Arguably, no other document is as pivotal in determining the future of your startup or business as the term sheet. Apart from attracting venture capitalists (VCs) and other prospective investors and generating competition to ensure you get the best deal, this key document can also serve as the blueprint for succeeding funding rounds.
Knowing the basics of a term sheet from the outset is crucial if you want to fund your startup or business successfully. Read on for our guide on creating an effective term sheet for investors.
What is a term sheet?
A term sheet is a preliminary contract that defines the key terms of a transaction agreement between parties. It can be binding or non-binding and can be used to negotiate the said key terms.
Consider this document similar to a letter of intent – it opens up negotiations between your founding team and an investor. It results in a legal document detailing their investment, so it’s essential to understand the provisions and implications and develop a negotiating strategy around it.
The term sheet contains two simple concepts: economics and control.
- Economics – This contains details on valuation, option pool and liquidation preference in the event the company is sold, goes public or bankrupt. It addresses the return on investment the investor will be entitled to during liquidation.
- Control – This is the extent to which an investor can exert control over business decisions.
As a startup, it is imperative you pay close attention to these two concepts and ensure you retain control of your business.
How to create a term sheet
Most term sheets are short and are usually in table or dot-point form for clarity. If you are thinking of creating a term sheet, here are some important reminders.
Make sure to understand the content
It is necessary to have a deep understanding of your business and investment requirements when creating your term sheet. This document usually includes the following:
- Investment amount
- Timing
- Company valuation
- Form of investment
- Stock option plans
- Parties’ rights and responsibilities
- Board representation
- Time frame for deal completion
To complete the term sheet, you must be able to identify the amount of funding you need and the type of investment you seek and then calculate your company’s valuation. These help ensure your term sheet is an accurate representation of your business needs, leading to productive discussions with potential investors.
Learn the key economic terms
Like any business document, it’s crucial to learn the terms and conditions used in the term sheet and be aware of how they can impact the economics and control of your startup. The most fundamental terms are:
- Valuation – Your startup’s worth before and after investment.
- Preferred stock – A type of equity security investors purchase with special rights attached to them, such as liquidation preferences and voting rights. Ensure you understand all the special rights attached to any preferred stock and negotiate accordingly.
- Liquidation preference – A right given to preferred shareholders to recoup their investments prior to the allocation of sale or liquidation proceeds.
- Protective provisions – These stipulations grant investors influence over business decisions, including matters like incurring debt or issuing additional shares.
- Pro rata rights – Rights that empower investors to avoid dilution and uphold ownership through active participation in subsequent funding rounds.
A term sheet is designed to protect your business’s best interests, delineating control and decision-making authority. It is critical that you are satisfied with the initial draft before finalising and signing the document.
Be open to negotiations
Startups and their investors can negotiate the term sheet before signing the formal investment agreement. Remember that the end goal is value creation for both parties. If you are able to negotiate your term sheet well, you can transform a good deal into something better.
To help you prepare for negotiations, here are some measures you can take before talking to VCs and investors:
- Identify the key elements within the term sheet that are most important for you and your business.
- Clearly articulate your preferences before creating the document.
- Foster competitive dynamics by conducting thorough research, networking and discussions with potential investors
- Concentrate on issues that help or impede your desired outcomes
Establish control
As previously mentioned, a term sheet also delineates the power dynamics between you and your investors. This document will typically outline how many seats on the company’s board of directors will go to investors. Of course, founders, especially during a startup’s initial phases, would want to avoid scenarios where they might be outnumbered or outvoted.
Exercise caution when allocating board seats and voting control in the early stages, as relinquishing control too soon may lead to diminished influence with subsequent investments. Aim to optimise a small but highly functional board of directors, minimising the number of board seats granted as much as possible.
Consult with a lawyer
Creating a term sheet can be daunting – apart from the confusing lingo, entrepreneurs and investors will look at the document with eagle eyes. VCs and investors are experienced and are highly likely to have negotiated tons of deals before this, so it’s important not to enter into negotiations alone.
Having a lawyer by your side can make a significant impact when navigating complicated deals. Remember, it is critical to have leverage in negotiations. You must be aware of the leverage you possess – or lack – before engaging in discussions about the contents of the term sheet. This also includes a clear understanding of your startup’s strengths and weaknesses.
An experienced lawyer can assist you in understanding your term sheet before entering any legal obligations. This safeguards your interests and underscores professionalism when dealing with potential VCs and investors. They can draft and finalise the definitive document that represents the legally binding shareholder purchase agreement.
Key takeaway
Investment talks are just the beginning of a term sheet. Apart from money and valuation, don’t forget to scrutinise other important details like preferred stock, liquidation preferences, and board composition. When you have any doubts, don’t hesitate to consult with your lawyer.
Protect your startup and let Lazarus Legal help you deal with legal matters and requirements like drafting a term sheet so you can focus on growing your company. Contact us today or sign up for our newsletter to stay informed about legal news, business trends, and more.
