No single document plays a bigger role in shaping your startup’s funding future than the term sheet. This essential blueprint from venture capitalists sets the tone for key details: your startup’s valuation, who gets a say in big decisions, and who walks away with the biggest check when your company is acquired or goes public.
Think of a term sheet as a letter of intent that, once signed, opens up negotiations between a startup’s founders and an investor. The term sheet is not the final binding agreement, but it does map that critical road. Given its role in your funding efforts, understanding what it is, its provisions, and its implications in developing your negotiating strategy is key.
What is a term sheet?
A term sheet is typically a short, non-binding document serving as the framework for the final agreement between a company founder and an investor. Once the parties agree on the major details of a term sheet, they can negotiate the specifics of the legally binding investment contract.
Founders consider this document essential when seeking investment, particularly from venture capitalists, who may provide the funding needed to support new businesses.
The term sheet paints a general picture of a funding deal, allowing all parties to decide whether to proceed or withdraw. When they agree on major aspects of an agreement, it lessens the chances of a misunderstanding and avoids costly legal challenges later on.
No two term sheets are identical, but they follow similar outlines. They all include the assets, initial purchase price, contingencies that affect costs, and time frames.
Picture this: a term sheet in an acquisition or merger typically outlines key details such as the assets involved, the initial purchase price, and the preferred payment method. It might also highlight specific items to be included or excluded for one or both parties.
A term sheet isn’t just a formality; it’s your early chance to clarify expectations and reduce the risk of costly misunderstandings. By locking in the big-picture terms up front, both parties can move forward with confidence (or walk away if the fit isn’t right).
While every term sheet is unique, most follow a similar structure. They highlight the deal’s key elements, like valuation, funding amounts, voting rights, and liquidation preferences, helping everyone get on the same page.
What’s included in a term sheet?
The nature of the agreement will determine the specifics outlined in a term sheet. An angel investment term sheet for early-stage funding will differ significantly from one prepared for a commercial real estate development deal. There are certain elements you can generally count on:
- Nonbinding Terms: The provisions in a term sheet are typically nonbinding. The silver lining? Neither party is legally obligated to follow the outlined terms.
- Valuations: Key details such as company valuations, investment amounts, stake percentages, and anti-dilution provisions should be explicitly outlined.
- Voting Rights: These outline who gets a say in critical decisions. In funding scenarios, particularly with startups, venture capitalists (VCs) often want significant control to safeguard their investments.
- Liquidation Preference: This details who gets paid first (and how much) between the founders and the investors in the event of a sale.
- Investor Commitment: This should specify the length of the investor’s involvement in your company.
For debt agreements, the following are typically included:
- Financial Details: These include the loan term, amount, interest rate, and other financial conditions common to debt instruments.
- Risk Mitigation Provisions: Lenders often require certain conditions to be met or information to be provided to manage risks.
- Extension Rights: Borrowers may have the option to extend the loan, with the term sheet outlining the terms, conditions, and costs associated with the extension.
- Due Diligence at Closing: The term sheet may specify the requirements the lender needs to be satisfied with before finalizing the loan agreement.
Types of Term Sheets
Not all term sheets are created equal. They vary depending on the type of deal
Equity Term Sheets
These govern equity financing, where investors take an ownership stake in your company. Key terms include valuation, share price, liquidation preferences, and board structure. Provisions often address anti-dilution rights, voting rights, and dividend policies.
Convertible Note Term Sheets
Convertible notes serve as debt instruments for bridge financing that convert into equity during a later funding round. These term sheets specify interest rates, valuation caps, and conversion mechanics.
SAFE Term Sheets
SAFEs (Simple Agreement for Future Equity) simplify early-stage investment by allowing investors to provide funding in exchange for future equity. These term sheets emphasize the valuation cap, discount rate, and equity conversion terms for future financing rounds. Because of their simplicity and equity upside, they are particularly suited for high-growth startups.
Debt Term Sheets
Focused on debt financing without equity ownership, these term sheets specify interest rates, repayment schedules, collateral, and covenants. These are less common, but debt financing can address working capital requirements.
Strategic Investment Term Sheets
These term sheets are designed for investments involving strategic partnerships, emphasizing collaboration beyond capital. They address exclusivity, distribution rights, product co-development, and traditional financial terms.
Hybrid Term Sheets
These term sheets blend elements of equity and debt, such as structured convertible loans or equity investments with debt-like repayment clauses. They are customized to balance funding needs and risk-sharing objectives.
Royalty Term Sheets
Royalty term sheets offer non-dilutive funding with predictable returns. Investors receive a share of future revenues or profits rather than equity or debt repayment. Commonly used in entertainment, pharmaceuticals, and mining industries, they are suitable for startups seeking stable, non-dilutive financing.
Each term sheet type aligns with the startup’s stage, investor preferences, and strategic goals.
Key Elements in a Term Sheet
Two primary types of term sheets—investment and loan term sheets—serve distinct roles. Investment term sheets are central to equity financing, outlining the conditions of a potential investment by an investor in a company. In contrast, loan term sheets focus on debt financing, detailing the terms of a loan agreement between a borrower and a lender.
Investment Term Sheets
An investment term sheet establishes the core terms and conditions of an investment arrangement between a company and an investor. It includes elements such as valuation, ownership structure, board composition, rights (e.g., voting or anti-dilution), and liquidation preferences.
- Dividends: Specifies how and when investors will receive distributions from net income—whether monthly, quarterly, or annually—and outlines the dollar amounts.
- Drag-along Clause: Protects majority stakeholders by requiring minority stakeholders to comply with decisions such as selling the company.
- Liquidation Preference: Defines the order in which owners are compensated in the event of a company sale, minimizing investor risk.
- No-Shop Agreement: Restricts the company from accepting investment from other parties for a set period.
- Pro-rata Rights: This section details the investor’s rights in future funding rounds, including the right to first offer or penalties for non-participation.
- Valuation (Pre-money and Post-money): Establishes company value before and after the investment, forming a basis for negotiations.
- Valuation Cap: Specifies the value at which convertible notes convert into equity, ensuring a fair valuation and protecting investor interests.
- Voting Rights: This section clarifies the investor’s influence over company decisions, including the number of votes they hold and any restrictions.
Loan Term Sheets
A loan term sheet summarizes the main terms of an agreement between a borrower and a lender. It typically includes information such as loan amount, interest rate, repayment schedule, collateral, covenants, and conditions precedent.
- Collateral: This section identifies assets pledged by the borrower to secure the loan, often requiring the lender to hold a first deed of trust.
- Financial Covenants: This sets out the conditions for borrowers to demonstrate financial stability by providing certified financial statements or other agreed-upon records.
- Guarantee: Requires a creditworthy legal entity to vouch for the debt and assume liability in case of default.
- Interest Rate: Outlines the interest structure, including a fixed spread and a variable rate, such as the secured overnight financing rate (SOFR), reflecting Treasury-backed overnight borrowing costs.
- Loan Amount: Specifies the total funds to be borrowed, potentially based on loan-to-value ratios, debt service coverage, or net operating income.
- Loan Costs: This section details additional fees, such as annual administration or one-time closing fees, which can be substantial for larger loans.
- Term: Defines the repayment timeline, including periods when only interest may be due for certain types of loans, like lines of credit or development loans.
Although nonbinding, each type of term sheet serves as a critical framework for negotiations. They ensure clarity and alignment between parties before finalizing a binding agreement.
Do you need legal counsel when creating or reviewing a term sheet?
Negotiating a term sheet isn’t just about knowing the terms, it’s about playing your hand wisely with the help of vetted legal experts. Here’s how:
- Understand Your Leverage: Before diving into term sheet discussions, understand the leverage you bring—or lack. Know your strengths, weaknesses, and how much interest your startup is generating. A strong pitch can shift the balance in your favor.
- Don’t Do It Alone: Remember that VCs negotiate term sheets for a living. For many founders, this is a first – and that’s okay! Partner with a seasoned attorney to ensure your interests are protected, the terms are fair, and potential red flags are spotted early. They can also help you negotiate like a pro.
- Choose Your Battles: While it’s crucial to understand every deal term, you don’t need to negotiate all of them. The ability to discern when to compromise and when to stand firm is one of the most critical skills in early negotiations. Focus on the provisions that impact your control, equity, and exit strategy.
- Vet Your Investors: A term sheet is more than numbers on a page. It’s a partnership! Research your potential investors. Dig into their track records. Do their values align with yours? Don’t let the thrill of a potential partnership cause you to sign on a dotted line you’ll regret.
Remember: most of the groundwork for a successful negotiation happens beforehand. That involves knowing your startup’s strengths and weaknesses inside and out, assessing investor interest, and crafting a compelling narrative to present. You’ve got this.
What are the common pitfalls when drafting a term sheet?
Common mistakes include being overly vague or excessively detailed, failing to differentiate between binding and nonbinding terms, setting unrealistic time frames, and omitting key financial terms and conditions. While term sheets primarily focus on financial aspects, they also define the balance of power between you and your investors.
Term sheets often outline the allocation of seats on the company’s board of directors, a critical factor in maintaining control. Picture this: a straightforward Series A board structure might grant the lead investor one seat while the founders appoint two. Because subsequent investment rounds will probably dilute your control, avoid giving up board seats or voting power at this stage of the game.
Another example of risk: assigning a board seat to the CEO rather than a founder. If you are both a founder and a CEO, you could lose your board position if you are replaced as CEO. Also, be wary of “protective provisions” that require the consent of holders of preferred stocks to make significant decisions. These would be choices like budget approvals, hiring, or operational changes. The more rights you grant new investors, the more these will compound in later rounds – future investors often expect parity with earlier terms.
The Bottom Line
A term sheet serves as the starting point for structuring a deal between two parties. It signifies a serious commitment between them and often marks the initiation of a transaction. While term sheets are usually non-binding, they can involve a good faith deposit held in escrow. This deposit reflects a genuine intent to pursue a future agreement. At the end of the day, a term sheet is more than just paperwork – it’s a roadmap for your startup’s future.
Are you ready to try your hand at your first term sheet? First, you need to work on your pitch. Join our Pre-Launch Founder Community and access the knowledge, tools, and connections to navigate every step of your funding journey.
