Chasing investment funding can be an exciting but daunting time for a startup founder. If they have delivered a great pitch and attracted the attention of investors, a Term Sheet could be the next step along the capital raising journey. But it is important for founders and investors to understand those terms because they can have a major impact on the future of the business.
What is a Term Sheet?
A term sheet is a document that outlines the key terms of an agreement between an investing party and a company seeking funding. Similar to a letter of intent or memorandum of understanding, a term sheet sets out the understanding and key principles of a deal. Unless stated otherwise in the document, a term sheet is non-binding. The contractual obligations come later once a legally binding formal agreement is accepted and signed by both parties.
Understanding Term Sheets
Even though a term sheet is not legally binding, it is still a very important document because it sets the terms of an investment deal. It is important to note that while the term sheet itself may be non-binding, some of the conditions within it may be legally binding, such as exclusivity and confidentiality (more on these later). Term sheets are generally short, often only one or two pages long and are usually written in relatively plain English rather than in complex legal jargon. But the terms are important and carry significant weight that can affect future funding rounds.
Common Elements of a Term Sheet and What Should be Included
Term sheets vary depending on who prepares them and according to the preferences and objectives of those involved. As a guide, a term sheet should include the following items:
- Valuation: This figure shows the value of what the company is deemed to be worth and will often include the “pre-money” valuation (prior to investment) and / or “post-money” valuation (equal to the pre-money valuation plus the investment funds).
- Identification: Details of the parties involved in the deal.
- Percentage stake: The percentage of the company that the investor will own once the financing is complete.
- Investment amount: The amount being invested by the investor named in the term sheet.
- Aggregate proceeds: The total amount to be raised in the funding round from all investors. For example, a lead investor might take a major portion, say 50% of this figure, but the founder may need to source the remaining investment funds from smaller investors.
- Major investor status: The lead investor and other significant investors may be specifically listed as major investors with special rights such as information rights, pro-rata rights etc.
- Voting rights: This will describe any special rights an investor may have to vote on key decisions affecting the company operation and structure.
- Board of directors: An investment may require the creation of a board of directors if one is not already established, and major investors may specify a requirement for a board seat.
- Liquidation preference: This specifies the rights of an investor in case of a liquidity event. We have written extensively about liquidation preferences earlier.
- Option pool: Specifies the percentage of company shares that are reserved for company employees or key stakeholders.
- Timeframe: This will set the time period for expiry of the term sheet offer, and (if applicable) the exclusivity period nominating how long the company must not seek funding from other parties.
- Other provisions: Any other miscellaneous items such as responsibility for legal fees, information rights, non-disclosure requirements, etc.
What to be Wary of in a Term Sheet
While a term sheet is generally non-binding, it is important to still be cautious of terms that might be included in a term sheet that may not be in the best interests of the company. Such terms could include:
- Participation rights: Holders of preferred stock may be allocated participation rights enabling them to first receive their liquidation preference, and then, in addition, participate in the deal as a common shareholder. This is commonly termed ‘double-dipping’.
- Large controlling stake: A stake in the company may be large enough to give an investor a controlling interest. This becomes especially tricky if the investor is a large corporation.
- Short timeline: A very short expiration date or “exploding deadline” can be used as a pressure tactic by investors to force the hand of a founder and discourage them from seeking funding elsewhere.
- Unfair financing: Funding conditions that place too much pressure on a company’s operation and ability to repay financing.
- “No-shop” clause: This refers to an exclusivity requirement that prevents a company from “shopping around” for other investors. This period should not be too long.
- Limiting terms: These terms may limit the potential for future fundraising.
Example of a Term Sheet
To help build understanding of term sheets, example templates can be downloaded from organizations such as Series Seed or NVCA. Shown below are screenshots of the Series Seed Term Sheet template, with some key terms highlighted followed by some context and explanation.
The image shown above is the first half of the Series Seed Term Sheet template. Highlighted terms are discussed below:
- Non-binding agreement means that apart from the specifically listed “Binding Terms”, the document is not legally binding.
- Aggregate Proceeds means the total amount of funding that must be raised in this round in order for the deal to proceed.
- Purchasers identify the investors.
- Pre-money valuation defines the value of the company prior to this investment.
- Liquidation Preference specifies the rights of the investor to liquidation preferences and the multiple.
- Conversion specifies the investor’s rights to convert preferred stock to common stock.
- Voting rights outlines the rights of the investor to vote on decisions regarding the company structure, company operation, future investment, etc.
The image shown above is the second half of the Series Seed Term Sheet template. Highlighted terms are discussed below:
- Major Purchasers could be the lead investor and other significant investors with special rights.
- Participation Right lays out the pro-rata rights in this instance. It specifies that the investor will have the right to invest in future rounds an amount proportional to their current holding percentage..
- Board of Directors sets out the rights of the investors regarding the election of directors.
- Future Rights specifies the rights and entitlements of current investors in future funding rounds.
- Key Holders are investors named in the share register who hold a large number of shares or hold stock with particular rights or stock options. Usually these are the founders.
- Binding Terms lists terms such as exclusivity and confidentiality that are legally binding, even if the term sheet as a whole is non-binding.
Tips for Evaluating a Term Sheet
When it comes to evaluating term sheets, the priorities and objectives of investors and startup founders are not always in alignment, but it is important for both parties to see the other side and look at the agreement from both perspectives. A term sheet that is unfairly biased towards the benefit of one party could have serious future consequences. Balance in the agreement is important to ensure mutual success. The following tips provide some guidance for evaluating a term sheet:
- Review the valuation carefully and consider whether it is realistic, especially relative to currently prevailing terms in the market for comparable companies.
- Identify any particularly onerous terms that could create problems in the future or where compliance might be difficult.
- Evaluate what the balance of power and control in the business will be once the agreement is signed.
- Understand that a term sheet is not a guaranteed contract and that there are still steps required before the deal is done.
- Seek expert advice from trusted advisers and experienced founders and investors.
- Do some research on the other party (investor or founder) to confirm their history and credentials and ensure you can work with them.
- Ask questions!
Term Sheet FAQs
The following lists some frequently asked questions regarding term sheets:
Why are the terms important if they are non-binding?
While terms in a term sheet may be non-binding, they still represent the conditions of an agreement that both parties have agreed in-principle, like a handshake deal. If the due-diligence progresses well, these are the terms according to which a binding stock purchase agreement will be prepared.
Is a term sheet legally binding?
Unless noted otherwise, a term sheet as a whole is not legally binding. However, some specifically identified terms within a term sheet are legally binding, such as exclusivity periods and confidentiality.
Who prepares the term sheet?
A term sheet may be prepared by either party – the investor or the founder. Usually, if a venture capital firm is investing, the VC offers a term sheet.
What makes for a good term sheet?
A good term sheet should be clear, concise, include all the important terms of the agreement, and be clearly understandable without excessive detail. As with any investment, doing your due diligence is critical, and understanding terms sheets is an important part of that process.