What is a term sheet? A how-to guide for first-time startup founders (with term sheet template)
Learn more about term sheets and download our term sheet template.
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1 minute
October 8, 2024
Term sheets are vital because they provide clarity to both a start-up founder and investors, establish the framework for the investment, facilitate productive negotiations, generate competitive tension, and demonstrate the investor's commitment, all of which are crucial to a successful startup fundraising process.
This guide is designed to help first-time founders—who may have little to no experience using term sheets—learn about them, how they are used, and how they can help secure funding for their startups.
Key highlights:
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In startup fundraising, a term sheet is a mostly non-binding document outlining the terms and conditions under which venture capitalist investors will invest in a startup.
The economic terms outlined in terms sheets include company valuation, investment amount, percentage stake, and liquidation preference. We will cover these and more terms in this blog.
In short, terms sheets outline the math behind a deal and what happens if a liquidation event occurs (e.g., IPO or M&A).
The control terms often established in a term sheet include voting rights on important decisions, pro-rata rights, and other specific provisions, such as whether a venture capital investor will be granted a board seat for funding the startup.
While term sheets are mostly non-binding, certain provisions related to exclusivity, sharing of confirmatory diligence costs, and confidentiality may be binding upon signing.
Let’s say a VC agrees to invest $3M in your early-stage startup at a $10M post-money valuation with a 2X liquidation preference.
If you are unfamiliar with any of these terms, you will be able to decipher this statement by the end of this guide. These conditions are likely outlined in a term sheet; we will review them below.
Term sheets are mostly non-binding, but that doesn’t mean they aren’t important. They help simplify the fundraising process by outlining the terms investors and startup officers agree to that will ultimately serve as the skeleton for a binding, contractual agreement.
They are typically only delivered once an investor sincerely desires to execute an investment subject to confirmatory diligence work.
Here is how term sheets help founders, investors, and parties involved in an M&A private equity transaction.
Term sheets provide crucial information for founders as they determine if the investment is right for them before they begin business and legal negotiations.
Term sheets:
Terms sheets are a resource for founders, helping them gain clarity and control during the fundraising process and ultimately secure the best possible investment deal for their company.
Term sheets are a key tool for investors to clearly define the investment parameters, protect their interests, assess the startup's potential, and establish a productive long-term partnership.
The term sheet contains important details and disclaimers, such as the valuation, investment amount, equity allocation, investor rights, and more. It also provides a framework that can be used to draft the definitive investment documents efficiently.
This document allows investors to negotiate favorable terms around liquidation preferences, board representation, anti-dilution protection, and other clauses that give investors more control and downside protection.
Reviewing the term sheet helps investors evaluate the startup's business model, team, proposed valuation, and the founder's ability to negotiate effectively. Investors can also use the term sheet to generate interest among multiple startups, potentially leading to better deal terms.
Importantly, the term sheet lays the groundwork for an ongoing relationship between the investor and the startup, setting the tone for future collaboration.
The term sheet is a crucial early step in the M&A process. It helps both the buyer and the target company agree on the key transaction terms before investing significant time and resources into negotiating the final, binding agreement.
It is typically the first step in an M&A transaction and outlines the major terms of the proposed acquisition.
It describes key deal terms such as the purchase price, structure (asset vs stock purchase), holdback/escrow provisions, indemnification caps, right of first refusal, survival periods, and exclusivity periods.
These deal terms are crucial because they affect the transaction's timing, certainty, and risk exposure.
As mentioned earlier, a term sheet is a mostly non-binding document signed by the target company and the prospective buyer. However, it often also contains a few binding provisions, such as exclusivity, non-solicitation, and confidentiality clauses.
Negotiating at the term sheet stage is important because it can be difficult to renegotiate at a later M&A stage.
The term sheet stage allows the parties to focus on the core deal structure and economics without getting bogged down in the detailed legal language of the final agreement. Furthermore, the term sheet serves as a framework that instructs the lawyers and advisors on how to draft the definitive agreement and other transaction legal documents. An outline of the key terms ensures the parties are aligned before proceeding.
For the target company, it clarifies the investor's intent and the potential impact on founders, entrepreneurs, and shareholders. For the buyer, the term sheet helps ensure their interests are protected, as well as the necessary control and information rights.
Terms sheets may deal with debt or equity financings and generally have different structures, focuses, and terms, depending on the type.
Equity term sheets and debt term sheets both serve as a framework for the final, legally binding investment agreement. They help founders and investors or lenders and borrowers align on the major terms before proceeding to lengthy legal negotiations.
As the name states, the major difference is that an equity term sheet outlines the terms and conditions for an equity investment, while a debt agreement term sheet outlines these for debt financing, such as a loan or venture debt.
Another major difference is in key terms included: An equity term sheet covers details that include valuation, amount of investment, type of shares (common vs. preferred), investor rights, control, and other key provisions.
On the other hand, a debt agreement term sheet outlines the loan amount, interest rate, repayment structure, collateral, events of default, and other key provisions.
The primary difference between a term sheet and a contract is that a term sheet is much less detailed and largely non-binding.
The term sheet serves as a precursor and framework for the final documentation. A contract is the final, legally binding agreement that formalizes the deal, often accompanied by various addendums and related agreements.
A term sheet provides an overview of the essential terms, while a contract includes thorough legal language and provisions.
Drafting a term sheet generally requires less time and fewer resources than a full contract, and it allows the parties to focus on the key business terms before investing in the detailed legal work.
Another key difference is that the term sheet is typically used in the early negotiation stage to align the parties on the core deal terms before proceeding to a binding agreement.
The contract is the final, legally enforceable document incorporating the terms agreed upon from the term sheet.
Note: There are some portions of the term sheet that are legally enforceable, like the confidentiality provision.
While these terms are often used interchangeably, they have some key differences.
As the name suggests, a letter of intent (LOI) is often written in narrative form for an investor to express their interest in purchasing or investing in a business. They are common in real estate transactions.
A term sheet serves as a skeleton for an eventual contractual agreement, outlining key terms and conditions of a deal.
The goals are different. Term sheets help align parties on deal conditions and reduce legal administration costs. Letters of intent express interest and provide a level of assurance to a seller.
Generally, term sheets contain the key terms of the contemplated transaction in a more abbreviated format, such as bullet points.
Yes, absolutely. Term sheet negotiation is a crucial part of the startup fundraising process, allowing founders to shape the key terms of the investment and protect their interests before finalizing the binding agreement.
Founders should negotiate the following key items:
While most term sheet provisions are negotiable, founders should be careful not to have excessive demands and risk losing the investment deal altogether.
Founders should use the term sheet negotiation process strategically and create a sense of competition among investors to drive better terms.
We’ll break down the key terms typically included in different types of term sheets.
An investment term sheet covers the financial, operational, and control-related terms governing the startup and investor investment deal. In a term sheet, you will usually find the following components:
A debt agreement term sheet covers the essential financial, legal, and operational terms governing the loan between the lender and the borrower. It includes the following components:
Investment term sheets and loan agreement term sheets differ in their purpose, the type of financing involved, the key terms covered, the binding nature of the documents, and the negotiation dynamics between the parties.
These distinctions are important to understand when navigating the fundraising process.
The pre-money valuation represents the company's value before the new investment. It is an important metric to determine the price per share and ownership percentages in the financing round.
The post-money valuation is the company's value after adding the new investment.
The valuation cap determines the price at which the investor's convertible securities, such as convertible notes or preferred stock, will convert into equity in the company during future funding rounds.
The purpose of the valuation cap is to protect the early investors from excessive dilution of their ownership stake if the company's valuation increases significantly in later financing rounds.
By capping the valuation, investors ensure they can convert their investment at a lower price, effectively giving them a larger ownership percentage in the company.
The founders want to set the cap high enough to leave room for future growth, while the investors want it low enough to protect their investment. Negotiating this provision is a key part of the term sheet process for startups seeking investment.
Drag-along rights are designed to protect the majority shareholders in an exit event, such as a sale or merger, by ensuring they can negotiate the sale of the company without minority shareholders blocking the deal.
These rights give the majority shareholders the power to "drag along" the minority into a transaction they may not have otherwise agreed to, allowing the majority to negotiate the sale more effectively.
While the minority is forced to sell, the drag-along clause typically requires they receive the same price and terms as the majority shareholders, providing some protection. Drag-along rights normally expire once the company goes public through an IPO.
Dividends are the distribution of a company's profits or excess earnings to its shareholders, typically cash or stock.
The company's board of directors can declare them, but most states don’t allow companies to pay dividends unless they meet certain financial requirements.
The liquidation preference is a key provision in a term sheet that outlines how proceeds will be distributed in a liquidity event, with important implications for investors and founders that must be carefully negotiated.
The term sheet will outline the voting rights granted to preferred stockholders, a key provision that impacts the balance of control between founders and investors. Careful negotiation of these terms is essential.
Pro-rata rights are a common and important term in term sheets. These rights allow investors to maintain their ownership percentage in a startup as it raises more capital over time and welcomes new investors.
A no-shop agreement grants the investor a period of exclusivity. This agreement prohibits the startup from soliciting or negotiating with other potential investors during a specified exclusivity period.
This assures the investor that the startup is committed to the current investment deal and will not use the term sheet to gain leverage with other investors.
The no-shop period typically lasts 1-3 months, with a shorter duration being more favorable for the startup as it provides more flexibility.
It may allow limited exceptions or carve-outs to the no-shop clause, such as permitting the startup to notify the investor of unsolicited third-party offers.
The term sheet will specify the total amount of the loan or debt financing, either as a fixed amount or a range. This represents the maximum amount the lender will provide to the borrower.
Guarantees provide additional assurance and recourse for the lender. Sometimes, the term sheet may require personal guarantees from the company's founders or key individuals to secure the loan.
The term sheet will outline the annual interest rate or "coupon" that will be charged on the outstanding loan balance. This can be a fixed or variable rate tied to a benchmark bond, such as the U.S. Treasuries.
The term sheet will also specify the frequency of interest payments, typically monthly or quarterly.
The term sheet will indicate the length or maturity date of the loan. This can be structured as an amortizing loan with regular principal payments or a "bullet" loan with a single lump sum repayment at maturity.
The term sheet will describe the collateral or security the lender will require, such as accounts receivable, inventory, property, or other assets. An advance rate against the collateral's value may also be specified.
The term sheet will outline any financial performance covenants the borrower must maintain, such as minimum liquidity, debt service coverage ratios, or leverage limits. Violation of these covenants can trigger an event of default.
The term sheet may include details on any upfront fees, closing costs, or ongoing expenses associated with the loan. This can include arrangement fees, commitment fees, or legal/diligence costs.
Gain clarity about what you are asking for, including the amount and type of investment.
What would be a best-case scenario?
Then, identify your company’s valuation.
This way, you can clearly communicate your business needs and have meaningful conversations with potential investors that will move the needle forward.
By structuring the term sheet to address these key elements clearly, you can create a comprehensive framework for the investment that aligns the interests of both the company and the investor.
Specify the total amount of investment the investor will provide. This is a key term that determines the company's post-money valuation.
The valuation will determine the percentage of equity the investor receives and how much employee stock options are worth. Include the company's pre-money valuation the value before the investment. Also, specify the post-money valuation, which is the value after the investment.
Outline the type of security the investor receives, such as common stock, preferred stock, or convertible notes. Clearly define the rights and preferences associated with the security.
Specify the liquidation preference, which determines the order and amount the investor gets paid in a liquidity event. This is a key protective provision for the investor.
Outline the structure of the board of directors, including the number of seats allocated to the investor. Remember, board composition impacts the investor's level of control and influence.
Identify any special rights or "veto powers" the investor will have over certain company decisions. These protective provisions safeguard the investor's interests.
Specify the vesting schedule for any founder or employee equity, including any initial "cliff" period. This aligns with incentives and helps retain key talent.
Outline any dividend rights or preferences the investor will have. This impacts the distribution of the company's profits.
Describe any anti-dilution provisions that protect the investor's equity stake from being diluted in future funding rounds.
Include a provision that gives the investor a period of exclusivity to finalize the investment. This prevents the company from shopping the deal to other investors during negotiations.
Consulting an attorney when creating a term sheet is highly recommended. Lawyers can leverage their legal expertise to protect your interests, avoid potential issues, and establish a strong foundation for the investment agreement. Also, having a lawyer review and negotiate the term sheet helps to set the stage for a smoother, more successful fundraising process.
By following these tips, you can effectively navigate the term sheet process, secure the best possible deal for your company, and lay the foundation for a successful long-term partnership with your investors.
Identify your company's 3-4 most critical terms, such as valuation, liquidation preference, and board composition. Focus your negotiation efforts on the terms that will significantly impact your company's future. De-prioritize the rest.
Engage with multiple investors to generate interest and competition for your deal. Leverage other offers or the ability to "walk away" to strengthen your negotiating position. Research the investors and understand their typical deal terms and pressure points.
Proactively share your ideal terms and priorities with the investor before they provide a term sheet. This allows you to anchor the negotiation and set the tone rather than reacting to their initial offer. Demonstrate that you understand the key terms and are prepared to negotiate assertively.
Avoid negotiating term sheets live. Instead, do it in writing. This allows you to consider your responses and carefully control the process. Live negotiations can make it difficult to conceal your negotiating position and leverage.
Remember that you'll work with the investor for the long term, so establish a productive relationship. If the negotiation process is overly difficult, it may indicate future challenges. Aim to create a "win-win" situation that aligns the interests of the founders and the investors.
Identify the 3-4 key terms that are critical to you, such as valuation, liquidation preference, and voting rights. De-prioritize less important provisions, such as dividends, information, and registration rights. Understand which terms matter most to both you and the investor.
Proactively share your ideal terms and priorities with the investor before they provide a term sheet. Anchor the negotiation and set the tone rather than just reacting to their initial offer. Demonstrate that you understand the key terms and are prepared to negotiate assertively.
Talk to multiple investors to generate interest and competition for your deal. Leverage other offers or the ability to "walk away" to strengthen your negotiating position. Research the investors and their typical deal terms to understand their priorities and pressure points.
Concentrate your negotiation efforts on the terms that will most significantly affect your company's future, such as valuation, ownership, and control.
Be willing to compromise on less critical provisions to maintain goodwill and reach an agreement. Understand the investors' structural limits and red lines, and avoid pushing too hard on those points.
Even basic terms found on a term sheet may be complex to a founder who has never used one, but luckily, we have a term sheet example here you can download.
Editor’s note: This content is for informational purposes only. It doesn't necessarily reflect the views of Rho and should not be construed as legal, tax, benefits, financial, accounting, or other advice. If you need specific business advice, please consult an expert, as rules and regulations change regularly.
Once a term sheet is signed, the founder must move quickly to close the deal, stick to the term sheet, manage the process efficiently, and ensure alignment with the investor before finalizing the investment.
The term sheet is intended to serve as a framework and starting point for negotiations, not a final, legally binding agreement.
The non-binding nature of term sheets is a deliberate design choice that provides flexibility, encourages good faith negotiations, and avoids prematurely locking the parties into a final agreement before all the details have been agreed.
While some specific provisions, such as confidentiality and exclusivity, may be binding, most term sheet terms are non-binding and open for further negotiation.
With a non-binding term sheet, either party can leave the deal if the talks break without being legally obligated to complete the transaction.
Liquidation preference is a VC term determining the order and amount of payouts to shareholders in a liquidity event, such as a company sale or acquisition.
Liquidation preferences have significant implications for both investors and founders. These preferences set investment agreements that outline how a startup will distribute its sale or liquidation proceeds among its investors.
The term sheet is a largely non-binding document that provides an initial framework for the key terms, while the stock purchase agreement is the final, legally binding contract that governs the actual stock sale transaction between the parties.
The term sheet precedes and informs the drafting of the stock purchase agreement.
Similar to the stock purchase agreement, the term sheet is a mostly non-binding document that outlines the proposed investment terms.
In contrast, the shareholder agreement is the final, legally binding contract that governs the ongoing relationship between the shareholders and the company. The term sheet is created first and informs the drafting of the shareholder agreement.
While both term sheets and MOUs are generally non-binding preliminary agreements, the term sheet is focused on the financial and transactional details.
Conversely, the MOU establishes a general framework of cooperation and collaboration between the parties and is not likely to include specifics on economics and governance.
Whether you are a first-time founder raising your pre-seed funding or a seasoned, multi-time founder raising your Series A, a term sheet will likely be involved.
Terms sheets are a cost-effective way for investors and founders to quickly align on the important details around a potential investment in a startup and shorten the timeframe so founders can focus on building their business, not drafting legal documents.
However, successfully pitching investors and raising cash is only half the battle; you want to ensure your cash is effectively allocated to earn yield that can potentially extend your cash runway.
Rho makes this easy, offering a business banking platform with cash management services that help you put your cash to work. Learn more about our treasury products today.
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Isabel is a guest contributor. The views expressed are hers and do not necessarily reflect the views of Rho.