VC Term Sheets: What They Include & Why They Matter

VC Term Sheets: What They Include & Why They Matter

It’s all too common for founders to be confused by venture capital (VC) term sheets. Many founders often find the agreement’s terms complicated or foreign. On the other hand, investors see term sheets all the time.

It’s important for founders to understand what a term sheet is, what its main components are, and how to identify what a “good” term sheet looks like. Having a basic understanding—plus the help of a lawyer who is familiar with startup and venture deals—can make closing a deal less daunting.

What Is a VC Term Sheet?

A VC term sheet is a nonbinding agreement showing the terms and conditions between a company, its founder(s), and a potential venture capitalist investor or venture capital firm. It serves as a template for the more detailed and legally binding documents that follow. Even if you’re working with other types of investors, you will receive a term sheet before you close a financing round with them.

Think of a term sheet as the opening position in a negotiation. The relationship between a founder and an investor has to start somewhere, and the term sheet outlines where the drafter wishes to start the negotiation.

Angel, seed, and venture capital (VC) investors all use term sheets to summarize the major aspects of an investment agreement, defining what the startup is going to give in exchange for the investor’s funding. It also explains how the investment’s upsides and risks are divided amongst the founder(s) and investor(s).

Risk allocation, as much as financial concepts, if a critical part of good term sheets. Furthermore, it helps all parties involved sort out any issues or differences before executing the legal agreements and time-consuming due diligence. For example, the founder’s ownership over the growing company’s intellectual property is a common topic addressed in a term sheet.

When a term sheet is presented by an investor, it usually signals that they are ready to go ahead with the deal. In fact, most investors will agree to provide some kind of funding after they present a term sheet to a founder or co-founders.

Many startups begin with the founder’s savings or backing from the founder’s friends and family. This type of bootstrapping doesn’t typically involve serious investment documents compared to receiving funding from a venture capital firm.

Because of this, you’ll usually encounter term sheets at the Seed and Series funding stages. The content and complexity will vary depending on the round, how much is at stake, and who else is involved. You will also use the latest term sheet you sign to create a precedent for the terms and conditions of any future rounds you raise.

In this article, we’ll define term sheets and their basic components. Additionally, we’ll discuss the legally binding aspects, who authors the document, whether or not it expires, and what happens after it’s signed. Hopefully, demystifying the term sheet will make it less daunting when it comes time to sign one.

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What Does the Term Sheet Include?

A term sheet is not the investment contract itself, but it lays out the groundwork for ensuring that all parties involved in the transaction agree on the major components of the deal. It can be anywhere from a single page to several or even a dozen pages.

Over the past decade, many investors—specifically, VC firms—have started shortening their term sheets in order to make them more “user friendly” to founders. Rather than get into the weeds of legalese, these single page term sheets aim to make the closing of a deal easy, standard, and fast.

That being said, term sheets can still vary in length. Depending on the participants and what funding stage you’re in, as well as the perceived upsides and risks, the content may differ. For instance, a term sheet you receive during a seed round might look quite different compared to one you receive during a Series A round.

To provide an example, we’ll list what a simple Series A term sheet often includes:

  • Company Name (that’s you!)
  • Securities
  • Investment (total dollar amount from lead investor)
  • Amounts (total dollar amount from other investors)
  • Company Valuation (valuation methods vary)
  • Liquidation preference
  • Dividends
  • Participation Rights (the investor can benefit along with shareholders)
  • Conversion Rights
  • Anti-Dilution Clauses
  • Voting Rights
  • Drag-Along Rights
  • Board Representation
  • Founder and Employee Vesting
  • No-Shop Provision (once signed, you can’t shop around)

There may be other provisions or clauses involved as well, but the items included above are typically the most common, as well as the most important, term sheet details to know. Some term sheets may omit some sections or list the heading with terms TBD.

Ideally, the term sheet is founder-friendly. The investor or investors you are partnering with are interested in building long-term value rather than only reducing perceived risks, and the term sheet reduces the chances of a misunderstanding or dispute going forward.

This document will also help create a foundation and precedent for terms in future rounds. Settling on one that defines terms and conditions you find optimal is key. This may sometimes involve negotiating a term sheet.

Is It Legally Binding?

A term sheet is a non-binding document, however, it does include binding conditions, such as confidentiality and exclusivity (or No-Shop) provisions. They go into effect after the document has been signed and are a legally enforceable agreement.

Confidentiality and exclusivity provisions allow both the company’s founders and the investors to keep the terms of the negotiations confidential, and, once the term sheet is signed, ensure the founders cannot shop around until a definitive agreement is reached (i.e. the deal either goes through or doesn’t).

Who Provides the Term Sheet?

If you are raising a Seed or Series Round through equity financing, the investor—be it a traditional VC firm or seed fund—will typically provide the term sheet. Some business incubators, accelerators, or other programs teaching founders how to pitch to investors will include training on drafting a term sheet.

However, it has become more common for founders to serve up a term sheet, specifically when no one is stepping up to pitch the company during a seed round composed of a large group of investors. This is often referred to as a “party round.” Outside of party rounds, founders usually do not provide the term sheet.

Does It Ever Expire?

A term sheet can expire. Not every document includes an expiration date. However, some do include a provision stating that the term sheet will expire a certain date unless signed. The time frame, or “fuse”, is usually somewhat short, ranging from 2-5 days. This range can often include up to 10 days, especially if the term sheet is founder-drafted. The provision makes sure the deal won’t sit on the table in perpetuity.

However, depending on the relationship you have between yourself and the investor, they may not include such a provision. If they do, they will likely give you an extension in order to help you get comfortable with the terms.

The extension can be anywhere from a few extra days to an entire week so long as you are working with the investor in good faith. When you get an extension—or an expiration date is not included at all—it’s usually a good sign that you’re working with someone who will be an excellent business partner in the long-run.

Ultimately, it’s somewhat unusual for an investor to pull the term sheet just because a “fuse” expired. When a term sheet is offered, the investors are typically very committed to closing the deal.

It’s important to briefly note so-called “exploding term sheets”. Exploding term sheets are any term sheets with a very short fuse that have no extensions. They are associated with high-pressure negotiations and impulse decisions. If you receive an exploding term sheet, ask the investor why the time limit is so short.

Investors like Mike Collett and Michael Arrington recommend leaning towards saying no to any high-pressure deal. If a potential partner doesn’t want to give you the time you need to understand the terms and be comfortable with them, protect yourself and seek another investing partner.

What Happens After You Sign?

Once the term sheet has been signed and both parties have agreed to move forward, due diligence is performed and definitive, legally binding documents are drafted. The investment agreements are based on the term sheet but are much longer, often 100 pages or more. These documents serve as the binding contracts that control the actual exchange of money, binding promises, and authority within the company.

Importantly, once parties sign the term sheet, any nondisclosure or non-shop clauses become enforceable. Signing the term sheets marks the beginning of a period of caution and diligence.

Don’t Hyperfocus on a “Perfect” Deal

A term sheet is a non-binding agreement outlining the terms and conditions between a founder and various types of investors, such as VC investors and VC firms. It details what a founder will provide to the investor to secure funding for their business, as well as what each party will do to protect the company and the investment.

There are numerous venture capital term sheet samples available online. Be careful that you understand these samples from the web; some are old copies, oddball cases, or pertain to a certain stage of company growth. A number of VCs, angel investors, and accelerators providing capital to early-stage companies provide sample term sheets for startups to review, so they have a better understanding of what they might expect. For example, Y Combinator, a prolific startup accelerator, is well-known for its simple Series A term sheet template. You can also study the term sheet templates from visible.vc or take a workshop like those offered by Rockies Venture Club.

Whomever you receive a term sheet from, it should act as the foundation of the terms you will agree to in order to receive an investment. It should set a precedent for any future rounds that will be raised.

Starting off with a “good” term sheet means the next term sheet and financing round will be quick and easy. The terms should also help you confirm whether the investor is trustworthy. Even after confirming investor trustworthiness, you should identify the terms that are most important to you and your team. Knowing the terms you are comfortable with and the ones you can negotiate will raise your confidence when interacting with investors.

In fact, It’s important to know that negotiation is possible! But, it takes legal knowledge and an understanding of term sheets, in addition to a certain amount of leverage and civility, to accomplish negotiations.

If you receive what you feel to be a “good” term sheet, try and close the deal. Don’t spend too much time trying to negotiate the “perfect” deal. No one ever built a successful company simply by winning a Seed or Series A negotiation.

Even if you don’t believe you got everything right or exactly how you want, you will, hopefully, always have the power to execute. Investors are often a great source of advice, so listen carefully if the investor is pushing back on a certain topic. The credibility you build can establish some leverage to help you renegotiate later.

Ultimately, you can’t lose sight of your number one goal when looking over term sheets or negotiating: getting back to work and building your business.

This article is informative. Before making any legal or financial business decisions, you should consult with a professional who can advise you based on your individual situation.