Term Sheet Guide for Startup Founders

Learn everything you need to know about term sheets when fundraising for your startup.

Raising capital as a startup founder involves tons of negotiations and finding common ground with investors. One key element of such a process is a term sheet. It’s a preliminary agreement that adds structure to the negotiations between you and an investor as it describes the terms of a potential investment deal. After reading this guide, you will understand the key elements of a term sheet, what to keep an eye on when fundraising, and how to streamline the process of due diligence and deal-making.

What’s a Term Sheet?

A term sheet is a document used during the process of startup fundraising between founders and potential investors. It lists the essential conditions and terms of a proposed investment. A term sheet is a crucial element that simplifies the negotiation process and provides the foundation for an official deal and a legal agreement to be reached.

The purpose of a term sheet is to provide a structured framework for investment negotiations. It sets the stage for discussions around the key terms of an investment, including valuation, investment amount, and terms under which the capital will be exchanged for equity. A well-crafted term sheet paired with an easily accessible company's cap table can speed up the process of due diligence and deal-making (something that will be covered later on in this guide).

When is a Term Sheet Legally Binding?

Term sheets imply serious interest but are not legally binding. Understanding this can save you from costly legal disputes and broken deals in the future. A term sheet provides flexibility and allows for negotiations to take place without fear of being sued in case the negotiations break down. Such a lack of commitment can create more uncertainty and result in wasted resources if no agreement is reached.

However, a term sheet serves the purpose of creating legally binding agreements once you agree on the terms of the investment deal. At the same time, a term sheet will be considered enforceable once it lists the terms of the investment and "unambiguously provides that ‘[t]he Parties intend to be legally bound to [the] transaction once [the] Term Sheet is mutually executed'".

Term Sheet vs LOI

Both documents, a term sheet and a letter of intent (LOI), highlight the details of a potential investment deal in your startup. The closing rate of signed term sheets is 90%+. A term sheet is a document that goes in-depth over the key elements of a potential agreement. However, as we saw already, it’s typically a non-binding agreement.

A letter of intent (LOI) is a document that presents a preliminary interest in a particular investment. It signals a commitment and expresses the intention of negotiating a business transaction with another party. A letter of intent is typically non-binding and provides a general overview of the deal. The closing rate of a LOI is lower as parties begin detailed negotiations and engage in due diligence afterwards to advance the deal.

Essential Components of a Term Sheet

Here is an overview and explanation of the main components of a term sheet you will need to understand and negotiate:

  • Valuation and Ownership: Your startup's valuation (either pre-money or post-money) is one of the most critical elements that will have to be negotiated. The equity ownership that will be given to an investor will directly depend on the valuation you agree on.
  • Investment Amount: The investment amount is used to actually calculate the equity to be given. The term sheet should specify the capital that will be invested and the corresponding round (Seed, Series A, etc.)
  • ESOP Pool: Oftentimes, investors require you to launch employee equity compensation programs as a part of the deal. That means you will be required to create and allocate shares of your company to be distributed among the beneficiaries of such a compensation program.
  • Liquidation Preferences: This section should outline the priority in which the startup’s assets will be allocated in the event of a liquidation event such as a sale or an acquisition.
  • Voting Rights: Voting rights detail the decision-making power of investors in the startup's operations. Founders should be aware of the extent of control they may be relinquishing to investors.
  • Board Representation: Investors can get a seat on the board of directors. The term sheet can present the composition of the startup’s board and imply whether the particular investor will get a seat once they become a shareholder.
  • Anti-dilution Provisions: These provisions protect investors from potential dilution of their ownership percentage in the event of future fundraising rounds at lower valuations. You should carefully review the anti-dilution clauses to understand their implications for future financing.
  • Vesting Schedules: A term sheet can specify the vesting schedules of founders and key members of the team. Reverse vesting is common among startup founders. Investors often request that founders commit by following a reverse vesting schedule.
  • Rights of Preferred Shares: Preferred shares that an investor is expected to receive can have provisions such as dividend preferences. Those need to be reviewed carefully to determine their impact on your company’s financial situation.
  • Exit Strategy and Liquidity: The term sheet may outline an exit strategy that would describe how an investor can make a return. This can provide an overview of a long-term company strategy that can have an impact on the decision-making of both parties.

Term Sheet Negotiations and Deal-making

The negotiation process will most likely demand a lot from you. It’s important to be prepared to devote time, energy, and resources to the cause. Here are some suggestions and things to keep in mind when embarking on the journey of raising capital for your company:

  • Focus on key terms: With a lot of elements on a term sheet, it’s important to pick your battles. One of the most impactful elements is the company’s valuation. Given its power, the negotiations tend to be the longest around it. In his book “Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist”, Brad Feld says: "As you'll learn, there really are only two key things that matter in the actual term sheet negotiation—economics and control."
  • Finding common ground: Investment negotiations will require finding mutually beneficial opportunities and compromising. Therefore, approaching the negotiations from such a perspective will allow both of you to find solutions faster and more effectively.
  • Leverage the leverage: Once you receive a term sheet from an investor, you can leverage it to generate interest from others. Here is a great post explaining the ‘leverage the leverage' concept a bit.
  • Maintaining good relationships: Building strong and positive relationships with investors in advance and throughout the whole process can drastically improve the deal itself and the outcome of such a partnership in the long run.
  • Transparency and communication: Honesty and transparency during the negotiation process are vital. Founders should clearly communicate their vision, goals, and concerns to investors to avoid misunderstandings in the future. Again, it comes down to building trust and relationships with investors and partners.

Painful Mistakes to Avoid in Term Sheet Negotiations

  • Giving away too much equity: While raising funds is crucial, founders must strike a balance between attracting investors and retaining enough ownership to maintain control over their startup. “Investor support is going to be worth a lot more than any extra ownership you get from a bad investor.” says Brett Fox, the former CEO of Touchstone Semiconductor.
  • Rushing into a deal: Term sheet negotiations take time and careful consideration. Rushing into deals without fully understanding the terms can result in regrettable outcomes (financially, business-wise, and, as a result, psychologically and health-wise for founders).
  • Overlooking investor reputation: Doing your homework and looking into investors’ current investments, past activities, and reputation in the industry can prevent you from entering into partnerships that won’t serve you in the long term. Make sure to check their LinkedIn profile, contact founders who worked with this investor. “A bad relationship with your investors is the one relationship that is almost impossible for you to recover from.”

Due Diligence and Closing the Deal

Conducting due diligence on potential investors is critical. Founders should verify the investor's track record, reputation, and compatibility with the startup's values and vision. At the same time, investors and their teams will perform their own due diligence on you. 

Having a virtual data room and an accessible cap table can greatly improve the experience from the perspective of investors. In that way, you can increase your chances of impressing them while also being able to organize the process of sharing key documents and cap table data easily. With Capboard, you can have the best of both worlds and leverage a document management system directly connected to your up-to-date cap table inside of one software. This way, you will be able to share sensitive information about your company securely.

Virtual data room when fundraising

Moreover, having legal counsel throughout the negotiations, due diligence, and closing process can safeguard the interests of both founders and investors. So once both parties are satisfied with the negotiated terms, the term sheet becomes a blueprint for the subsequent legal agreements and the closing of the investment deal.

Cap Table Implications

Many say that startup fundraising is a full-time job: finding investors, preparing pitch decks, negotiating the terms, doing the due diligence, and actually closing the deal. The process is lengthy, and there is no guarantee that it will play out the way you want it to. Having access to the right tools can greatly simplify the process and make it more manageable and efficient. Which, in turn, can increase your chances of a successful raise.

Once the deal is set and the money is transferred, one of the biggest things you will need to do is update your cap table. Bringing your cap table up to date will allow you to visualize the current ownership post-round and see the equity dilution of existing shareholders. In addition to that, if the deal involves creating or increasing your ESOP pool, a digital cap table should be a no-brainer for you or anyone responsible.

Cap table example

Streamline your Fundraising with Capboard

There is no better feeling than knowing you have the capital and resources to make your vision a reality. Fundraising can be a lengthy and demanding process. But the whole experience can be optimized and streamlined once you have the tools. Join thousands of founders using Capboard to help them in their fundraising and beyond. Begin your journey with Capboard here.

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