The terms and conditions between an entrepreneur and an investor, as well as other important details, can all be found in a term sheet. This relationship between a startup entrepreneur and investors is a very crucial one. Regardless on which side of the table you sit, it’s important to fully layout the terms and conditions of the investment before any type of commitment is made.
This post is a step-by-step guide to prepare a term sheet. We start by identifying what a term sheet contains, the purpose, and the basis for the terms and conditions. Much of this content will surround the financial aspects of an investment in a startup company.
In this article, we will break down this written document which outlines all terms of the deal between the entrepreneur(s) and investor(s). Whether you’re the entrepreneur or the investor, it’s important to review and fully understand the conditions of the term sheet. Likewise, it’s even more important to know how to prepare it, the part of the process that many fail to understand.
What is a Term Sheet?
Think of a term sheet as a contract between the startup founder and the investor. More or less it’s like a marriage between the two, the only difference, it’s usually non-binding. The only time it is considered “legally binding” is if that is agreed in the term sheet itself. This is the case when founders are restricted from making additional negotiations for a period of time.
All terms and conditions involved in the investment are included in a term sheet including:
- How much money is expected from the VC, or venture capitalist, to the founder of the startup,
- A detailed overview of the financial side of the investment, and
- The power and controls given to the VCs.
The term sheet “details what you as the start-up are giving, and what you are getting in return. Then it lays out the guidelines of how both parties will act to protect the investment.” Source: Forbes
In addition to the investment side of the term sheet, details are also discussed such as:
- The closing date of the deal between the founder and investor,
- The starting value of the company, and
- Certain provisions, to name a few.
These are also considered to be the first step of any form of transaction between the two parties involved.
A term sheet is provided by the investor for the founder of the company to look over and read through.
Once all the terms and conditions have been understood and all negotiations have been agreed upon, both parties will sign off on the document. This signifies that both parties’ needs have been clearly addressed in the term sheet.
The Purpose of a Term Sheet
The term sheet is a negotiation document. It is the first formal step towards moving forward with an angel investment deal, it’s extremely important that all conditions and terms of the deal are explained clearly throughout the document. Once these details have been negotiated and signed off on, a final, legally binding contract can be written up.
This contract will then serve as the legal document to which both parties have fully agreed to a final investment.
Having a proper and clearly written term sheet that addresses the interests of both parties is important in order for everyone to be on the same page.
A term sheet that is poorly written, does the complete opposite and could create problems down the road.
Basically, a bad term sheet could cause miscommunication between the founder of the company and the investors and possibly, create points of conflict between the two.
A good term sheet will have the elements previously mentioned and lack the elements that should be avoided such as:
- Redemption rights,
- Excess unnecessary fees, and
- Several other aspects that will be mentioned later on in this article.
Furthermore, this is where knowing how to understand a term sheet comes in handy.
Whether you’re the founder of a startup or the one investing in a company, it’s important to understand, from both sides, what a term sheet is and the purpose it serves.
Overall, the purpose of a term sheet is to serve as a layout, or better yet, a blueprint for the legally binding contract to follow once an agreement has been made.
Angel Investing and Term Sheets
A term sheet is essentially like a prenuptial agreement between two parties, the founder and the investor. With that in mind, it’s equally as important to understand the relationship between a term sheet and the realms of angel investing and venture capital investing.
There is a slight difference that exists between the two.
Over the years, angel investing has taken on several different meanings.
Originally, the term “angel investor” referred to a wealthy individual who funded theatrical productions in a bid to save them from shutting down.
As of today, the term carries a much different meaning and refers to wealthy individuals who invest in startup businesses. In exchange for this investment, the investor is given ownership equity in the startup. The terms of this exchange are then identified and outlined in a term sheet.
Unlike venture capital investors, who invest pooled funds that have been managed by a committee of investors, angel investors invest their own money, often earned through past entrepreneurial ventures.
If you’ve ever watched the very popular show, “Shark Tank,” you’ve seen a prime example of how angel investing works.
The “sharks,” a group of wealthy entrepreneurs and investors, listen to the sales pitch of a startup entrepreneur. Once the investors have listened to this sale pitch, if interested, one, or several of them, will either accept the offer or request a higher percentage of ownership equity in the company in exchange for the amount of money they’re investing.
What is Included in a Term Sheet?
Generally speaking, a good term sheet consists of anywhere between 15 to 25 pages of content detailing the terms and conditions of the investment and exchange of ownership equity. If you’re not familiar with term sheets as a whole, the contents may seem a bit overwhelming at first due to the vastness of all that’s involved.
No need to worry. A term sheet is a vast document, but with a bit of reading and familiarizing yourself with the terms, you’ll know how to prepare a term sheet in no time! Similar to an outline template, you would follow for standard documents such as a research essay, resume, cover letter, or thesis, the same applies to a term sheet.
Most standard term sheets, with a few exceptions, all follow the same type of outline.
Essential details such as:
- The target company,
- The starting value of the company, and
- The investors involved in the exchange should always be included in any term sheet.
In addition to these, other important details in a term sheet include, but are not limited to:
- Common shares as well as B class and preferred shares (if applicable)
- The core terms which include all financial aspects of the investment, including the:
- Capitalization table,
- Stock options, and
- Percentage of ownership
- Confidentiality agreement
- Post-money value of the company
- Liquidation preference
In addition to knowing what to include in a term sheet, knowing the different types of term sheets that exist is also important.
An angel investment term sheet is the primary topic at hand; however, a venture capital and seed investor term sheet also exist.
Angel investment terms sheets tend to be less standardized and not as strictly detailed.
How to Prepare a Term Sheet
Preparing a term sheet is not a task that is exclusively completed by the investor or the founder.
Preparation is more or less a collective effort, however, there are investors who prepare the term sheet in the absence of a startup founder. There is no specific party that prepares an angel investment term sheet, either party can prepare it.
Because understanding the provisions of a term sheet is by far the most important thing to consider before signing off on anything, having them on hand as well as any other information to be included, will make preparing the term sheet less of a daunting task.
Sure, you could simply go online, download a term sheet template that has all the bells and whistles outlined, and fill in the gaps to make it your own, but what fun would that be?
By knowing how to prepare a term sheet, you will have first-hand experience with all that is involved in the process and therefore, understand it more.
The steps listed below take into consideration the interests of the angel (investor) and the startup founder, and therefore, are aspects of the term sheet that either party should follow when preparing a term sheet.
Identify the Purpose of the Term Sheet Agreements
In identifying the purpose of the term sheet, you will need to list:
- What it is for,
- The target company at the center of any of the term sheet negotiations, as well as
- The date on which the term sheet is to be completed.
This is considered the simple task at hand in starting a term sheet, but there are a few more tasks to be completed in this step.
Identifying the purpose of the term sheet is not only limited to those tasks previously mentioned, but this step should also involve compiling any information required for the next steps of preparing the term sheet.
- What are some of the key terms that should be prioritized for negotiation when discussing the term sheet?
- What type of investment deal is to be discussed in the term sheet?
- Is this type of term sheet for the sale/acquisition of a business, the preferred stock financing of a company, or whatever purpose is appropriate?
These are some of the questions you can try to answer in order to identify the purpose of the term sheet.
Even you aren’t able to fully answer these questions, you can at least gain an idea, or some perspective of what terms should be addressed in the document before it’s finalized.
Briefly Summarize the Terms and Conditions
The very first section of a term sheet is a brief paragraph that explains the principal terms and conditions that will be summarized in the document.
In this paragraph, you should list:
- The target company for which the terms summarized will address,
- Whether the term sheet is binding or non-binding, as well as
- Who the buyer or buyers are.
Likewise, it should be stated that the terms discussed in the term sheet are not a commitment of any kind to invest, if “non-binding,” and any type of commitment depends solely on the closing of the conditions explained in the document.
Depending on the specifics of the term sheet, i.e., the purpose of the document and the type of investment/sale involved, the summary may go to include more details referring to additional matters involved.
List the Offering Terms
Following the summary of the term sheet, is none other than the offering terms.
In this section of the document, the majority of the matters listed below are addressed:
- Closing date and conditions to closing
- The issuer of the document (the founder of the startup)
- Amount of the offering, including the price per share
- Investors involved
- Pre-money valuation
Generally speaking, this section of the document is concerned with addressing the offerings on the table, so to speak. This too is another detailed part of a term sheet where the basic aspects of the negotiation will be outlined.
The closing date refers to the date on which an agreement, to the terms and conditions of the document, between both parties has been made. There is not just one specific closing date referred to, but multiple dates. At a minimum, it must include a certain date by which an agreement must be made.
When listing the investors involved in this non-binding agreement, it is optional to list:
- The type of share,
- The percentage of the share, and
- The money offered for the share by each investor in the offering terms.
In simpler terms, the amount of the offering from the investors would be listed together. This could also include the price per each share.
Last, but not least of the offering terms that will need to be listed, are the securities and pre-money valuation.
The securities refer to the type of share that has been purchased by the investor and could go to include:
- A Class A share,
- Class B shares,
- Preferred shares,
- Common and preferred stocks, and
- Warrants, to name a few.
The valuation refers to the percentage ownership.
This is simply the company’s pre-money valuation plus the amount of money from investors, which then equals the percentage of ownership for the incoming investors into the company.
Include Dividends, Liquidation Preference, and Provisions
The listing of the dividends should follow the offering terms once they’ve been established.
Dividends are profits disbursed amongst the shareholders in a company. Once distributed, the value of the dividends slowly accrues over time and can be distributed in either stock or cash form.
The main types of dividends typically discussed include:
- Non-cumulative—the rightful owner of a dividend is determined by the Board of Directors of the company each fiscal year
- Cumulative—though not very common for the initial startup of a company, a cumulative dividend works in favor of the investors involved in the deal
- Anti-dilution—this refers to the rights by which preferred stockholders are protected in the event that the company’s valuation decreases. Two further anti-dilution rights are full-ratchet and weighted average. The weighted average right is the more preferred of the two by stockholders.
The liquidation preference refers to the protection in place should something go wrong as far as any preferred stock goes.
“Generally, liquidation preferences would be equal to the amount invested. However, at times, it would be a multiple of the amount invested.” Source: WallStreetMojo
For instance, say your startup experiences a bit of hardship in the beginning of the process and ends up failing completely. Having this in place would allow investors the possibility of receiving a portion of their investment back.
As far as provisions go, those are simply the rights in place should something not go according to the plan, and the company itself, as well as the money of the investors is at risk.
In this case, protective plans are put in place in the term sheet and should address what is to be returned to investors if the company value decreases.
Identify the Participation Rights
When it comes to participation rights, think of them as rights that protect investors should they require the return of their share or investment in the company.
Similar to liquidation preferences, the participation rights give investors the opportunity to get a return on their investment before all other individuals involved in the deal.
In addition to this return, investors receive a percentage of what’s left from the return, should no one else be present to claim their portion of the return.
With this protection, investors get the opportunity to fully participate in the startup without the risk of losing the majority of or all of their invested money.
“Also known as ‘double dipping,’ participation rights let preferred stockholders get their money back before anyone else, and then also participate fully.” Source: Shareworks
The participation rights section is typically one area of a term sheet both parties may struggle with coming to an agreement on. This is mainly due to the fact that investors are typically in favor of the participation rights, for obvious reasons, however, founders tend to not be in favor of them, also for obvious reasons.
Participation rights are also included in the same pool with an option pool, no pun intended! Both aspects of a term sheet are not required but are necessary in order to protect either or both parties. Participation rights aren’t considered standard because they aren’t favored by founders, but if included, there should be a cap on the return amount.
Create a Board of Directors
Having a Board of Directors may not seem like a priority for a startup company, however contrary to common belief, this is far from the truth.
As a newly founded company begins to grow, over time, the power will begin to shift from the sole founder and into the hands of those who help manage the company.
“The board is a crucial governing body in any company, and term sheets will often include provisions on how it will be structured and who will control critical board votes. In many ways, the board is the most important control mechanism of the typical VC-backed company.” Source: Shareworks
For this reason and many others, it’s important to include a Board of Directors in a term sheet, even in the absence of an actual Board of Directors.
Even if the company has a sole founder, having this idea in place will help to envision the future growth of the company.
It’s okay if you don’t have a full list of people to name. In this case, it would be appropriate to list an independent member of the board. This could include someone familiar to both parties such as the founders and the investors.
End with the Voting Agreement and Other Matters
Closer to the end of the document the following should be listed:
- Board and founder matters,
- The option pool, and
- The share purchase agreement.
Board and founder matters could include voting agreements, the selection of board members, and more.
In the case of an important matter having to do with the future of the company, a voting protocol and agreement should be in place. This would also include matters requiring investor/director approval, as mentioned above.
The option pool of a term sheet refers to the amount of stock strictly reserved for current and future employees of the company. Having an option pool agreement outlined in a term sheet is not only important, it’s quite necessary for many reasons.
One reason is that in addition to the stock being reserved, how the stock gets issued is also a matter of importance.
If you already have an option pool handy, you may simply need to use a term sheet to improve and expand upon it.
Furthermore, an option pool is necessary, though it is not required. For this reason, some founders and investors choose to leave this part of the deal out in fear of valuation becoming manipulated.
Things to Consider Before Finalizing the Document
Once the document has been fully prepared, you should read over the terms and conditions and keep an eye out for any information that seems unclear or that may cause confusion for both parties.
This could include mistakes in defining the number of shares held by investors, as well as the percentage of each share owned.
A term sheet, though a non-binding agreement, does require a certain amount of detail.
Remember, although it is a non-binding agreement with some legal aspects involved, it is the first step in moving towards the production of a legally binding contract between an investor and a founder.
In addition to rereading the terms and conditions, you should also consider avoiding some of the common mistakes made in preparing a term sheet.
The document should only include matters necessary to negotiations and agreements to be made, any unnecessary fees and information should not be included.
They could end up causing a rift over unnecessary matters if they are included.
Likewise, redemption rights are also a section you should avoid including in the document. Redemption rights slightly differ from participation rights in that they allow the investors the right to request their money back should the company experience hardship or fail completely.
Finalizing the Document for Signatures
Once the document is ready to be finalized, you can go on to prepare the term sheet for signatures and the date on which the agreement between both parties is to be executed.
After a final read through, you should determine that a term sheet has been fully prepared is ready to be finalized.
Preparing a Term Sheet with the Help of a Template
Preparing a term sheet without the help of some form of a template is best reserved for professionals. And even then, there are professionals who prepare term sheets with the help of an outline or template that has been partially completed.
As you work to prepare your term sheet by using a template, however, you should diligently make sure that any and all information in the term sheet has to do specifically with the parties involved.
This means that sensitive information such as specific numbers and percentages will have to be included, and the sections of the term sheet template may need to be adjusted to accommodate those figures.
For an example of a sample term sheet template, click here. To find more templates and outlines, simply do a quick search online!