Term sheets are important negotiation tools for investors and founders. What exactly are they, why are they important, and what terms do they commonly include? To founders in the middle of fundraising, this article will go over some of the basics.
What Are Term Sheets?
Term sheets contain a list of the proposed terms and conditions of a specific investment or, more generally, the fundraising round. During negotiations, they can be supplied by either the investor or the founder. At this stage, they are non-binding, which means that they don’t impose actual legal obligations and can be revised on an ongoing basis by legal counsel representing the parties. Term sheets typically become binding upon the execution of subscription or purchase and sale agreements that contain the finalized clauses of the deal.
Why Are Term Sheets Important?
Term sheets are simple. They don’t exceed six to eight pages, even for the most complicated of investments. They are an easy way for investors and founders to discuss key terms of deals without having to go back and forth on wordy legal agreements. Term sheets are also phrased somewhat informally, avoiding the legalese of private placement memorandums or subscription agreements. By summarizing key terms in this way, term sheets help investors and founders get straight to the point on issues that are most critical to the transaction.
What Do Term Sheets Include?
Given how short they are, term sheets include quite a lot of information. The first page usually contains the following:
- The type and number of securities being offered
- The valuation of the company
- The price of each security sold
- The amount expected to be raised in the fundraising round
Founders should keep an eye out for the liquidation preference. Investors prefer higher liquidation preferences because they get a much higher payout upon a liquidity event, such as a sale or merger. Even if they own a sizeable stake in their companies founders can end up with close to nothing if investors take all the profits.
Investors may demand a number of other terms, including one or more board seat allocations, the installation of certain company policies, and rights to be attached to their preferred shares. These rights may include:
- Voting rights: the right to influence major decisions of the company, including to affect changes to the capitalization, management, and sale of the company
- Drag-along rights: the right to drag dissenting shareholders into selling the company
- Anti-dilution rights: the right to maintain a certain percentage of equity in the company, even in subsequent fundraising rounds when new investors come in
- First refusal and co-sale rights: if any existing shareholders of the company want to sell their shares to a third party, then the investors will have the right to purchase the shares that are being offered to the third on the same terms
- Registration and information rights: the right to access detailed reports of the company, including audited financial reports, quarterly and monthly financial reports, and annual budget and business plan
- Rights to participate in future financing: the right to invest in the company in subsequent fundraising rounds on a pro rata basis
Finally, founders should expect to provide information on their expected use of the proceeds, some expenses associated with the fundraising round, such as legal costs, and expectations of confidentiality with respect to the term sheet and the deal.
In a Nutshell
Early-stage founders whose fundraising efforts have paid off may find themselves having to navigate term sheets for the first time. Before they start negotiating with investors, they should have a good understanding of what’s commonly found in term sheets to be on a stronger footing during the negotiation process. Investors tend to have the upper hand not only because they are supplying the money, but also because they have more experience than founders in reading the fine print. Most investors have probably already seen tens, if not hundreds of term sheets. The terms and conditions that founders are reading for the first time? Investors probably know them already on the back of their hands.
That’s not to say that investors are evil in any sense. Investors have a stake in seeing the company succeed as well, and term sheets reflect their ideas on growth strategy. Founders should read between the lines to understand how this growth strategy aligns or conflicts what they already envision. At the end of the day, the relationship between investors and founders is like a dance; if the tango flows smoothly, then there could be rewards beyond imagination.
