISI) Foundation surveyed more than 100 industry professionals between 2021 and 2022, there was an overwhelming consensus that an impact term sheet was needed to:
- ensure agreement on mission and foster trust between the parties
- embed impact – including through positive incentives – with a focus on long-term outcomes
- be more practical and less legal
LISI, therefore, set out to create an impact term sheet that would:
- break through the most common roadblocks to impact identified by the survey: poor governance (53%), opportunism on the side of a specific party (44%), and lack of incentives tied to impact goals (44%)
- incorporate clauses considered key for anchoring impact in a term sheet: shared purpose and statement of intent (83%), remuneration linked to sustainability targets (58%), and legal structure changes, due diligence to determine baseline performance, and internal governance (all 56%)
What needs to change
When parties enter into a legal contract, they’re entering into a relationship. Sometimes it’s a short relationship – like when you buy food from the supermarket. Other times it’s a longer relationship – like a marriage. Of course, there are many variations in between. Any relationship comes with certain expectations about how each party will behave. These expectations are based on general knowledge, spoken agreements and individual preconceptions. Successful relationships are often successful because they are based on mutual trust and understanding – that’s why many faith groups hold sessions with couples before marriage to help them explore their expectations of each other and the relationship as a whole. This helps make sure things get off to a good start.
Most investors are not looking to enter into an indefinite “marriage” with the companies they enter into contractual agreements with. Nor are they likely to want to be a silent and subservient partner. But investors don’t always fully interrogate their reasons for investing – over and above profit. Nor do they question possible limits on investment – in terms of time or target returns, for example.
They must also properly communicate these objectives to their business partners at the start of the relationship. Failing to do so can lead to relationship difficulties later on, especially in the “sickness” era of a marriage – where both parties need to pull together to get a company back to health, but are not necessarily encouraged to do so by the contract terms.
Similarly, many companies have had to fight so hard to attract sufficient funding that they are drawn into an unbalanced deal, or one they don’t fully understand. Companies sometimes avoid asking difficult or uncomfortable questions of investors at the outset, in order not to sour the deal. Companies may also agree to expend disproportionate amounts of time and money on due diligence disclosures and measurements that satisfy an investor’s checklist, but do not add any value to the company itself (even though the company is the party footing the bill).
While looking after their own interests, investors and companies can sometimes forget about the needs of others affected by their new relationship: the “children” and other friends and relatives that surround the marriage. These stakeholders don’t always have a direct say in how the investor and the company will act, but still have a vested interest in their decision-making. They may either support the “Shared Vision” of the parties or work against it, depending on how they are consulted and incentivised along the way.
How does the Impact Term Sheet address these issues?
The Impact Term Sheet is longer and more detailed than a traditional term sheet. It acts as a guide during the initial relationship stages and encourages the parties to:
- initiate important conversations – both internally and with the other party – right at the start
- agree about the point the parties are trying to reach together (the “Shared Vision”), and then plan the contractual terms around that – rather than starting from “usual” or “boilerplate” clauses, and trying to shoehorn unique aspects of this deal into an existing template
- agree on how the parties are going to interact through a set of Guiding Principles: a set of golden rules to guide future decision-making (relating to both contractual documentation and during the wider relationship) and to make sure parties continue to foster balance and trust
- think about external stakeholders from the start, and integrate them into decision-making where appropriate
- integrate measures of success throughout the fabric of the company, so that the directors, employees and investors are all incentivised in the same direction
How is the Impact Term Sheet designed to be used?
The Impact Term Sheet serves as a template document, which parties can work through to ensure the necessary elements for securing impact. The Term Sheet also helps to memorialise initial agreements, which can then be incorporated into Transaction Documents by lawyers. It contains recommended wording to inspire parties and make the task less daunting for those intent on fully incorporating impact, or obtaining impact finance for the first time.
The Impact Term Sheet fits together as a whole – reflecting the need for a Shared Vision woven into all terms of a deal. Acknowledging that concepts like the imperative to empower stakeholders require significant levels of transparency to work in practice.
However, with the help of legal advisors, parties may opt to draw from specific elements of the Impact Term Sheet and its recommended structures or to tailor specific elements depending on legal requirements that differ across jurisdictions.
The Impact Term Sheet should serve to start conversations and foster agreements on a balanced deal, giving rise to a healthy and productive relationship. It’s up to the parties to make this a reality, of course, by building on the Impact Term Sheet’s solid foundation.