Startup term sheets: Everything you wanted to know

Author: Partha Chakraborty Published on: March 12, 2023 Published in: Startup funding

When a startup company seeks funding from investors, one of the key documents that is often negotiated and drafted is the term sheet.

A term sheet outlines the terms and conditions of an investment, including the amount of funding, the valuation of the company, the percentage of ownership that the investor will receive, and any other rights or protections that the investor will have.

The term sheet serves as a roadmap for the investment, providing a framework for the negotiation and finalization of the legal documents that will ultimately govern the investment.

It is typically a non-binding document, meaning that it does not create a legal obligation for either party to move forward with the investment. However, the terms outlined in the term sheet are often used as the basis for drafting the binding legal documents, such as the stock purchase agreement and the investor rights agreement.

What are the key terms to look for in a term sheet?

A term sheet is a document that outlines the terms and conditions of a deal or agreement. In the context of startups, a term sheet is a document that outlines the terms of a proposed investment in the company.

Here is a list of some of the key terms that are typically included in a startup term sheet:

Amount of funding: This is the total amount of money that the investor is offering to invest in the company.
Valuation: The valuation is the estimated value of the company based on a variety of factors such as revenue, growth potential, and market demand.
Investment structure: This section outlines the type of investment being offered, such as debt or equity.
Dilution: This term refers to the percentage of ownership that the investor will receive in the company in exchange for their investment.
Board seats: The term sheet may specify whether the investor will have the right to appoint a representative to the company’s board of directors.
Preemptive rights: Preemptive rights give the investor the right to maintain their percentage ownership in the company by participating in future rounds of funding.
Voting rights: This section specifies whether the investor will have voting rights on important company decisions, such as the appointment of new board members or changes to the company’s bylaws.
Liquidation preference: The liquidation preference determines the order in which investors will be paid out in the event that the company is sold or goes bankrupt.
Protections for the investor: These may include provisions such as covenants, which are agreements that the company must follow, or drag-along rights, which allow the investor to force the sale of the company if a majority of shareholders agree.
Vesting: Vesting refers to the process by which an employee or founder earns the right to ownership of equity in a company over time. In the context of a startup investment, vesting may be included in the term sheet to ensure that the founders and employees continue to work for the company for a certain period of time in exchange for their equity.
Board seats: A term sheet may specify whether the investor will have the right to appoint a representative to the company’s board of directors. The board of directors is responsible for making important decisions about the direction and operation of the company.
Dividends: A dividend is a distribution of a portion of a company’s profits to its shareholders. A term sheet may specify whether the investor is entitled to receive dividends as part of their investment.
Other rights: A term sheet may also include other rights such as preemptive rights, which give the investor the right to maintain their percentage ownership in the company by participating in future rounds of funding, or drag-along rights, which allow the investor to force the sale of the company if a majority of shareholders agree.

How is a term sheet different from shareholders agreement (SHA)?

A term sheet is a non-binding document that outlines the terms and conditions of a proposed investment in a company, while a shareholder agreement (SHA) is a legally binding contract that outlines the rights and responsibilities of the shareholders in a company.

The term sheet is typically used as a starting point for negotiations between the investor and the company, and it serves as the basis for the more detailed and legally binding SHA. The SHA outlines the specific terms of the investment and sets out the rights and obligations of the shareholders.

It is typically used in situations where there are multiple shareholders, as it helps to establish how the company will be run and how decisions will be made.

Some key differences between a term sheet and a shareholder agreement include:

Non-binding vs. legally binding: As mentioned earlier, a term sheet is a non-binding document that outlines the terms of a proposed investment, while a shareholder agreement is a legally binding contract that sets out the rights and responsibilities of the shareholders.
Level of detail: A term sheet is typically a high-level document that outlines the key terms of the investment, while a shareholder agreement is much more detailed and covers a wide range of issues such as voting rights, board composition, and exit strategies.
Purpose: The primary purpose of a term sheet is to outline the terms of a proposed investment, while the primary purpose of a shareholder agreement is to establish the rights and responsibilities of the shareholders and to regulate the operation of the company.

Who initiates the term sheet?

The investor will usually send a term sheet to the company outlining the terms of their proposed investment. The company can then review the term sheet and negotiate the terms with the investor.

It is important to note that a term sheet is a non-binding document, which means that the terms outlined in the term sheet are not final and can be negotiated by the company and the investor.

Once the parties have agreed on the terms of the investment, they can then move forward with the drafting of a more detailed and legally binding shareholder agreement (SHA).

How do you prepare a term sheet?

Here are some steps you can follow to prepare a term sheet for a startup investment:

Determine the key terms of the investment: The first step in preparing a term sheet is to determine the key terms of the investment. This may include the amount of funding being offered, the valuation of the company, the type of investment being made (e.g. debt or equity), and any protections or rights being granted to the investor.
Research and gather market data: To support the terms of the investment, it is helpful to research and gather market data such as industry benchmarks and comparable deals. This can help to justify the terms of the investment and ensure that they are reasonable and in line with market conditions.
Outline the key terms in the term sheet: Once you have determined the key terms of the investment and gathered relevant market data, the next step is to outline these terms in the term sheet. Be sure to include a clear and concise summary of the key terms, as well as any supporting information or data that may be relevant.
Review and revise the term sheet: After the initial draft of the term sheet has been prepared, it is important to review and revise the document to ensure that it is complete and accurate. This may involve reviewing the term sheet with legal counsel or other advisors to ensure that it is in compliance with any relevant laws or regulations.
Negotiate the terms of the investment: Once the term sheet has been finalized, the next step is to negotiate the terms of the investment with the company. This may involve back and forth negotiations to arrive at mutually acceptable terms.

How to read a term sheet?

Reading a term sheet can be a complex process, as it involves understanding a wide range of financial and legal terms and concepts. Here are some tips to help you read and understand a term sheet:

Familiarize yourself with the key terms: Make sure you have a good understanding of the key terms that are commonly included in a term sheet, such as valuation, dilution, and liquidation preference.
Pay attention to the details: A term sheet is a detailed document, and it is important to pay attention to the specific terms and conditions that are outlined in the document.
Seek legal and financial advice: If you are not familiar with the financial and legal terms used in the term sheet, it is a good idea to seek the advice of a lawyer or financial advisor. They can help you to understand the terms of the investment and ensure that you are making an informed decision.
Negotiate the terms: Remember that a term sheet is a non-binding document, which means that the terms outlined in the document can be negotiated. If you are not comfortable with any of the terms, be sure to raise your concerns with the investor and try to negotiate a more favourable deal.

Where can I find standard template of term sheet?

There is no “standard” template for a term sheet, as the terms and conditions of an investment can vary widely depending on the specifics of the deal.

However, there are many resources available that provide examples of term sheets and can serve as a starting point for creating your own term sheet.

A great place is to check YCombinator’s term sheet template.

Here are a few places where you might be able to find a template or example of a term sheet:

Online legal resources: There are many online legal resources that provide templates and examples of term sheets. Some popular options include Docstoc, Law Insider, and Rocket Lawyer.
Investment organizations: Professional investment organizations such as venture capital firms and angel investor groups often have their own standard term sheets that they use for investments. These term sheets can serve as a useful reference when preparing your own term sheet.
Legal counsel: Working with a lawyer or legal advisor is a good way to ensure that your term sheet is complete and accurate. They can also provide guidance on any legal issues that may arise during the investment process.

What are the red flags in a term sheet?

There are a number of potential “red flags” that you should be aware of when reviewing a term sheet for a startup investment.

These are issues that may be unfavorable to the company and could impact the success of the investment. Here are a few red flags to watch out for:

Unfavorable valuation: A valuation that is significantly lower than the company’s estimated value could be a red flag, as it may indicate that the investor is not confident in the company’s potential or is trying to take advantage of the company.
Excessive dilution: Dilution refers to the percentage of ownership that the investor will receive in the company in exchange for their investment. If the dilution is excessive, it could mean that the company’s founders and existing shareholders will have less control over the company and may be less incentivized to grow the business.
Unfavorable liquidation preference: The liquidation preference determines the order in which investors will be paid out in the event that the company is sold or goes bankrupt. If the liquidation preference is unfavorable to the company, it could mean that the investor will be paid out before the company’s founders and other shareholders.
Onerous protections for the investor: Protections for the investor, such as covenants (agreements that the company must follow) or drag-along rights (the right to force the sale of the company), can be important for the investor to reduce risk. However, if these protections are overly onerous or restrictive, they could be a red flag for the company.
Lack of alignment with company goals: It is important to ensure that the terms of the investment are aligned with the company’s goals and objectives. If the investor’s goals are not aligned with the company’s, it could lead to conflicts and hinder the company’s ability to grow and succeed.

For startups, the term sheet is a critical document that can have a significant impact on the success and future of the company.

It is important for founders and management teams to carefully review and negotiate the terms of the term sheet to ensure that they are aligned with the company’s goals and objectives, and that they provide the necessary funding and support to help the company grow and succeed.

Thanks for reading. If you liked this post, check out our other posts on venture capital.

Startup term sheets: Everything you wanted to know

What are the key terms to look for in a term sheet?