What is a Startup Term Sheet and how to read it?

Finding investors and funding is a very crucial step while launching a startup. After an attractive pitch deck, a term sheet may be the next step to finalizing your funding.

A term sheet is an important part of creating the contract regarding your funding. Here in this article, we will cover everything about startup term sheets.

Index:

What is a startup term sheet?

A term sheet is the first formal but nonbinding document between the founder and an investor. It is an outline of the key terms and conditions which are to be written in the contract. It serves as a basis or a template for the more detailed, legally binding contract. Usually, after a term sheet is made, you agree to confidentiality and do not enter into negotiations with other investors at that time. A good term sheet enlists the interests of both the investors and the founders. The two primary issues covered in a term sheet is:

Economic matters: matters related to funding and liquidation of the startup.
Control of the company: matters pertaining to issues about the corporate governance of the company.

What are the features of a term sheet?

The features of a term sheet are:

A written document presented in a bullet point format
Non-binding by nature
Is subject to modifications after negotiations

Acts as a blueprint for the final document
Prepared before the final agreement
Usually acts as a sign of confidentiality

Why is a startup term sheet important?

A term sheet is the basis of the investment contract and thus is crucial for the finance of a company. Thus, it is important for the following reasons:

Brings the focus of both the Parties on essential commercial matters at an early stage.
Enables them to clarify confusion and incomprehension regarding the agreement

Defines the key legal principles, thus, framing the transaction’s documentation in the correct way.
Allows the parties to fulfill the conditions of the agreement before the final contract is made.
It defines the due process from gaining funds to generating revenue.

It reflects the concern of both the parties regarding the agreement and how it should be written in the contract.

What are the main components of a term sheet?

Company details, the names of founders and investors
The money the company aims to raise

Amount of investment
What happens if the company faces liquidation
Information on the use of funds

Limits on founder’s activities
Valuation of the company
Percentage stake

Anti-dilutive provisions
Investor commitment
Shares and price

Rights to future investment
Other requirements and regulations
Non-disclosure requirements

Signatures

What are the pros and cons of making a term sheet?

PROs:

Non-binding:

It is a nonbinding agreement between both parties. Thus you can create a term sheet for clarification of expectations and not be at any risk legally.

Clarify expectations:

It contains all the terms and conditions that are necessary to be avoided by both parties. So by writing a term sheet you can rule out areas of dispute and negotiate regarding those particular matters. It clarifies the expectation of both the parties and the octopus that must be overcome to finalize the deal

Commitment:

Even if it’s not binding signing a term sheet is a sign of commitment for both parties and it feels like the deal is almost finalized.

Avoid misunderstanding:

It includes all the terms and conditions regarding the deal. Thus, it eradicates any misunderstanding which turns out to be detrimental later.

CONs:

Expensive:

A term sheet is created with the help of professionals. The more complex your agreement is, the more expensive your term sheet may turn out to be.

Unintended legal consequences:

You may face unindented legal consequences if you accidentally include a binding clause in the term sheet.

Dispute due to minor reasons:

As the term sheet contains all the major and minor points in detail, sometimes one of the parties may get stuck on one of the minor details and rule out the major things.

Leverage:

Sometimes, the unsaid words are held out as leverage. In a term sheet, all the details are written out and thus any leverage that any party had is lost.

How to read a term sheet?

When you open a term sheet for the first time, the various complex terms and phrases may get your mind reeling. Having a good knowledge of the turns and having a good lawyer may take you a long way. Moreover, one of the biggest mistakes that entrepreneurs make is that they negotiate well in verbal agreement with the investors and then leave the gory legal details with the lawyers. Thus, to help you familiarise yourself with the terms and clauses in the term sheet, we are here. Term sheets have these basic sections:

The Core Terms

Firstly it contains information about who is investing, how much amount they are investing, and how many hours do they expect to get in return. Besides that where there are a few more things that are included in the section. They are as follows:

Target amount: here is included how much money you aim to raise.
Price per share: this is figured out after having extensive negotiation regarding the valuation of your company.

Pre-money valuation: this is the valuation of the startup before the investor and money into the company.
Option pool: This is a pool of the company’s stock set aside to award talented employees.

Preferred investor rights:

This section is focused on protecting the investor in various future situations. Key terms here include:

Liquidation Preference: This states who gets the money back first in case a liquidation event (merger, shutting down, sale) occurs.
Anti-dilution provision: This term ensures fairness for the investors in case the next round of investors gets a lower price per share than them.

Pay to play: The investors are encouraged to invest in the next round as well. If they don’t, their preferred share is converted to common shares.

Terms giving the VC board members and shareholders additional powers:

This is the most critical part of a term sheet containing the additional powers of the VC board members.

List of the board of directors: This contains the people who are on board after the deal closes. The investor too has one of their people on your board.
Protective provisions: List of things you can not do without the board’s permission anymore.
Matters requiring investor director approval: These things need the permission of not only the boards but also the approval of the investor’s board member.

Board matters: This puts the new board member on the committee and states that all the board members need director and officers’ insurance.

Registration rights:

By virtue of these rights, the investors may force the company to register its shares with SEC. Without SEC registration the company cannot go public. Nevertheless, this is a non-negotiable section.

Terms that are binding even if the financing isn’t completed:

Although most of the terms are non-binding if the actual financing falls apart, there are a few exceptions:

No shop: The company agrees not to seek other deals for the next four weeks else they may be charged by the investors.

Confidentiality: The terms are supposed to be kept secret (with the exception of the founders’ lawyers/financing people/board) unless the investors give permission to announce them.
Expenses: The company agrees to cover all legal and miscellaneous expenses that occur while negotiating this deal even if the deal doesn’t go through unless the investors walk away without a good reason. The company also needs to pay for the Companies and investors’ Counsel.

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