Term Sheets Explained

Confused by term sheet jargon? Worried about hidden investor clauses? This guide simplifies term sheets, helps you avoid negotiation pitfalls, and empowers you to land a win-win investment deal. Read more.

Farheen Shaikh

7 June 2024

Table of Contents

Like most startup founders, Noah Kraft, when looking for an investor to invest in his company, Doppler Labs, had a simple goal: to raise as much money as possible on the best possible terms from the most reputable investors in the ecosystem. 

Until his company shut down in 2017, they had raised $51 million dollars. 

In retrospect, while Noah did raise a lot of money, he forgot a really important aspect of fundraising—investor-founder fit. 

He now reflects that 'fit' is just as important as everything else, including the money and reputation of an investor.

“The most important term in the term sheet is not a legal one — it’s really who you’re working with.” “Who’s the firm, and who’s the partner or lead on your deal?” - Andrew Beebe

With that said, let’s get to know about term sheets in detail.

What is a term sheet?

A term sheet is a concise, non-binding document that bridges the gap between initial discussions and a final binding agreement in investment deals. It outlines the core terms and conditions of a potential investment, acting as a blueprint for the final deal.

By capturing the essence of the agreement early on, the term sheet ensures that all parties the startup and the investor have a clear understanding of the deal's structure, financial aspects, and mutual expectations before more detailed and expensive legal work begins. 

This early clarity helps streamline the negotiation process, saving time and resources. It also minimizes the risk of misunderstandings and disputes down the road.

When are term sheets used?

Typically, term sheets are used during the fundraising process, when the company is seeking investment from investors, angel investors, or other types of investors.

Here are some specific scenarios when term sheets are used:

1. Seed funding

In the early stages of a startup, when founders are seeking initial capital to develop their product or service, a term sheet is presented by seed investors or angel investors.

2. Series A, B, C funding, etc.

As companies progress through funding rounds, term sheets become even more critical for outlining investment specifics as they seek capital to scale operations, expand market reach, and develop new products.

3. Bridge financing

When a startup needs temporary funding to bridge the gap between larger financing rounds, a term sheet is used to outline the terms for this interim capital.

4. Acquisitions or mergers

If a startup is being acquired or merging with another company, a term sheet is used to outline the preliminary terms of the deal.

5. Convertible Notes or SAFEs

In cases where the investment is structured as a convertible note or Simple Agreement for Future Equity (SAFE), a term sheet outlines the conditions under which the note will convert into equity or the terms of the SAFE.

Read more about convertible notes and SAFEs.

Term sheet examples: What's Included?

While the specifics of each deal can vary, a typical term sheet will include the following headings:

1. Deal overview

It describes the parties involved. This includes the names of the startup and the investor, along with the nature of the transaction. It might also specify if it's a Seed funding round or a Series A round.

It describes the parties involved, including the startup's name, the investor's name, and the nature of the transaction (e.g., funding round, acquisition). It may also specify the specific funding round (e.g., Seed round, Series A round) or the purpose of the acquisition.

2. Deal economics

This section details the financial aspects of the investment:

a. Investment amount: This specifies the exact amount of money the investor is willing to invest in the startup.

b. Valuation: This refers to the total estimated value of the startup before and after the investment.

For instance, the term sheet might state a pre-money valuation of $10 million (company value before the investment) and the investor is willing to invest $2 million. This means the post-money valuation (company value after the investment) would be $12 million ($10 million + $2 million investment).

c. Type of security: This clarifies the type of financial instrument the startup is offering to the investor in exchange for the investment. It could be common stock, preferred stock (grants the investor certain privileges like voting rights or dividends), or convertible notes (a debt instrument that converts to equity later).

Read more about types of security in our equity management blog post.

3. Investor rights and protections

This outlines the rights and protections granted to the investor in exchange for their investment.

a. Board representation rights: The investor might be entitled to appoint a certain number of representatives to the startup's board of directors. This gives them a say in major company decisions.

b. Information rights: The investor will typically have the right to access the startup's financial statements and other relevant business information to stay informed about the company's performance.

c. Liquidation preference: Liquidation preference dictates who gets paid first and how much in the event a company goes through a liquidity event, i.e., goes out of business and sells its assets, or is acquired for less than the sum of all investments. It is common for investors to request a liquidation preference of 1x, but anything more than that isn't ideal.

d. Anti-dilution provisions: Anti-dilution provisions safeguard the investor's ownership stake by triggering a conversion price adjustment for their preferred stock. This adjustment occurs if the company issues new shares at a lower price than the investor's investment, a scenario commonly known as a down round. 

e. Preemptive rights: This gives the investor the first right to purchase additional shares if the startup issues new equity in order to maintain their ownership percentage.

4. Covenants

Covenants act as guardrails for investors, placing restrictions on the startup's actions to protect their investment. For example, a covenant might prevent the company from taking on excessive debt or selling certain assets without the investor's consent.

5. Investment instrument details

This could go beyond simply specifying the type of security (common stock, preferred stock, etc.) and delve into specific terms like conversion rates for convertible notes, liquidation preference multiples for preferred stock, and dividend rights.

6. Participation rights

Participation rights give the investor the option to participate in future funding rounds to maintain or increase their ownership percentage.

Here's an example:

Imagine you invest $10,000 in a startup that gets valued at $100,000 (pre-money valuation). This means you own 10% of the company.

Later, the startup raises another $20,000 at a valuation of $150,000 (post-money valuation). This means new investors get a piece of the company at a higher price.

Here's where participation rights come in:

Without participation rights: The company issues new shares for $20,000, diluting your ownership. You still own $10,000 worth of the company, but that might only be 6.67% now (because the company is worth more).

With participation rights: You get the chance to invest another $5,000 (your pro-rata share) to maintain your 10% ownership. This way, even though the company brings in new investors, you don't get diluted.

This additional investment is calculated as:

New company value x your desired ownership percentage - your initial investment ($150,000 x 10%) - $10,000 = $15,000 - $10,000 = $5,000

7. Pay-to-play provisions

Pay-to-play provisions are basically a "skin in the game" clause for investors in startups. These provisions require existing investors to invest more money in future funding rounds, typically proportional to their current ownership. If an investor chooses not to invest more in the next round, they face consequences. This could be losing certain privileges like voting rights or having their shares downgraded to a less valuable class.

While pay-to-play provisions are obligatory, preemptive rights and participation rights are optional.

8. Governance and management

This section defines how the startup will be governed and managed after the investment:

a. Board composition and voting rights: This details the makeup of the board of directors and how voting rights will be allocated. It will specify how many board seats each party gets and the voting power associated with each seat.

b. Decision-making authority for key matters: The term sheet might outline which decisions require board approval and which can be made by the founders alone. This could include decisions related to product development, fundraising, or hiring key personnel.

9. Exits and liquidity

This section addresses how the investor can eventually exit and realize their investment:

a. Potential exit strategies for investors: This might mention common exit strategies for investors, such as an acquisition of the startup by another company or an initial public offering (IPO) where the startup goes public and sells shares in the open market.

b. Rights to sell shares (put/call options): investors can negotiate terms that give them the right to sell their shares in the startup at a predetermined price by a certain time (put options) or buy back shares from the company at a set price if things don't go as planned (call options). These options provide some flexibility and a potential exit strategy for the investor, increasing their overall investment liquidity.

10. Valuation caps and floors

Valuation caps and floors act like safety nets for both the investor and the founders during a buyout.

  • A valuation cap protects the investor by setting a highest acceptable price per share they would pay to acquire the founders' shares in a buyout event.
  • Conversely, a valuation floor guarantees the founders a minimum price per share for their shares in the same scenario.

11. Drag-along and tag-along rights

These rights grant the investor some control over the sale of the startup:

a. Drag-along right: Allows the investor to force the founders to sell their shares if they (the investor) decide to sell theirs.

b. Tag-along right: Allows the founders to sell their shares alongside the investor if they are acquired.

12. Founder vesting and stock options

This provision outlines the vesting schedule for founders' shares, which details the gradual acquisition of ownership percentage over time, often granted directly or through stock options.

13. Non-compete provisions

These clauses may limit the founders' ability to work for a competing business or start a directly competing company for a specific time frame after they depart from the startup.

14. Conditions to closing

Before the deal is finalized, there are certain conditions that need to be met by both parties. 

These might include:

a. Due diligence: This involves scrutinizing the startup's financial health, legal compliance, and business operations to assess its viability and potential risks.

b. Obtaining necessary approvals: The deal may require approval from the startup's board of directors and, in some cases, its shareholders. Additionally, depending on the industry or the size of the investment, regulatory approvals from relevant authorities might be necessary.

15. Term sheet exclusivity (Optional):

This section is not included in all term sheets. If present, it grants the investor exclusive negotiation rights for a set period. This means the startup cannot negotiate with other potential investors during that time. Exclusivity can be beneficial for the startup if it allows them to focus on finalizing the deal with a single investor. However, it's important to ensure the exclusivity period is reasonable and doesn't hinder the startup's ability to secure funding.

What makes a dirty term sheet?

A clean term sheet is one that's considered fair and balanced for both the investor and the startup while a dirty term sheet is unfair and unbalanced.

Here's what makes a term sheet "dirty":

1. Loss of founder control

a. 2-2-1 Board structure: A term sheet that proposes a 2-2-1 board structure with an independent member could be a red flag. In this scenario, with two founders, two investors, and a neutral party, founders lose voting control of the company. This can significantly impact their ability to make key decisions and even lead to situations where they are voted out of their own company.

b. Approval rights: Look out for provisions requiring investor approval for critical decisions like hiring/firing the CEO, setting the annual marketing budget, or pivoting the business model to a new market. These limitations can restrict your agility and ability to adapt to changing market conditions.

2. Non-standard economic terms ("dirty terms")

a. High liquidation preference: A liquidation preference greater than 1x means the investor gets more than its investment back first in case of a sale. For example, a 2x liquidation preference allows the investor to recoup $2 for every $1 they invested before any remaining funds are distributed to founders or other shareholders. This can significantly limit the potential returns for founders and other shareholders, even in a successful exit.

b. Participating preferred stock: This allows the investor to "double dip" by getting their money back plus a share of the remaining proceeds upon exit. 

Imagine the investor invests $1 million at a $10 million pre-money valuation. If the company is later acquired for $100 million, the investor would get their $1 million back due to liquidation preference) and still keep its 10% ownership of the remaining $99 million ($100 million acquisition price minus $1 million returned to investor). This translates to a $9.9 million gain + recouped investment of $1 million.

Whereas with non-participating preferred stock, the investor's net gain would only be $9 million (10% of $100 million = $10 million) - $1 million (initial investment).

c. Cumulative dividends: A term sheet with 8% cumulative dividends means the investor's liquidation preference increases by 8% every year if the company doesn't get acquired or go public. This makes it harder for founders and employees to see any value until a significant exit, as the investor's payout increases over time.

d. Warrant coverage: This term grants the investor warrants, which are essentially options to purchase additional shares of the company's stock at a predetermined price.

Imagine a term sheet that includes 1x warrant coverage. This means for every $1 the investor invests, they also receive warrants (options to buy shares) for an additional $1 worth of stock at the same valuation. This essentially increases the investor's ownership percentage without requiring them to put in more money upfront.

3. Other red flags

a. Veto power over future funding: Avoid terms that give the investor veto power over future funding rounds. This can restrict your ability to raise capital and grow the company. Imagine a term sheet that allows the investor to veto any funding round where the new investors get better terms than they did. This could limit your options for securing funding in the future.

How to negotiate a better investor term sheet

Negotiating a investor term sheet is a crucial step in securing funding for your startup. Here are some key strategies to help you negotiate a better term sheet that is fair for both you and the investor:

1. Preparation is key

a. Know your market: Research standard terms for your industry and funding stage. This equips you to identify potential "dirty terms" and negotiate from a position of knowledge.

b. Understand the term sheet: Don't be afraid to ask questions and seek clarification on anything you don't understand. There are many resources available online or through lawyers specializing in venture investing to help you understand the legalese.

c. Set realistic expectations: investors are in business to make money, so complete alignment is unlikely. However, understanding their priorities allows you to find common ground.

2. Negotiate key provisions

a. Valuation: This is a critical factor determining the amount of ownership you give up. Research comparable companies to estimate a fair valuation for your startup. Be prepared to justify your valuation with data and projections.

b. Board structure: Aim for a board that balances the interests of both founders and investors. A 2-1 founder-friendly structure gives you more control, while a 2-2-1 structure with an independent member offers investors more oversight. Negotiate a structure that allows for decision-making while protecting your vision for the company.

c. Liquidation preference: This dictates how much the investor gets back before founders in an acquisition. A standard preference is 1x, but some might propose higher. Negotiate a reasonable preference that protects the investor's investment without excessively diluting your potential returns.

d. Other economic terms: Be wary of provisions like participating preferred stock, cumulative dividends, or high warrant coverage. Understand how these terms impact your potential returns and negotiate for founder-friendly terms where possible.

e. Anti-dilution provisions: These protect the investor's ownership percentage if the founder issues new shares at a lower price in future funding rounds. Negotiate for reasonable anti-dilution provisions.

3. Negotiation tips

a. Be collaborative, not confrontational: Frame the negotiation as a partnership where both parties aim for a mutually beneficial outcome.

b. Focus on the big picture: Don't get hung up on minor details. Prioritize the terms most critical to your long-term success.

c. Be prepared to walk away: Don't be afraid to reject a term sheet that is not favorable. There may be other investors willing to offer better terms.

d. Consider professional help: A lawyer specializing in venture deals can be invaluable in understanding complex terms, negotiating effectively, and protecting your interests.

Are term sheets legally binding?

No, term sheets are typically not legally binding. They function as a preliminary agreement, outlining the key terms of a potential investment deal between a startup and a investor. However, despite not being formal contracts, they do hold some weight. Once signed, both parties are expected to act in good faith and negotiate towards a final, legally binding agreement.

Understanding a term sheet's enforceability:

a. Not contracts: Term sheets lack the legal clout of formal contracts. Simply having a signed term sheet doesn't create a legal obligation to complete the deal.

b. Express intent: However, certain provisions within a term sheet can be legally binding. These might include clauses related to:

  • Confidentiality: Protecting sensitive information disclosed during negotiations.
  • Exclusivity: Preventing either party from exploring other investment options for a set timeframe.
  • Good faith efforts: A commitment from both sides to negotiate a final agreement in good faith.

How long does it take to close a term sheet?

The time it takes to close a term sheet can vary significantly depending on the type of financing you're pursuing and the complexity of the deal. Here's a breakdown of closing timelines for different funding instruments:

1. Forward equity instruments (SAFEs, ASAs)

Designed for simplicity and speed, these instruments can be closed within a few days to a week. Since they convert into equity later, the terms are typically more standardized, requiring less negotiation.

2. Debt instruments (Convertible notes)

Convertible notes add a layer of complexity to forward equity by introducing elements like interest rates and maturity dates. This additional complexity usually translates to a closing time frame of 1-2 weeks. Lawyers might need to spend more time ensuring these terms are clearly defined and protect both parties.

Read more about convertible notes.

3. Equity rounds

This is the most time-consuming option, with a typical range of 3-5 weeks for closing. Equity rounds involve immediate issuance of ownership stakes in your company, so the terms are more intricate and require careful consideration. This can lead to more back-and-forth negotiation between you and the investor, potentially extending the timeline.

The above ranges provide estimates, and the actual time can vary considerably.

Factors affecting closing speed

Several factors can influence the closing timeline:

1. Number of negotiation rounds: Ideally, you want to avoid excessive back-and-forth. Experienced founders typically aim for no more than two rounds of negotiation for a seed round, with later stages potentially involving more complex discussions.

2. Documentation workload: Every revision of the agreements requires effort from both sides and increases legal fees. Streamlining the process by collecting input from all stakeholders upfront can minimize unnecessary iterations.

Tips for a speedy closing

Here are some tips to expedite the closing process:

1. Experienced founders take charge: Prepare an initial draft of the agreements and give the lead investor(s) 4-10 days for review.

2. Efficient negotiation: Schedule a meeting to discuss feedback and circulate updated drafts within 2-3 days.

3. Respect for investor time: Remember, investors manage multiple companies. While it's important to maintain progress, avoid being overly aggressive. Delays can happen, and a good investor partner will be working towards closing just as much as you are.

Term sheets are stepping stones towards securing vital investment for your startup. Understanding the common provisions, potential pitfalls, and negotiation strategies will empower you to approach the process with confidence. Remember, it's a collaborative effort. By aiming for a fair term sheet that aligns with the investor's interests while protecting your own, you can lay the foundation for a successful partnership that fuels your startup's growth.

Once you raise funds, another thing you will have to start thinking about is cap table and options management for your stakeholders, check out EquityList's dashboard for the same.