What is a Term Sheet?
A term sheet is a document that outlines the material terms and conditions of a potential investment. It’s typically a non-binding agreement between two parties that covers the basic conditions of a deal.
Once the parties agree on the details in the term sheet, it’s used as a template for creating more detailed, legally binding contracts.
Say an investor and a startup founder had great conversations and things are looking serious. The investor decides to put some capital into the startup. But the conversation between the two parties doesn’t end after a successful pitch and a handshake. In fact, it gets more detailed.
The next step after an investor commits is for the two parties to hammer out a summary of their agreement in a document called a term sheet. This document, usually non-binding, is essentially the first draft of what will become the final, binding contract between them.
Term sheets explained
A term sheet includes details such as:
- The valuation of the startup so that the founders and investor agree about what they think the company is worth
- Details about stock options for employees
- Agreements on what the investor expects to receive if the startup fails, liquidates, or is sold
- Agreements about the investor’s right to acquire stocks
- What the dividend structure will be
- How any future board of directors for the startup will be structured
A great deal of negotiation can go into a term sheet, or it wouldn’t be such a necessary document. The goal is to work out any tension in the course of preparing the document to avoid a major legal battle later. The hot issues typically are money and control. The startup needs the money and has to give up some control over the company in exchange, while the investors want their interests protected.
The most common source of conflict often is the valuation of the startup itself, since this number is so fundamental to the deal. Other sources of conflict are the definitions of success, who has how much say in the company, who gets paid when, and how proceeds of the startup will be divided.
Founder-friendly term sheets
Sam Altman, president of the startup accelerator Y Combinator — which nurtured Reddit, Dropbox, and Airbnb, among others — recommends what he calls “founder friendly” term sheets. Having been on both sides of the table as a serial entrepreneur and a serial investor, he saw how startup founders can get burned in the term sheet stage if they aren’t careful. In his opinion, term sheets should not include an option pool agreement, confidentiality clauses, or any commitment that the startup must cover the investors’ legal fees.
He’s not alone in advising startups that term sheets can often favor the venture capital side of the partnership. Investors typically come to the deal with more experience in safeguarding their interests than do startup founders. The Entrepreneur’s Handbook recommends that founders stay involved in the term sheet development and not simply hand it off to their attorneys.
After all, the future of their company is at stake, and some items in a term sheet may limit their ability to grow the business even if the deal with that specific investor falls through in the later financing stage. For example, term sheets may require that the founders not approach other investors for some set period of time and may even impose a financial penalty for doing so.
Term sheets are not unique to venture capital and startups. They are prepared in advance of a wide range of business deals, such as commercial real estate investments or the outright purchase of a business. What they have in common is the “first draft” aspect, putting down on paper the definitions of the deal and the obligations and benefits both parties can expect. This ensures that everyone knows what they’re really getting into before they sign a final contract.