What is a Term Sheet – Everything You Must Know When Raising Capital
If you are a startup business owner or an aspiring entrepreneur, at some point, you are likely to encounter a term sheet. What is a term sheet? What is it actually used for? And what issues one needs to consider? A term sheet is also referred to as a letter of intent and a primary entity in startup fundraising. Term sheets are vital but can be complex. As a startup owner, the goal is to know what to expect and what you want from a term sheet. Most importantly, it is knowing what you will not be obliged to.
You have pitched to venture capitalists, and some are showing interest in your idea. But before moving onto solid negotiations, you should first learn everything you need to know about the term sheet, along with its commonly used clauses.
It is a prominent fundraising term and probably one of the most important documents you will ever sign. If you are new to fundraising and its common terms, this post discusses everything, there is to know about term sheets.
What is a Term Sheet?
A term sheet is a written document that a business owner and the investor exchanges. It contains important terms and conditions of the business deal. Before the actual legal agreements are executed, a term sheet summarizes the key points of the deal and sorts out any differences.
Technically, a term sheet is a ‘non-binding’ agreement that only reflects the broad and key points under which the investment is made. In addition, the document acts as a guide for the external or in-house legal teams for drafting definitive agreements.
Above all, the clauses and content of the term sheet differ from transaction to transaction.
What is a Term Sheet Negotiation About?
As a startup owner, you try to fundraise the necessary capital while limiting downside risks, keeping control, and retaining upside. Nevertheless, it is all about dividing the risk and upside between the entrepreneur and the investor. There are numerous standard clauses that you can include in your term sheet.
In order to make the right decision, it is vital to understand these clauses, given that any situation might differ. For an entrepreneur, a term sheet is a key document to understand who the investor really is. Moreover, you can get a feel of where they stand regarding the agreement depending on the things they stress on.
Understanding the Key Term Sheet Clauses
There are some clauses within the term sheet that need proper understanding before you sign the contract. Many people will tell you that an investment is signified by two key factors – investment and valuation.
However, because investors are looking to lower their risk while aiming for the best return, they will include a number of new clauses. These additional clauses can have a significant impact on the deal.
For an investor, an agreement with a lower valuation but with friendly terms can often prove to be an ideal deal. You can categorize the key clauses of a term sheet into four groups –
- Deal economics
- Governance management and control
- Investor rights and protection
- Exits and liquidity
Let’s discuss each group in detail.
#1 Deal Economics
Deal economics is who gets what. The concept of deal economics is you would rather have a smaller piece of a larger pie than a larger piece of a smaller pie. It is important to watch the deal economics closely because the investors use special clauses. The following are the essential items on a term sheet:
- Investment amount
- Valuation – including pre-money and post-money valuation
- Conversion – converting shares of preferred stock into shares of common stock
- Option pool – sharing equity with employees
- Liquidation preference – who gets paid first
- Participating preferred
#2 Governance Management and Control
One of the key aspects when setting the rules through a term sheet is who is in control of the company. The key terms involved in this are:
- Voting rights – rights of a shareholder to vote
- Board rights – hiring/firing, setting board goals, dividends and option policies, and executive compensation
- Information rights – investors require owners to share the company’s business and financial condition with them on a regular basis
- Founder Vesting – if the founder gets bored with the business, he/she can walk away. Investors, to protect themselves from such scenarios, look for mechanisms to lower the risk of losing founders, such as founder vesting
#3 Investor Rights and Protection
Investors create a clause that helps them in protecting their investment. It is an essential clause in this category as it provides investors protection against several entities that may harm their investment. Anti-dilution provision is its most prominent clause. Dilution occurs when a company issues more shares resulting in a decrease in the existing shareholders’ ownership. Dilution is sub-categorized into different entities, namely:
- Anti-dilution rights
- Pro-rata rights or pre-emptive rights
- Co-sale rights and rights of first refusal
- No-shop clause – prevents the company from asking investment proposal from other investors
#4 Exit and Liquidity
Exit and liquidity clause tells what happens when it is time to cash on investment. There are several different clauses within this category, including:
- Drag-along and tag-along rights – drag-along rights prevent situations where minority shareholders block the sale of the company. Tag-along rights give the minority shareholders the right to join any action along with the majority shareholders
- Redemption rights – it is a right that allows investors to have an obligation to demand redemption of the equity within a specific time period
A term sheet can be a single page or even 10 pages long. Entrepreneurs prefer simplicity, as it makes the agreement easier to read and understand. Even investors prefer short contracts. When reviewing the term sheet, it is helpful when you have a professional lawyer by your side. It will make things easy to understand. And if there are any concerns, you can easily raise questions on the spot. Once you sign the contract, there is nothing you can do to go back.