What is a term sheet?

by Adarsh Raj Bhatt in
person wearing black coat close-up photography

TLDR

  • One of the most significant documents you will ever sign is the term sheet. This document, which outlines the terms and conditions of your deal with investors, is a non-binding contract
  • The term sheet includes information such as the startup's valuation, investment amount, percentage stake, liquidation preference, and voting rights.
  • The term sheet is about distributing the upside and risk among the parties that invest in your startup. There are a variety of clauses that can be used to achieve this. Every scenario is unique, but knowing these provisions is a good starting point towards making the right decision.
  • This document is also an important opportunity to determine who your investor is. You can get a clear idea of where they stand depending on what they advocate for and what they don't.

What is a Term Sheet?

man sitting beside woman looking at a contract on DocuSign

A term sheet is a non-binding agreement that outlines the fundamental requirements for making an investment. It is used as a reference point for designing more comprehensive, legally binding documents.

An arrangement or contract that adheres to the conditions of the term sheet will be formulated after the parties involved have reached an agreement on the details laid out in the term sheet. In this manner, the term sheet effectively provides a framework for determining that the parties involved in a commercial transaction agree on the most crucial aspects of the deal (and to what extent they do so), reducing the risk of misunderstandings and needless lawsuits later on. 

Term sheets also guarantee that the costly legal fees associated with drafting a binding contract or agreement are not incurred prematurely.  

Certain basic elements are included in all term sheets, such as details about the parties' identities, the preferred mode of payments, and valuation. It also contains information about all of the assets concerned, as well as the initial purchase price (along with any contingencies that could influence that price), a response time frame, and all other necessary records. 

The initial offer of the purchase price, preferred means of payment, and assets included in the deal are usually included in a term sheet used as part of a merger or attempted acquisition. It will also provide specifics about what, if anything, is omitted from the deal, as well as any requirements that one or both parties may have.

How Does a Term Sheet Work?

pile of printing papers

The term sheet is a document that outlines the terms and conditions of both the investment and collateral. It outlines what you, as a startup, are offering and receiving in return. The document then sets out the rules for how both sides will act to protect the investment. 

Term sheets will differ based on the sort of funding round you're in, the amount of money at stake, and who's involved. Seed rounds will usually have much simpler and shorter-term sheets than those of series A and onward. The less at stake, the less complicated term sheets are. When using a third-party funding portal, the procedure can be greatly streamlined. 

Founders desire investors who’re committed primarily to the business (as opposed to personal financial gain) - and vice versa. The term sheet should provide for a win-win scenario for both parties. The general rule is that each round of financing would result in a dilution of about 15 - 20%. You don't want to exceed that range.

A term sheet without signatures is neither a commitment nor an executed deal. It's crucial to do due diligence such as looking at past annual and quarterly financial information, reviewing sales and gross profits by product, and looking up the rates of return before signing a term sheet.

Benefits of a Term Sheet

woman signing on white printer paper beside woman about to touch the documents

#1: Non-Binding Nature

Term sheets are typically non-binding, meaning you can prove that you're sincere about executing the deal without getting locked in or risking too much too soon. With that said, if you think that binding obligations would be more beneficial during negotiations, then you have the option of including them in the term sheet.

#2: Clarity and Details

A term sheet specifies the different terms and conditions of a contract that all sides have agreed to in theory. 

You could identify points of contention or disagreement and focus the negotiations on those specific areas by drawing up a term sheet. Therefore, the term sheet will help to explain goals and recognize barriers that must be addressed in order to make the deal a true success.

#3: Introducing Stability to the Deal

Even if the term sheet may not include any legally binding commitments, merely signing it will make both sides feel far more committed to the contract. Term sheets include a moral obligation to live up to the promise, which may serve to settle - and add stability to - an otherwise unstable deal.

Limitations of a Term Sheet

man writing on paper

#1: Expenses Incurred

Creating an appropriate term sheet typically necessitates extensive planning, competent negotiating, and overall cognitive load. 

This is not a free service. Writing a term sheet can be pricey based on the complexity of the transaction, to say nothing of the valuable “founder time” invested in writing and negotiating an advantageous term sheet.

#2: Unexpected Legal Consequences

Incorporating a term sheet into the agreement could result in unexpected legal consequences. 

For instance, based on the wording of the term sheet and the circumstances of your contract, you might unintentionally establish a contractual obligation to negotiate in good faith or agree to other inadvertently binding provisions included within the term sheet.

#3: Compromising your Negotiating Position

In a business deal, it's really the things that aren't said that give you the most control. 

You might be displaying your cards and thereby compromising your negotiation position by including a term sheet. Even when there are no legally binding conditions, going back on terms (even for legitimate reasons) that were agreed to in the term sheet during the negotiating process could prove detrimental to your reputation.

Despite these limitations, most startups and investors prefer to get a term sheet made prior to solidifying investments.

What is the Difference Between an LOI and a Term Sheet?

Term sheets and letters of intent are somewhat similar. Both documents set down the terms of a deal that two or more parties intend to make. A letter of intent is written in the form of a letter, while a term sheet is most commonly a list of the key elements of the expected deal or arrangement.

Here's an example of a term sheet.

Term sheets are analogous to "letters of intent" (LOI) in that they are both preliminary and non-binding agreements used to register the expectations of two or more parties before entering into a potential arrangement based on specified (but unfinished or preliminary) terms. 

An LOI is usually written in letter form and reflects on the participants' intentions; a term sheet skips much of the formalities and lists the terms of the deal in a bullet-point or equivalent style. The implication is that an LOI is an agreed-to document. On the other hand, a term sheet may be a proposal rather than a legally binding text.

The LOI is often commonly used by sophisticated parties in broader, more complicated transactions. The LOI is like the Term Sheet, but it will describe the terms of the transaction in greater detail. Parts of the LOI, such as Confidentiality and Exclusivity, can be legally binding, in contrast to the Term Sheet. After an LOI is completely executed, due diligence and securing funding become more serious, and attorneys begin preparing the APA.

Venture Capital Term Sheet

The venture capital term sheet would include all of the main facets of the funding - including economic considerations like the business's valuation; control issues such as the composition of the Board of Directors and the owners' consent or "veto" rights; and post-closing equity rights, such as the right to join the board. 

Usually, the term sheet would claim that it is non-binding, with the exception of such clauses as no shop and exclusivity. Even though it is not legally binding, the term sheet is perhaps the most relevant paper to discuss with investors because it addresses nearly all of the issues that matter, leaving minor issues to be addressed in the financing documents that follow. 

The term sheet should be seen as the roadmap for an entrepreneur's partnership with his or her investor(s), and it should therefore be given careful consideration. Finally, having a long-form detailed term sheet that can alleviate potential issues in the definitive document drafting stage, is typically preferable for both investors and entrepreneurs.

Who provides the term sheet to a Venture Capital Fund?

A VC term sheet is a concise paper that an investor produces for presentation to a company, in which the investor notes - among other things - the amount of money that he/she is prepared to invest in the company. Typically, this document is 5-8 pages long. 

A "term sheet" drafted by the venture capital firm and delivered to the entrepreneur records the majority of venture capital financings. The term sheet is critical because it shows that the venture capital firm is adamant about making an investment and wants to complete due diligence to file definitive legal investment papers. In fact, many VC entities would have received permission from their investment committee before issuing term sheets. 

While term sheets do not guarantee that a contract will be executed, we have observed that a high percentage of negotiated and signed term sheets result in completed financings.

Term Sheet Template

Source

For more templates and examples of term sheets, check these out! 

  1. 47 Simple Term Sheet Templates
  2. Free Term Sheet Templates
  3. Term Sheet Template: What Entrepreneurs Should Include

Convertible Note Term Sheet

A Convertible Note term sheet is a clear, non-binding document that specifies the formal terms of the agreement between an investor and a company concerning the issuance of a convertible note.

In the negotiation stage, creating a Convertible Note Term Sheet aids communication between the founder(s) and the investor(s). Since a Convertible Note Term Sheet is not legally enforceable, the parties must enforce a Convertible Note Subscription Agreement or Convertible Note Instrument to document the binding terms in their entirety. 

The convertible note funding term sheet is released in conjunction with a startup company's seed financing. A convertible note is a loan by a lender to a firm that turns to shares when the company receives preferred stock funding that satisfies certain criteria. Practical advice, drafting notices, alternative clauses, and optional clauses are all included in the term sheet. 

Seed-stage funding is used by startups to secure operating capital for a span of 12 to 24 months as they develop their product and test the demand. Among the most common instruments used to introduce seed-stage funding is a convertible note. In cases where provisions are fluid in the marketplace, the terms of the note listed in this term sheet are typically marked, with a preference for being borrower-friendly.

Series A Term Sheet

man in brown jacket looking at contract on DocuSign on a laptop

The Series A term sheet will act as a guideline for future funding rounds

It aids shareholders in comprehending your advantageous clauses or even finding errors that could result in a lack/reduction of ownership or a poorer payout in the case of an acquisition. As a consequence, it determines things like: 

  • What you, as a startup, are offering
  • What you are receiving in return
  • Who will run the business; and 
  • Who will prosper the most if it is sold or if it goes public

Following are some of the key elements of a Series A term sheet:

Valuation

What is the pre-money valuation of the company that has been agreed upon?

Liquidation Rights

 If the business is dissolved or sold, who gets what and in what order?

Founder Vesting Period

When do the founders' shares become fully vested? Three or four years is a common vesting period.

Voting Rights

How much voting power will the investor have on business decisions like acquisitions or company sales?

Options Pool

How many shares will be put aside for potential hires, prospective buyers, etc. in the options pool? What effect does this have on the valuation?

Anti-dilution 

What anti-dilution provisions are in place? Anti-dilution clauses are available in most venture capital financing rounds, but those that are broad-based limit the founders.

Board of Directors Assignment

How much power will the investor gain by way of board seats? 2-3 seats are usual.

We can help!

At AbstractOps, we help early-stage founders streamline and automate regulatory and legal ops, HR, and finance so you can focus on what matters most.

If you're looking for help with your term sheet, drop us a note at hello@abstractops.com.

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Note: Our content is for general information purposes only. AbstractOps does not provide legal, accounting, or certified expert advice. Consult a lawyer, CPA, or other professional for such services.

References

  1. Startup funding: All you want to know about term sheets
  2. Term sheet template (angel or venture capital investors): Ontario startups
  3. The Ultimate Guide to the VC Term Sheet
  4. Series A Term Sheet Template
  5. byFounders' Guide to the Term Sheet
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