A term sheet marks the beginning of a potentially long relationship between investor and company. Accepting the terms is a major commitment with long-term repercussions. In the words of our CEO Russ Heddleston, “Getting your first term sheet involves a lot of processes: It takes a lot of pitching and building the right relationship with your investor. If you get married, you can get divorced. But if you take a round of financing, you can’t break up with that investor—you’re in it to win it with them.”
With so much on the line, it’s essential to carefully review, understand, and evaluate a term sheet.
What is a term sheet?
A term sheet is a document that outlines the financial terms of an investment offer. Angel investors, VCs, and other investors typically present their terms to a company’s founders after a successful pitch meeting. The founders must then decide whether to accept the terms or make a counteroffer.
Term sheets are non-binding unless otherwise specified in the document. For early seed rounds and Series A funding rounds, term sheets are often just a single page with summaries of the terms of the investment agreement. If both parties agree to what’s proposed there, then the term sheet is the template that legal teams will use to draft a binding agreement, which may be 100 pages or more.
While not legally binding, the term sheet agreement is difficult to rescind once both parties accept it. Trying to renegotiate or rescind terms once you’ve agreed on them will likely derail an investment, often permanently.
Common elements of a term sheet
While most investors are well versed in the strategy and terminology behind a term sheet, new founders may be less familiar. Here are some of the common provisions you can expect to see:
Perhaps the most exciting element of a term sheet is the company valuation. This is what most founders will look at first. The investor’s assessment of how much your company is worth is typically divided into two sections: pre-money and post-money. The pre-money figure is how much they believe your company is worth as it is today. The post-money valuation is the pre-money number plus the amount of money the investor has agreed to contribute.
A high valuation is exciting, but don’t blindly accept an overly optimistic valuation. Contrary to popular belief, your fundraising amount doesn’t guarantee success. If you aren’t able to meet expectations, an overvaluation can cause major problems during your next round of fundraising. Only accept a fair valuation that accurately reflects your company’s development and potential.
Board of director provisions
If you’re raising Series A funding, investors may dictate that you establish an official board of directors if you have not already. The board’s job will be to oversee the management of the company and protect the interests of the shareholders. As part of their terms, investors will want to claim one or more board seats. Be very wary of provisions that give majority control to anyone but the founders. During early investment stages, the founders should maintain majority control of the board and company.
“Major Investor” rights
Typically, the lead investor and any other significant investors listed by name on the term sheet can be designated Major Investors, meaning that they can receive certain rights beyond those of general stockholders. Rights typically include pro rata rights (participation rights) and information rights, but they can also include the right of first refusal, co-sale rights and more. The more Major Investors involved, the harder it is to negotiate decisions for the future of the company.
An option pool is a percentage of the company that doesn’t belong to you or the investors. Instead, it is set aside for enticing future employees to the company. Term sheets usually set the option pool terms at 10-25% of the pre-investment evaluation of the company. The higher the designated option pool, the greater it dilutes the ownership of the founder and early investors.
Investors may put in liquidation preference stipulations as a form of risk management to ensure that they get a return on their investment even if the company goes under. In the event that the company is sold or liquidated, liquidation preference is the right of the investor to receive a specified amount of money (a multiple of their original investment) before common stockholders (the founder and employees) are paid out. In early fundraising, this multiple is usually 1x, meaning the investors would just get their original investment back.
Investors don’t want companies to leverage their term sheets in order to get a better deal elsewhere, so they will often institute an exclusivity period, during which the company cannot court other investors. Thirty days is standard, although investors will occasionally stipulate up to 60 days. Beware of an exclusivity period that is longer than that or of a term sheet that doesn’t set a time limit at all.
For a more in-depth primer on term sheet stipulations and negotiation tactics, check out Atrium’s Term Sheet Negotiation Whitepaper.
Expert tips for evaluating your first term sheet
Term sheets are one of the final steps in the fundraising process. You’ve already won over the investor, and now you must decide whether to accept their conditions for funding. Though you don’t want to put your new relationship with an investor in jeopardy, you must put your company’s best interests first.
Evaluating a high-stakes deal can be extremely overwhelming for first-time founders. As DocSend CEO, Russ has encountered many term sheets while guiding the company through seed funding, a round of venture debt, and Series A funding. In a Q&A with Atrium, he shared some of his top tips for approaching your first term sheet.
Define your priorities
Before you even speak to investors, sit down and sketch out your dream financing. Ask yourself some questions:
- What do I estimate a realistic valuation for my company should be?
- How important is it for me to maintain control of my business? How much control am I willing to give up?
- What sort of terms would I love to see?
- What are serious dealbreakers for me?
You may not get everything you want, but establishing your priorities ahead of time puts you in a better position to evaluate an offer when it does come in.
Ask for help
Smart entrepreneurs know when to ask for expert advice. Once you’ve received a term sheet offer, reach out to a trusted adviser or attorney who is well versed in term sheets to walk you through the conditions.
Russ recommends having an attorney look at the term sheet before you agree to anything. “It’s really beneficial to you and your fundraising efforts to get your attorney involved early on,” he said. “First-time founders often have this feeling that they need to respond right away to the term sheet, with no time to involve their lawyer. But there’s always time—and your lawyer will help you walk through the process and better strategize.” You may be cash-strapped and reluctant to spend money on an expensive lawyer, but fully understanding your commitments now can save you a lot of money and effort in the future.
Term sheets contain sensitive information, so as you review them with vested parties, use secure file sharing instead of email attachments.
Evaluate the investor, not just the terms
You’re not just accepting money from your investors; you are also legally tying your company to them for the foreseeable future. So, in addition to evaluating the terms of the agreement, make sure the investor is someone you can work with.
The term sheet itself can give you clues to what a working relationship with an investor will look like. Russ warns, “People often overfocus on the general terms, such as the valuation and the amount raised…you know, getting the TechCrunch headlines. But in my opinion, I care more about the cleanliness of the terms, how they define the working relationship with my investor, and the rights I get to keep as the entrepreneur.”
Certain red flags in a term sheet indicate that an investor might be too demanding, is trying to take control of your company, or simply doesn’t have your company’s best interests in mind. Be alert to the following:
- Harsh debt terms
- Terms that limit future fundraising
- A controlling stake that is too large
- Poor definition of timelines
Don’t be afraid to ask questions. A good investor will take the time to walk through the terms with you and address your concerns. If they are unable or unwilling to do that, it may be a sign that you need to rethink the relationship.
Know that a term sheet is not a done deal
Getting a term sheet is an exciting confirmation that an investor wants to be in business with you, but don’t get ahead of yourself. A term sheet is basically a letter of intent. The deal isn’t official until a legally binding final agreement has been signed by both parties. Don’t start spending money before you actually have it.
Take your time
Accepting a funding deal is one of the biggest decisions you will make for the future of your business, so take the time you need to make confident decisions. Understand the sheet fully, discuss it with third-party experts, and make sure you can live with the proposed arrangement. While most term sheets come with a deadline, investors will often extend it if you need more time to review the information. After all, they want to be in business with you, too.