When your startup is ready to go looking for funds, term sheet usually serves as the first set of document you send to investors or investors send to you. It is a negotiation document that details the intended equity participation from the investors in your startups. Most times, term sheet is a bullet-point document outlining the material terms and conditions of a business agreement. Term says in details what your start-up is giving, and what it is getting in return. It then lays out the guidelines of how both parties will act to protect the investment.
More or less, a term sheet is generally not binding, unless the parties say so. Once a term sheet has been “executed”, it guides legal counsel in the preparation of a proposed “final agreement”. The length or the volume of a timesheet depends on the stage of funding your startup is in.
Generally, term sheets for seed rounds are usually much lighter and shorter than for series A or beyond. That is, once you have less at stake, you should expect a term sheet that is less complex, as no one wants to unnecessarily spend on extra legal fees, or burn hardly found the time. In all, term sheet could be a pager, or 10 pages of documents, in simple, clear terms.
What To Look Out For In Every Term Sheet
For every founder or investor reviewing a term sheet proposed by potential investors, or drafting one, they should specifically look out for:
- Unfavorable terms. Such terms include a harsh term on debt financing and convertible note terms that could bankrupt you
- Demand for too much controlling stake that may replace you
- Terms that can restrict your ability to raise further funding
- Investors that are impatient and or want a short and quick exit, and that are not willing to respect your timeline of breaking even.
What And What Should Be Found In A Term Sheet?
- Who is issuing the note or stock
- Type of collateral being offered
- The valuation
- Amount being offered
- Shares and price
- What happens on liquidation or IPO
- Voting rights
- Board seats
- Conversion options
- Anti-dilution provisions
- Investors rights to information
- Founders obligations
- Who will pay legal expenses
- Non-disclosure requirements
- Rights to future investment
- Signatures
General Points About Reviewing These Common Terms In A Term Sheet
- Investors may want to generally prolong the negotiation after term sheet stage may have been completed. When you see this coming, just exercise some patience. Every single provision in that document may not matter today as they would in the long run.
- Make the term sheet a win-win for everybody. Founders do not want difficult or greedily overbearing investors, much as investors would not want dishonest or crooked founders.
- As a general rule, aim for dilution of around 20% per round of financing. Don’t be in a hurry to go beyond that amount. Your startup may still have a long way to go.
- Dilution occurs when holders of stock options, such as company employees, or holders of other optionable securities exercise their options. As the number of shares outstanding increases, each existing stockholder owns a smaller, or diluted, percentage of the company, making each share less valuable.
- When you are still at the seed stage of your fundraising and you desire to give up a good amount of your stocks or company’s shares to outsiders, just know that those shares will not come back to you, until you, of course, restructure your startup.
- A term sheet is not permission to go on a spending spree. Founders should not make the mistake of thinking the money will be transferred once they receive a term sheet, and therefore go on a spending spree. Wait until the deal is closed. This is because a term sheet itself is not an executed deal or even a promise.
Negotiating A Term Sheet
The best way to win the whole term sheet episode is to carry a lawyer with you who understands the intricacies of every clause inserted into the term sheet. Hone your negotiation skills.
‘‘Having information that the other side doesn’t have gives [you] an advantage… [VCs] take advantage of entrepreneurs who haven’t been through this before… they were totally willing to take advantage of us.” — Mitch Kapor, Founders at Work
Make Sure You Do Not Leave Due Diligence Out Of The Question
Due diligence is very important both for the investor and the founders. Due diligence can cover a wide range of many subjects ranging from legal to technological to human resources. Your in-house team can do this, or you hire an external solicitor or organization. So take time and conduct due to diligence on your potential investors, and particularly answer the following questions:
- Do you trust the investor? Trusting is the make-or-mar of your startup.
- Are you going to get along with the investor even if funding is immense? This is better imagined than never.
- Are there companies that have benefited from their contributions?
- What do the investors do when a portfolio company doesn’t do well?
Then Seal The Deal
A little space is usually allowed for investors to conduct their due diligence on your company. Make sure your technology is well patented and that trademarks and designs are registered, and that the documentation of your company is well preserved at the company and trademark registries. This is because investors usually check to see if those things are in order and if the sole owner of the products or business rightly belongs to you.
Sign A Binding Contract
Having noted that the term sheet is not a binding agreement, have it at the back of your mind to negotiate any term you feel deeply uncomfortable with. The best advice is usually to let your lawyer do the job and help you reach a win-win deal.
Time-Lines
Negotiation from the stage of the term sheet to the final agreement usually takes some weeks, depending on whether the deal is simple and the parties are easily agreeable. For complex deals, however, expect a long time for due diligence, legal restructuring, and aligning with many investors.
Charles Rapulu Udoh
Charles Rapulu Udoh is a Lagos-based Lawyer with special focus on Business Law, Intellectual Property Rights, Entertainment and Technology Law. He is also an award-winning writer. Working for notable organizations so far has exposed him to some of industry best practices in business, finance strategies, law, dispute resolution, and data analytics both in Nigeria and across the world.