As a founder of a startup, at some point, you will likely find yourself in need of securing capital through an investor.
To come to an agreement with your investor(s), you will want to outline some specifics of who gets what in this deal which is where a term sheet comes in.
What is a Term Sheet?
A term sheet is essentially what it sounds like. It states the terms and conditions of an agreement between a startup and its interested investors. It is typically a non-binding contract between the two parties and can be treated as a negotiation document.
The term sheet clearly states what the interests are for the investment and summarizes the key points of your arrangement.
Once finalized, the sheet will serve as a basis for the forthcoming legal documents to go ahead with the investment. It is important to understand what is included to ensure your best interests are met in the term sheet.
Investors and Term Sheets
There are two types of investors that a startup can receive: angel investor or venture capitalists. Angel investors refer to wealthy individuals that invest their own money into startups, while venture capitalists, on the other hand, are typically firms or companies that use a managed fund to invest in multiple startups.
Depending on which type of investor you have, term sheets can vary and so can negotiations. Be aware of what the investor wants out of this deal and how they view the growth of your startup as that is going to shape the inclusions of your term sheet and potentially the direction of your business growth.
What is Included in a Term Sheet?
A term sheet can be very detailed and can span anywhere between 15-25 pages. Most term sheets follow a specific outline and at a minimum include the starting value of the company and the investors involved. We will go into more detail below on what information is typically included in a term sheet.
How to Prepare a Term Sheet
Typically preparing a term sheet is done by both the investor and the startup founder. To start, you will want to include these major categories.
Term Sheet Agreements
Terms and Conditions
- State all applicable parties in this section i.e. the startup and the investors.
- List the terms for binding vs. non-binding. These terms are typically not a commitment but rather what the agreement will be based upon if the investor does eventually fund your business.
List the Offering Terms
- Closing Date: This could be multiple dates. You want to include the date an agreement must be reached and then the date of the anticipated closing as well as any conditions to closing.
- Type and Prices of Securities: The types of shares that are being purchased by the investor i.e. preferred vs. common (Class A or B) and the price per share
- Common and preferred shares: Common shares have 2 classes, A and B. Class B shares have fewer voting rights than Class A shares. Holders of preferred stock are the individuals that will get the first distribution before common stockholders. Most venture capitalist investments deal with preferred shares since that is most beneficial to recoup their investment.
- Pre-investment Valuation: The valuation of the startup before any investors contribute capital. It is important to distinguish pre-investment valuation and post-investment valuation as this will determine the percentage the investors will receive upon closing.
- Capitalization table: You can also add a cap table to this section which outlines the proposed equity ownership of all parties involved. They are typically stored in a spreadsheet and include all types of equity that are being proposed to issue as well as how much each party is receiving. The cap table will include any stock options issued and will detail the percent of ownership each stakeholder has.
Include Dividends, Liquidation Preference, and Provisions
- Dividends allow stakeholders to grow their investment over time. When a company issues more shares as they grow, any existing shareholders ownership starts to decrease. Anti-dilution rights can help prevent this as the company is then prohibited from selling the shares to someone else at a lower price than what the initial investors paid.
- Liquidation Preference essentially is a way for investors to determine when and how they get their money. If the startup eventually gets sold, goes bankrupt, or decides to liquidate, this gives the investors their money first before other shareholders despite if the investor is holding common or preferred stock.
- Provisions are the rights stated in the term sheet if there is a decrease in valuation so the investors are aware of what they will receive back in that case.
Identify the Participation Rights
- Participation rights are included in the term sheet to indicate how investors can receive their return on investment before other individuals involved. This ensures investors retrieve at least a minimum of what they put in to decrease their risk. Typically, there is a cap on the return amount investors can claim.
- If the investor has participating preferred rights, then they will receive their first distribution that goes to all preferred shareholders, and they also receive a pro rata share of anything leftover after that initial distribution. For example, if a company has $4m of preferred equity and $6m of common equity, it has a 40% to 60% split between the two, respectively. If the company gets sold for $100m, the preferred shareholders will receive $40m first and then they would also receive 40% of the remaining $60m because they get a share of the common stock as well if they have participating rights.
- This is clearly favorable for the investor so it could be a point of disagreement when negotiating the term sheet details. Be prepared to defend your position on this section if the investor wants to opt in and you do not want to allow participation rights.
Board of Directors and Voting Matters
- Board of Directors: Include the list of people that will act as the Board of Directors. If you do not have this finalized, you can always include at least one or two names of individuals that you want to include to act as a third party between you and your investors.
- Voting Rights: Include the rules for voting protocols and how agreements will be handled as well as anything that would require investor or board approval.
- Option Pool: An option pool is the number of shares that are reserved for employees of the company including any future hires. Determining an option pool is attractive to investors as it will not be dilutive to their shares because it is calculated with pre-investment valuation which means it does affect your total shares as a founder. The benefit is that an option pool attracts candidates to hire as it is usually seen as an added benefit of working at a startup.
Finalizing Your Term Sheet
Once you have outlined the above points, it’s time to finalize the agreement. Double and triple check the term sheet as this is going to be the basis of your investment deal even though it is non-binding. Make sure all points are clear and nothing can be misunderstood within the terms and conditions of the document.
Get Professional Assistance
The term sheet is a great milestone of any startup, and it serves as the guide to creating an agreement with investors and determining your share options. There are templates that can help create a term sheet but be careful as it does tend to offer more than needed and can be confusing to follow. Take the stress out of it and reach out to one of our experts at Pasquesi Partners. They are experienced in all startup accounting needs and are ready to help you prepare the term sheet you want.