Term Sheets: A Guide for Understanding the Basics

As a startup founder, understanding the intricacies of a term sheet is essential for navigating the fundraising process. A term sheet outlines the basic terms and conditions under which an investment will be made. Here’s a comprehensive guide to help you understand what a term sheet is, what it contains, and key considerations to keep in mind.

What is a Term Sheet?

A term sheet is a non-binding agreement that sets forth the terms and conditions of a potential investment. It serves as a blueprint for the final legal documents and helps both parties understand and agree on the key aspects of the deal before committing to a formal contract.

Who Drafts the Term Sheet?

Typically, the investor drafts the term sheet, although in some cases, particularly when multiple investors are involved, the lead investor may draft it. Founders should always review the term sheet carefully, ideally with the assistance of legal counsel, to ensure that the terms are favorable and clearly understood.

Key Components of a Term Sheet

  1. Valuation

    • Pre-Money Valuation: The valuation of the company before the new investment is added.

    • Post-Money Valuation: The valuation of the company after the investment has been added.

  2. Investment Amount

    • The total amount of money the investor is planning to invest in the company.

  3. Equity and Ownership

    • Shares Issued: The number of shares to be issued to the investor and the percentage of ownership those shares represent.

    • Capitalization Table: A summary of the company's ownership structure before and after the investment.

  4. Type of Security

    • Preferred Stock: Most common in venture investments, often comes with additional rights and privileges over common stock.

    • Convertible Notes: Debt that can convert into equity under certain conditions, often used in early-stage investments.

  5. Governance

    • Board Composition: The structure of the board of directors post-investment, including any new seats the investor may require.

    • Voting Rights: Details on voting power and any special voting rights for the new shares.

  6. Liquidation Preferences

    • Terms that dictate how proceeds from a sale or liquidation of the company will be distributed, often giving investors a preferential return on their investment before other shareholders.

  7. Anti-Dilution Provisions

    • Protections for investors against dilution of their ownership percentage in future financing rounds.

  8. Dividends

    • Information on any dividend policies, including whether dividends are cumulative or non-cumulative.

  9. Conversion Rights

    • Details on the conditions under which preferred shares can be converted into common shares.

  10. Exit Strategy

    • Right of First Refusal: Allows investors to have the first opportunity to purchase shares if a founder decides to sell.

    • Drag-Along Rights: Rights that allow majority shareholders to force minority shareholders to join in the sale of the company.

  11. Employee Stock Options

    • Provisions regarding the pool of shares reserved for employee stock options, including any expansion of this pool as part of the investment round.

Key Considerations for Founders

  1. Valuation and Ownership

    • Understand how the proposed valuation affects your ownership percentage and the company’s overall valuation.

  2. Control and Governance

    • Be aware of how board composition and voting rights could affect your control over the company’s decisions.

  3. Liquidation Preferences

    • Ensure you understand how liquidation preferences impact the distribution of proceeds in an exit scenario.

  4. Anti-Dilution

    • Review anti-dilution clauses to see how they might affect future fundraising rounds and your equity.

  5. Legal Counsel

    • Always engage a qualified attorney to review the term sheet and explain any terms or clauses you do not understand.

  6. Negotiation

    • Remember that a term sheet is negotiable. Don’t hesitate to discuss and negotiate terms that you believe could impact the future of your company.

Conclusion

A term sheet is a critical document in the investment process, setting the stage for the formal agreements that will follow. By understanding its components and key considerations, startup founders can better navigate the fundraising landscape, protect their interests, and set the stage for a successful partnership with investors. Always approach term sheets with diligence, clarity, and the support of experienced legal counsel.