What are term sheets for startups and VCs?

What are term sheets for startups and VCs?

What are term sheets and how can they help both startups and VCs?

 

A Complete Beginner's Guide to VC Term Sheets - Funding Note
Term sheets. (via Fundingnote)

When seeking financial or legal advice from a startup advisor, you may be asked to spend time drawing up a 'term sheet'. Perhaps you yourself are in the Venture Capital industry and have been approached with a term sheet when looking to use capital to fund enterprises. But what actually is a term sheet, and how can one be used to help both VCs and business owners to scale up a startup?

What are term sheets?


In order to understand how term sheets are important for both startups/venture-backed companies and Venture Capitalists (VCs) you must first understand the term.

Term sheets are a form of nonbinding agreement which highlight both the general points and key terms and conditions of an investment agreement or business transaction. Since they are not a binding agreement, they hold no legal weight and do not constrain any common shareholders or investors to any deal terms. They are only to outline the intent of the proposed transaction and it should be made clear in the term sheet that it is not a legally-binding document, such as in the image below.

 

A Standard and Clean Series a Term Sheet: Fundraising, Fundraising Docs,  Series A | Y Combinator
What are term sheets? (via Y Combinator)

 

Additionally, since term sheets give a general overview of the agreement, all involved parties can efficiently read the basic terms and decide whether or not they are in agreement with the points made. If all parties give the go-ahead and agree on the ultimate goal of their business transaction, they can then be used as a template for creating thorough legal documents.

If any party would like to re-evaluate certain rights or key terms, then term sheet negotiations may be held. However, if all parties have already agreed to the conditions laid out on a term sheet, then it may be difficult to renegotiate afterwards, even though they were not legally bound by the term sheet itself. This is because any renegotiations could negatively impact the business relationship and it may not be possible to ultimately come to a definitive agreement. When possible, always seek legal advice before drawing up a term sheet or even seek the help of experts in fundraising sources of startup capital.

Term sheets should ideally serve to benefit all parties and find the middle ground between them both. Nevertheless, studies measuring term sheet trends have shown that they often do favour one side over the other, such as term sheets in 2019 demonstrating more favourable key terms for startup owners than in previous years. Furthermore, new trends and key terms often arise due to events in the finance industry, such as drag-along agreements becoming more commonly seen in term sheets after the economic downturn of 2001-2003. This means that it could be worth keeping your finger on the pulse of industry trends and affairs before drawing up your own term sheet.

Where are term sheets used?

A chart that shows in which common transactions in the venture capital industry term sheets are used.
Where are term sheets used? (via Enterslice)

Term sheets are commonplace in many aspects of the finance industry, so can therefore be used in many types of transactions. This is why term sheets are so important to understand. Common transactions where term sheets are used include:


  • mergers and acquisitions,
  • seed funding agreements,
  • acquisition agreements,
  • due diligence,
  • and loan agreements.


A list of key terms in a term sheet for startups and VCs
Term sheets. (via World Commerce & Contracting)

What should a startup's term sheet contain?

Term sheets can contain a wide variety of information and no two term sheets will look the same. However, a sample term sheet may include four key categories:

 

  1. deal economics,
  2. investor rights and protection,
  3. governance management and control,
  4. and exits and liquidity.

 

These categories may then, for example, include the following term agreements and information:

 

  • the company valuation (including pre-money valuation, post-money valuation, and price per share),
  • liquidation preference,
  • pre-emptive rights,
  • investor rights (such as co-sale rights, tag-along rights, and drag-along rights),
  • investment amount,
  • anti-dilution provision,
  • sharing rights (such as whether a B class share or preferred shares will be used. This will then impact other aspects such as voting rights and equity),
  • percentage stake,
  • investor commitment and board rights,
  • asset information,
  • and a purchase price (along with preferred payment method and any related contingencies).

 

Term sheets may also include a capitalisation table. A capitalisation table, or 'cap table' as they are often called, is an efficient way to communicate the equity ownership of all stakeholders and their value, so therefore contains information a potential investor would be interested in. A basic cap table may look like the one below.

 

cap table
What should a startup's term sheet contain? (via Seraf-Investor)

Term sheets may stipulate terms that will not be included in the definitive agreement and may also outline the key terms each party considers a basic requirement. Transaction-specific disclosures should also be included here. Term sheets may also include a standard 'no shop' clause, which dictates for how long the startup owner may not shop around for other potential investors.

It is worth noting, however, that including too much detail may make the investment process slower and hinder any legal agreements, so it's important to ensure that a healthy balance between a detailed and ambiguous term sheet is found. It is therefore crucial that they are coherent and concise. Overall, a well-planned and structured term sheet should serve as the groundwork for the legally-binding document that follows.


Agreeing on a term sheet
Term sheets are not legally binding but they can provide the skeleton of a future legal agreement.

 

How can term sheets help both VCs and a startup company?

Now you know what term sheets are, it would be helpful to know how they can positively impact all parties involved in a transaction. There are three main reasons why term sheets are so important for both startup owners and Venture Capitalists.


  1. Firstly, for startup owners, term sheets are an important part of the process of scaling up your startup company because they summarise your deal terms with potential investors, such as Venture Capital Financing companies, so that everyone can be on the same page before a definitive agreement in the form of a legal agreement can be made. By attracting investors with the capital to fund startups, term sheets are considered highly useful in both the Venture Capital Industry and the startup industry. They are an important way of finding sources of startup capital and failure to do so is one of the most common reasons why startup businesses fail.


  1. Secondly, business consultants for startups may recommend term sheets as they are a great way to ensure neither party begins the investment relationship on bad terms and that no money is spent on drawing up a legal agreement before the deal terms have been agreed. This is useful for both startup owners and VCs because it can help prevent a good business deal turning sour.


  1. Thirdly, term sheets allow all involved parties to make a judgement of the other. They help you understand what it is the other party is looking for and can help give you a sense of the other's personality. This, alongside the previous point, gives you better chances of a positive and healthy business rapport with the other party. Term sheets can therefore help startup owners attract the right investor and VCs find the best match for their venture deals.


Signing a definitive agreement
Term sheets are useful for both startups founders and investors.

 

Conclusion

Term sheets are often used in Venture Capital financing to lay out the proposed key terms of a potential business relationship. They are not legal or definitive documents but rather a nonbinding agreement that should concisely communicate investment intentions of both a business owner and an investor. Term sheets are closely associated with startups and are an efficient way for owners to find startup investments, such as capital funding from VCs. As such, they are often recommended by experts in the industry, such as venture capital consulting firms or a startup consultant.

Amit Khanna, 7startup Founder

Amit has 18 years of experience in the industry and an MBA. He supports entrepreneurs with every aspect of their business including concept and product development, investor presentations, and fundraising.



Tags: Startup funding, venture capital, scaleups, fundraising, pitch deck review, OKRs, why do startups fail, equity research, term sheets