The term sheet is a concise, usually non-binding agreement that outlines all major terms of a funding round or exit. It is the first step of formal deal negotiations and it can be initiated by either party: the company, the lead investor or a group of investors. Key terms are the valuation and all value drivers, but also the special rights of investors and basic deal closing procedures.
Due to the non-binding nature of most term sheets, they come in all shapes and forms. They should always be seen in context to your specific negotiation. The goal of a term sheet is to find consensus on the main terms of a transaction. That’s it. In fact you might not even bother to sign it because, well, its not binding anyways.
Afterwards, still follow substantial part of especially the non-commercial side of the due diligence process. That is followed by drafting of the binding deal agreements and fulfilling all administrative deal requirements. While a term sheet is between 1 and 10 pages, the final deal agreement will be closer to 30-50 pages plus all the approvals and resolutions. This work will require some negotiation around the details, hence you should always keep timing in mind. Drafting your term sheet is only the first step of making a deal happen!
The Purpose of Term Sheets in a Startup Deal Closing
A fund raise or sale of a startup usually follows in a few predictable stages. They can be outlined as follows:
- Term Sheet
- Due Diligence
- Drafting of Binding Deal Agreements
- Completion (= signing and fulfilling all agreed prerequisites)
The entire process usually takes 3-9 months and speed depends on a host of factors. How professional or bureaucratic are all parties? Do sudden changes happen to the business, the market or the economy? Any unforeseen management changes on the investor side (especially if you are dealing with large strategic investors)? So one major factor to get any deal done is TIME.
One should always keep in mind how fast time goes by in deal negotiations. Even if you are running the hottest new startup, dealing with the most well regarded investors, there is always something unexpected coming up and at some point your deal falls through and you are left without runway.
Hence the term sheet! The term sheet really does build a bridge from pitch to deal closing. Its not binding and its terms might receive some polishing before deal completion, but it signals commitment. It does get you a great deal closer to signature-ready final deal agreements. For that reason always keep its true purpose in mind. If you can’t agree on something less important fast, maybe just postpone that discussion for the deal agreement drafting phase. Or, if you know the other side will flip-flop, be a bit more precise with your wordings upfront.
But never forget: Until you got money on your bank account everything can fall through.
What comes after the Term Sheet?
As mentioned, the term sheet is a bridge between pitch and deal closing. After the term sheet comes drafting the final deal agreements.
So what deal agreements are we actually talking about? Well depending on jurisdiction (and habits of your lawyer) the agreements would look like something below:
Deal Agreements of a Fund Raise:
- Shareholders agreement (either new or as a deed of amendment to the old one, if existent)
- Share subscription agreement (may be combined with the shareholders agreement)
- Approvals (agreements for director and each shareholders based on existing voting rights)
- Documentation needed in regards to Conditions Precedent (if applicable)
Deal Agreements of a Company Sale/Exit:
- Share Purchase Agreement
- Approvals (usually for all director and shareholder approvals, either combined or by individual party)
- Documentation needed in regards to Conditions Precedent (if applicable)
Just looking at the lists of documents required, its obvious these documents will take much longer to produce than a term sheet. Hence again the need to watch the time. Also just to populate all these with the right names and sending them to the signing parties, takes a considerable amount of time.
Main Terms of a Startup Term Sheet
The term sheet as mentioned can be between 1-10 pages depending on your various parties’ preferences and negotiation styles. Even a confidentiality clause can take up half a page, if you care about the details. Style wise, either you format everything into paragraphs or go with the also quite common table format. Both is fine, just keep the audience in mind. The term sheet definitely is going to be read by the decision makers while the final agreements are more closely read by the lawyers. Your investor might be some wealthy individual who is doing her first investment and isn’t too familiar with startup term sheets. In that case readability helps a lot. This is why there is a trend to short, to the point term sheets. A table format can definitely help with that.
Below is a detailed list of the main sections of a term sheet. More detailed explanations on the most important and complex sections can be found here.
Sample Term Sheet Sources
While you can engage a lawyer for drafting term sheets, you can very much make use of free templates found online. The reason is that term sheets are not binding anyways and many clauses follow common business practices. When searching for a template you will generally want to focus on reputation of the source and relevance to your deal. In addition there can be differences among the various startup ecosystems. Below we list a couple good sources to start your research.
Y-Combinator is the most well regarded startup incubator in the world with hundreds of alumni companies. Some of the most famous unicorns went through the program so any templates they put out will likely have been used extensively in deal negotiations. What we like about their term sheet is its conciseness: Essentially 1 page without leaving anything out. Unless you know your investor will renegotiate a lot later on, this is a great term sheet to use. You can find it here.
Things to Avoid when Negotiating a Term Sheet
Redemption Rights/Put Options
Redemption rights, also known as put options, allow their holder to “sell back” their shares to the company for a predetermined price. The advantage to an investor is that they now always got an exit option even if the company never gets to a real exit.
The argument that an investor would bring up to justify a put is the high risk and illiquidity. Startup investments are highly uncertain and selling their shares is very difficult. Besides the limited market there are all the selling restrictions of the shareholder agreements themselves. Hence, investors might say to the founder things like “I don’t even know, if you want to sell the company even if it gets successful”. Or: “My fund’s investment time horizon is 3 years so I need to have an exit guarantee by then”.
All of this is of course highly toxic. It creates significant asymmetry of interests among shareholders. But most importantly it is very dangerous for the cash flows of the company. Think of when an investor would exercise their put? Of course when the company is failing! That means right at the time when all cash is needed. Plus, startups often don’t have significant cash revenues early on. So the investor funds are a very substantial part of total funds available. Of course there can be lots of variations to puts. Especially regarding timing and whether there will be a built in guaranteed return.
Investors will of course try to frame their put as harmless and as a risk management tool. But depending on how this right is structured it can become a total deal breaker. It might be so detrimental that you might as well choose not to waste your time on your startup the next few years and declare bankruptcy right now. Or at least take a much worse valuation from another investor with better general terms.
A call option is a shareholder’s right to buy more shares of your company at a predetermined strike price for a predetermined exercise period. It essentially allows your investor to buy more shares later at a cheap price.
You investor will say: “I like your company so much, I want to support your company further in the future”. That’s sweet of him, but it’s a huge value you are giving to the investor. If your company performs well, it will be easy to raise funds and the valuation will go up. Your investor then will exercise his option at a potentially much lower price than what your shares are worth now. And if your company doesn’t perform well, your investor won’t be forced to invest by a call option.
For the founder and the company it is much better to not accept call options at all. Depending on the conditions however they could be acceptable. At least much more so than redemption rights or put options. The reason being, even if you have to sell shares at a not optimal price, you at least get more investment. Puts, as discussed above, can get you close to bankruptcy in a worst case scenario.
Tranches are installment payments of investments. If your investor wants to split his investment in several tranches, it means you will get the money over various predetermined payments. While sounding reasonable at first glance, this should be definitely avoided and is also not that common among professional investors.
The reason for requesting tranches is that the investor would like to reduce his cash risk. The tranches can be triggered by metric milestones or simply by reaching a predetermined date. Both arrangements should be avoided. This is because it is incredibly difficult to set reasonable metric targets, and swaying off your targets can immediately send your company into bankruptcy.
Remember how even a fast fund raise takes 3-6 months? Given a typical runway for the funds from one round is only 12-18 months, splitting this runway into several tranches will mean you will be totally out of options to get money from somewhere else, if one tranche doesn’t get paid on time. Even if tranches are triggered solely by deadlines: You still don’t know if your investor himself will run out of money by the time the tranche is due.
Furthermore, the party paying money always has an upper hand in legal disputes. Should there be what ever dissent among investor and startup, the investor can simply refuse to pay and wait for the startup to go bankrupt before it can launch a meaningful lawsuit. That means, no matter what is written in the documents, the investor can withdraw its commitment to invest relatively easily.
Finally, even if all tranches work out perfectly, what is the difference to re-investing at each tranche timing? The investor gets the same reduced risk of a lower initial cash outlay, but he also gets a way cheaper valuation. If he would invest lets say once every six month the price of shares would likely go up.
So definitely avoid tranches as much as you can as there are just downsides. And if you accept them at least negotiate for an escrow arrangement to ensure the investor is actually capable of payment.
Random Fees and Consulting Agreements
As a first time founder you need to be very cautious reading a term sheet. Its certainly exciting to finally get that document valuing your hard work at likely millions of dollars. However, share price is not the only thing that determines value. There are many clauses that determine payouts and on the face of it look harmless.
Investors love to sneak fees for fund raising or consulting services in to term sheets. E.g. “Investors earn a 5% commission if they help you find your next round investor”. While innocent sounding, it is really quite an unreasonable gift to them.
- First of all, if you got a decent startup you will make connections with investors naturally.
- Secondly, your investors are already benefiting from next round’s valuation increase. They are already benefiting directly from increasing values of their own shares!
- Thirdly, they will give you their contacts even without that commission anyways, because of point 2 above.
One exception to this is, if you had someone helping you finding that first or lead investor. Its not uncommon to provide a commission in cases where substantial help was provided. What we are warning about are all kinds of extra fees or consulting commissions that suddenly find themselves in your shiny new term sheet.
Unusual Board Structures (multiple seats per round, MD)
When an investor provides you with a large amount of money it is common that the largest investor of a funding round gets a board seat. The reasoning is as a director you get to sit directly at the table when the main decisions are made. Furthermore you get a more direct access to operational and business information. Its a reasonable safeguard and founders usually can even learn a fair bit from such a setup.
One however needs to be careful, if things get a little “unusual”. Starting out usually each founder has a board seat. Once the investors join the table, the lead investor of each round usually gets a board seat. Obviously as you raise more rounds this approach can get out of hand quickly. You don’t want too large boards and once you have more investors than founders on the board, you are loosing significant control even if you own the majority of shares. And if board seats are contractually guaranteed to certain investors you can’t even get rid of them with a shareholders vote (depending on jurisdiction).
A good number of board members is 3-5, with the majority of directors not being investors. As your company matures this could mean 2 investor directors, 2 founder directors and 1 external unrelated industry expert. That additional person can help striking a balance and bringing in new perspectives.
Tips for Drafting Startup Term Sheets
Calculate Value Scenarios
Term sheets are full of clauses that determine value aside from the actual valuation paragraph. It is really impossible to know the full implications of a term sheet until you actually take the time, open Excel and calculate some scenarios for potential outcomes.
For both fund raise and exit term sheets, think of scenarios that can test the following sensitive clauses:
- Liquidation Preference: How will it impact the cash payout of an exit? Make a graph for various exit prices.
- Anti dilution protections: Will anybody receive extra shares at various valuations?
- Conversion of past convertible notes or preferred shares: How are ordinary share equivalents impacted?
- Outstanding options: Will they be in the money or lapse?
Use Price per Share and Pre-Money Values in Funding Rounds
When putting in a price into the term sheet of a fund raise, founders often think in terms of valuation. That is probably related to the fascination of big numbers. “I am raising US$5m in my Series A. My company will be worth US$20m then. Hence, lets put US$20m into the term sheet”.
If you know about pre- and post-money you will realize right away, the company itself is only worth US$15m (pre-money). The US$5m investment tops it off to US$20m. You might argue, well does the difference matter that much? Isn’t this just a terminology thing?
The problem with putting post-money valuations in a term sheet is what if the amount of money to be raised changes? Most likely it won’t decrease, but maybe it increases. If you can’t raise the full amount, you’ll likely not close the round at all. That’s because investors know you need the full amount for living up to you plans. But if the market likes your startup you might choose to increase a round to fund a bit more growth. So imagine you increase the round to US$6m. If the round was promised at US$20m post-money, your investors will say “decrease pre-money to US$14m”.
The better approach is to go by pre-money valuations and list out price per share directly in the term sheet. While more shares still mean more dilution, it’s less than if you would have to reduce your pre-Money valuation. Also your price per share stays unchanged.
Long vs. Short Term Sheets
One question that always arises is how long should a term sheet be. As the term sheet is typically non-binding and only meant to get a common ground on the main terms, one might argue to keep the term sheet as short as possible. The flip-side is more potential for renegotiation during the drafting of the binding agreements.
For example, if you anticipate the investor is very familiar with startup deals, a relatively short term sheet could really speed up the deal. Your objective should be to get into deal closing mode ASAP.
In contrast, if you anticipate the investor might haggle a lot or be unpredictable, being a little more precise up front can save you time later on. That is because the wordings in a term sheet are much closer to plain English, while in the binding documents you can so easily get hung up around individual words. Also, you can actually negotiate a term sheet without a lawyer (remember, not binding!?). In contrast, if you are working on a Series A or any more substantial deal, you will likely have at minimum two negotiating parties (if not multiple large investors) plus at least two law firms all talking in circles about the details. Hence, deciding up-front at what deal value the Drag Along triggers can be as easy as a side-note at a coffee meeting. Later on it can be a week of expensive lawyer e-mails.
An example for an extremely short term-sheet is the one proposed by Y-Combinator, probably the leading incubator in the world. Look how individual standard clauses, such as stock restrictions are just named. It acknowledges that professional investors won’t bother to go into to lengthy negotiation games in those areas anyways.
Should you get a Lawyer for a Term Sheet?
Now that is a good question: Should you get a lawyer for your term sheet? While you should always engage your own legal counsel and make up your own mind, our honest recommendation is that you can negotiate term sheets yourself, if you UNDERSTAND the various terms and their language.
The reason being, as long as the term sheet somewhere says “non-binding” individual wordings don’t matter as much. Also you can correct some mistakes in the final deal agreements. Of course you shouldn’t use this a get out of jail card and renegotiate everything 2 months down the road. That will likely kill your deal.
That said, if you are unsure, you should be sure that you need a lawyer.
Receiving your first term sheet is one of the highlights of any Founder’s startup journey. Somebody believes in your business so much they are actually considering investing money into it. And that’s exactly what a term sheet represents: They are CONSIDERING investing.
Hence you need to strike a balance between getting your value, protecting yourself and to hurrying up! Its only the beginning of the deal closing process. You don’t want to be stuck negotiating over details that can be revisited by the lawyers in the final legal agreements. That is especially true when dealing with large (corporate) investors, who have plenty of internal process to go through for every new discussion point you bring up. Likewise, having enough detail in your term sheet will keep even inexperienced investors focused and not have you loose momentum. The name of the game is money in the bank.
This guide is not intended to and does not constitute legal or tax advice, recommendations, mediation or counseling under any circumstance. This guide and your use thereof does not create an attorney-client relationship with Startupvaluationschool.com or Ed.Pres Limited. The guide solely represents the thoughts of the author and is neither endorsed by nor does it necessarily reflect Ed.Pres Limited’s belief. Ed.Pres Limited does not warrant or guarantee the accurateness, completeness, adequacy or currency of the information in the guide. You should seek the advice of a competent attorney or accountant licensed to practice in your jurisdiction for advice on your particular problem.
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