TL;DR
A Term Sheet is essentially a blueprint for an investment deal, summarizing the key financial and legal terms agreed upon by both the startup and the investors.
While the term sheet itself is non-binding, it lays out the groundwork for the final, binding agreements that will be executed later.
It is typically issued by venture capital (VC) firms, angel investors, or other potential investors after initial due diligence, indicating their interest in investing under certain conditions.
Key Components of a Term Sheet
A term sheet typically includes several key terms and conditions, which fall into three main categories: economic terms, control terms, and other provisions.
Each section outlines different aspects of the deal and the relationship between the startup and the investors.
1. Economic Terms
Economic terms define the financial aspects of the investment, such as valuation, ownership structure, and how the proceeds of the investment will be distributed in the event of an exit.
- Pre-Money Valuation: The pre-money valuation refers to the valuation of the company before the new investment is added. This number is critical because it determines the percentage of the company that the investor will own after the investment.
- Amount of Investment: This is the total amount of capital that the investor is committing to the company. It’s usually expressed as a dollar figure, and along with the pre-money valuation, it determines the post-money valuation of the company.
- Post-Money Valuation: The post-money valuation is the company’s valuation after the investment has been added to its balance sheet. This valuation includes both the company’s original value and the new capital.
- Equity Ownership: This section details how much equity the investor will receive in exchange for their investment. It’s typically expressed as a percentage of the company that the investor will own after the investment.
- Liquidation Preference: A liquidation preference gives investors the right to be paid back first in the event of a liquidation (such as a sale or IPO). The liquidation preference specifies how much the investors will receive before other shareholders. A 1x liquidation preference, for example, means that the investor will get back the amount they invested before any other distributions are made.
2. Control Terms
Control terms outline how much influence the investor will have over the company’s decision-making process. These terms often include voting rights, board representation, and protective provisions.
- Board Seats: The term sheet may specify how many seats the investor will have on the company’s board of directors. The number of board seats determines how much control the investor has over key decisions within the company. In early-stage deals, investors typically request one or two seats on the board.
- Voting Rights: This section defines how much voting power the investor’s shares will carry. Voting rights are important in determining who has control over major company decisions, such as future fundraising, mergers, or changes to the company’s structure.
- Protective Provisions: Protective provisions give investors veto power over certain actions the company might take, such as issuing new shares, raising debt, selling the company, or changing the company’s bylaws. These provisions ensure that the investor has a say in decisions that could significantly affect their investment.
3. Other Provisions
In addition to economic and control terms, term sheets often include various provisions that protect both parties and clarify the terms of the deal.
- Anti-Dilution Protection: Anti-dilution clauses protect investors from having their ownership percentage diluted if the company issues new shares at a lower price in future funding rounds. The most common form of anti-dilution protection is weighted average anti-dilution, which adjusts the investor’s ownership in the event of a down round.
- Dividends: The term sheet may outline whether the investor is entitled to dividends, which are payments made to shareholders based on the company’s profits. In many startup investments, dividends are not a priority, as profits are usually reinvested into the company.
- Founder Vesting: Founder vesting is a provision that requires the founders’ shares to vest over time. This incentivizes the founders to stay with the company for a certain period and prevents them from leaving the company with a large portion of equity early on. If a founder leaves before their shares are fully vested, they forfeit some or all of their unvested shares.
- Exclusivity and No-Shop Clause: This clause prevents the company from seeking or negotiating other investment offers while the term sheet is in effect. It gives the investor a period of exclusivity to finalize the deal without competition from other potential investors.
- Confidentiality: A confidentiality clause ensures that the terms of the deal and any sensitive information shared during negotiations remain confidential between the parties.
Why is a Term Sheet Important?
A term sheet is a crucial part of the fundraising process for several reasons:
1. Clarity on Terms and Expectations
The term sheet outlines all of the important terms of the deal, ensuring that both the startup and the investors are aligned before moving forward.
By setting clear expectations early in the process, the term sheet reduces the risk of misunderstandings or conflicts later on.
2. Guides Legal Agreements
While the term sheet itself is not legally binding (with a few exceptions), it serves as the foundation for the final legal agreements, such as the stock purchase agreement and shareholder agreements.
These agreements will incorporate the terms outlined in the term sheet, ensuring that the final deal reflects what was initially agreed upon.
3. Facilitates Negotiations
The term sheet provides a structured framework for negotiating the key terms of the investment.
Both the startup and the investors can review and negotiate different aspects of the deal—such as valuation, control, and investor rights—before committing to the investment.
4. Reduces Time and Costs
By negotiating the key terms upfront, a term sheet helps avoid lengthy legal negotiations later in the process.
Once the term sheet is signed, both parties can move forward with drafting the final agreements, knowing that they have already agreed on the major points of the deal.
Benefits of a Term Sheet
For both startups and investors, a term sheet offers several advantages:
1. For Startups
- Clarity on Investment Terms: The startup gets a clear understanding of what the investors are offering and the terms of the deal, reducing the risk of confusion or unfavorable terms in the final agreements.
- Faster Fundraising Process: By outlining the key terms upfront, the term sheet streamlines the fundraising process, helping startups secure funding more efficiently.
- Preserving Founder Control: Through negotiations, founders can structure the deal in a way that allows them to retain control of their company while still securing the capital they need.
2. For Investors
- Control Over Investment: Investors can negotiate terms that give them control or influence over key decisions in the company, ensuring their investment is protected.
- Risk Mitigation: Terms like liquidation preferences and anti-dilution clauses help investors mitigate risk, ensuring they are protected if the company performs poorly or raises future rounds at a lower valuation.
- Clarity on Return Expectations: Investors get a clear understanding of the financial returns they can expect, based on terms like equity ownership and liquidation preferences.
VC Term Sheet Template
While term sheets may differ depending on the nature of the agreement, as well as other factors (such as each country’s laws and policies), the basic framework can more or less be used by anyone.
A good example of a term sheet template is that from Greek VC firm, Marathon, which you can find and download here.
Conclusion
A Term Sheet is a critical step in the investment process, providing a framework for the terms of a deal between a startup and its investors.
Interested in learning more VC related terms? Head over to our VC glossary!