What is a Term Sheet?

A term sheet is a nonbinding covenant articulating the fundamental intricacy governing an investment undertaking. This document, akin to a master template, lays the  for subsequent, more intricate legal instruments. Once the involved entities harmonize on the intricacies delineated within the term sheet, an obligatory accord or compact, aligning meticulously with the particulars of the term sheet, is meticulously drafted.

Key Features of a Term Sheet

• A term sheet is a nonbinding agreement outlining the basic terms and conditions under which an investment will be made.
• This dossier, predominantly relevant to entrepreneurial ventures, proves pivotal in enticing backers, particularly venture capitalists (VC), endowed with the financial resources to fuel nascent enterprises.
• The company valuation, investment amount, percentage stake, voting rights, liquidation preference, anti-dilutive provisions, and investor commitment are some items that should be spelled out in the term sheet.
• Beyond the startup landscape, term sheets extend their relevance to encompass mergers, acquisitions, and protracted financial obligations, exemplified by commercial real estate development endeavors.
• Term sheets are non-binding, though they may often require an upfront good faith deposit or other indicator of evidence that both parties intend to carry out an executed full agreement.

Why You Should Care About Term Sheets

The process of raising money for entrepreneurs has been demystified in recent years through both startup culture moving to the mainstream and more transparency being provided via various blogs and podcasts.

Yet, despite this, certain aspects of the fundraising process continue to be challenging for founders.  In my professional career, I frequently encounter anxious appeals for assistance from founders grappling with the intricacies of term sheets. In these instances, I have noticed that their discomfort arises from the legalese used therein or their insistence on specific clauses that are usually considered non-negotiable. In either case, they end up coming across as newbies, which is never a good impression to give and is highly detrimental in the context of fundraising.

Prepare Yourself for a Negotiation, Not a Ransom

Over the years, several efforts have been made to outline what a 'fair’' term sheet should look like. Even though I personally have reservations against specific clauses, Y Combinator's SAFE Financing Documents and NVCA's term sheet template are usually considered to be neutral for all intents and purposes.

In my experience, it is rare to see a term sheet full of aggressive terms that penalize the entrepreneur. Most investors know that alignment between founder and shareholder is pivotal for realizing a significant return on capital.

However, I don’t want to give the impression that the startup investment world is all hunky dory. At the end of the day, it is a business transaction where both parties are trying to maximize their returns. I have personally seen numerous cases where certain term sheet clauses can result in a founder unwittingly losing control or economics in their business.

Therefore, founders must familiarize themselves with these resources because, generally, investors are the ones who present the first draft of the term sheet. 

Term sheet examples: What’s included? 

A term sheet is a document that summarizes the main terms and conditions of a potential investment. It usually covers the following aspects:

• Party Details: This section states the parties involved, generally the investor, the startup, and the founders.  

• Preamble: It states the major points in a typical term sheet such as the non-binding statement of intent and that it cannot be construed as an offer but an expression of interest. 

• Valuation, Dilution, and Securities: This section defines how the startup's value is determined, how the new investment dilutes the existing shares, and what type of securities are issued to the investor.

• Economic & Participation Rights: This section describes the economic rights of the investor, such as the right to receive dividends, liquidation preferences, anti-dilution protection, etc. It also describes the participation rights of the investor, such as the right to participate in future rounds of financing, co-sale rights, etc.

• Control Rights: Investors, driven by the need to safeguard their interests and exert influence over strategic decisions, seek control rights. These rights encompass a spectrum, ranging from the ability to appoint board members to the exercise of veto rights and granting consent to crucial decisions.

• Conditions Before & After The Investment: Refers to the prerequisites of the deal that must be met both before and after an investment has been made.

• Information Rights: Investors, in their quest for transparency and oversight, require access to specific information. This includes financial statements, regulatory filings, and cap table details. These rights, far from being merely administrative, serve as a mechanism for investors to continually monitor the startup's performance and ensure adherence to regulatory compliance.
• Transfer Rights: These are the protocols for the transfer of securities by the shareholders. Transfer rights are split among investors, founders & key management roles and other stakeholders.

• Indemnities & Warranties: These are given by the company to the investors as an affirmation that the information and the documents given to them during due diligence are correct.  

• Cap table: The cap table is a visual representation of the shareholding structure of the startup, both pre and post-investment, serving as a crucial function of modeling investments' impact on shareholders. In intricate detail, it illustrates how equity is distributed among the various shareholders.

Term Sheet vs. Contract! 

In simple terms, term sheets are like a gentlemen’s agreement, outlining key terms without legal obligations. On the other hand, contracts are official, legally binding agreements. 

The term sheet acts as a preliminary guide, ensuring all parties are on the same page before diving into a formal contract. It's a way to prevent conflicts by confirming agreement on terms beforehand.