What are Term Sheets? 

A term sheet is a document presented to a company by an angel investor or venture capital investor who is considering an investment in your company. The terms stated in the term sheet are typically non-binding. In this sense, a term sheet is similar to a letter of intent. The term sheet provides a blueprint of the proposed investment, containing specific information regarding the conditions that the investor would expect the company to abide by in the event of the investor’s capital investment. Term sheets are often likened to a prenuptial agreement in a marriage.

Understanding the Parts of a Term Sheet 

Term sheets typically contain a great deal of important information, set out in three specific sections: 

  1. Funding

  2. Corporate Governance

  3. Liquidation

These sections, taken together, address two specific investment issues: the economics of the investment (funding and liquidation); and control of the company (corporate governance). Crossover between these two issues is inevitable, as discussed below. 

Term Sheets: Breaking Down the Economic Issues 

It is important to pay close attention to every section of the economic portion of a term sheet. Here’s a look at those sections of the term sheet that deal with the economic issues of the proposed investment:

Term Sheet Company Valuation 

The valuation section concerns what an investor believes the company is worth. Valuation issues addressed in the term sheet will include: 

  • Pre-money valuation: the investor’s estimate of what the company is worth before his or her investment of funds. 

  • Post-money valuation: the expected value of the company after investment of the proposed funds. 

  • Capitalization table: indicates the ownership of both founder and investor, equity dilution and equity value in each round of financing. This is required to ensure against any misunderstandings regarding share issuance and valuation, including options and warrants.

  • Price per share: the per share value of the company stock. 

Term Sheet Dilution/Anti-Dilution Clauses 

Dilution/Anti-Dilution clauses concern how future investments will dilute the ownership percentages of the founder and the investor. Typically, venture capital firms will require an anti-dilution clause to protect them from future sales of shares at a lower value. A clear understanding of dilution/anti-dilution clauses is critical, and consultation with a skilled business attorney is highly advised to avoid being bound by unreasonable terms.

Option Pools in Term Sheets 

An option pool clause concerns the amount of stock that a company sets aside to be used for a number of purposes, including: as compensation for employees; as an offering to service providers; as an incentive to attract new employees to the company. In most cases, it is a good idea to reserve 10 percent of your stock for use in your option pool. Keep in mind, however, that the valuation of these shares is typically on a pre-money basis, and so may dilute other pre-money shares. 

Founder Vesting Schedule in Term Sheets 

Venture capital firms will want to know, in specific terms, how the founder or founders of the company earn their shares, including dates of vesting commencement, circumstances of vesting acceleration (e.g., termination without cause or change of control) and any other related information.

Keep in mind, "credit" will be designated towards any time the founders have put into the company. For example, if your vesting schedule is five years, and you have already had the company for two years, then you have "earned" the first two years of vesting.  

Shares Offered Explained on Term Sheets 

“Shares offered” refers to the type of shares to be taken by the investor. A company may issue preferred shares and/or common shares. Preferred shares give certain rights to its holders that are not available to the holders of common stock. In most cases, an investor will indicate a preference for preferred shares in the term sheet.  (See “Fully Participating Preferred Stock and Liquidation” below.)

Dividend Accrual Contained in Term Sheets 

While dividends may never actually be paid out, they are typically listed in term sheets. Dividends are designed to provide preferred stockholders an additional return over time. Expressed as a percentage (5 percent, for example) dividend clauses will usually contain language stating "declared by the Board of Directors" or "non-cumulative". This language is the primary reason why dividends are seldom paid. 

Term Sheet: Liquidation Preference 

To help ensure their investments against business failures, venture capital investors commonly request what is known as a "1x" invested capital liquidation preference. Simply put, an invested capital liquidation preference entitles the investor to receive, upon company liquidation, the return of the amount of money it has invested in the company, at minimum, before any other shareholder receives any payout from the liquidation funds. Investors may additionally have the option to convert their preferred stock shares to common shares, thus allowing them to receive their percentage ownership payout in cash. Investors typically exercise this option when it results in a better return than under the 1x invested capital liquidation option. 

Fully Participating Preferred Stock and Liquidation

Liquidation proceeds are done on a prorated basis. This means that fully-participating stockholders will receive preference in the payment for their stock in the event of the company’s liquidation. The clause is written in a manner to ensure that the investor receives, at the very least, the original purchase price for their stock as well as any dividends they may be entitled to, and will receive their payments prior to any payments made to common stockholders. In addition, fully participating investors may receive a portion of the remaining proceeds after everyone with priority is paid, resulting in what may be described as “double dipping”. Participating preferred stock typically represents 20 percent of a company’s capital structure, but that percentage may be higher or lower.

Additional Financial Aspects of Term Sheets

There are additional financial clauses that you may find in a term sheet. These clauses are important, as they impact share conversions, liquidation and other aspects of financing. Some of them include:

Control Rights: Co-sale and Right of Refusal (ROFR) Drag-Along

Venture capital investors are interested in protecting their financial interests in a company. It is common, therefore, to include co-sale and right of first refusal (ROFR) clauses in their term sheets. Co-sale clauses are specifically designed so if a founder or key holder sells any part of their stake in a company, the investor has the right to do the same in regard to the same prospective buyer. An ROFR clause requires a holder of stock who plans to sell that stock to first offer the sale to the investor. The investor is not obligated to purchase the stock, but has the option to purchase it before anyone else.

Conversion

When an investor is to receive preferred stock as part of their investment, they will typically request a conversion clause that allows the option to convert their shares to common shares. This clause may also include specific language pertaining to caps, drag-alongs and other rights, as discussed elsewhere in this article.

Cost of Counsel

In nearly all cases, investors will ask for the company founders to reimburse them for the legal costs associated with conducting due diligence and developing an investment proposal. These fees may vary (usually from $25,000 to $75,000) and are typically non-negotiable.

Drag-Along Clauses

A drag-along right enables a majority shareholder to require a minority shareholder to join in the sale of a company, thus avoiding the havoc that minority shareholders might wreak when a company is sold. A drag-along clause is commonly found in term sheets in order to ensure that the investor and founders will have full power in the sale of the company by "dragging" the other shareholders along. It is important to be aware that this type of clause could result in significant additional legal fees.

Pay-to-Play

Pay-to-play clauses are designed to keep investors active in later rounds of financing by placing penalties on investors who are reluctant to follow through on investment plans. This reluctance may occur when there is a risk of the company failing to meet its financial goals. Common penalties include: conversion of preferred stock to common stock; loss of anti-dilution protection; and loss of other forms of investor control in the company. Venture capital firms are reluctant to include pay-to-play clauses in most cases.

Registration and Piggyback Rights

Registration rights allow an investor to insist upon a company registering their shares within a specific time after making an investment. Piggybacks allow shareholders to participate in the registration of their shares at any time a class of shares is registered by the company. Registration and piggyback clauses are designed to ensure that the founders take a company public within a certain period of time, that investors can force the company to go public if they wish, and that each investor can hold onto a certain percentage of ownership when the company goes public.

Warrants

Warrants provide an investor with the right to purchase additional stock in a company at a predetermined price within a specific period of time. Warrants are generally exercised if the value of the company exceeds the price of the warrant (strike price). Warrants also affect dilution for other shareholders, so it's important to review warrant clauses carefully before agreeing to any warrants for debt investors.

Term Sheets and Company Control 

In most cases, founders wish to retain as much control as possible over the day-to-day operations and decisions of their companies. Venture capital investors, on the other hand, also wish to possess similar control over the companies they invest in. As a result, issues of company control are of great concern and play a large part in the language of term sheets. Specific company control issues addressed in term sheets include: 

  • Board of Directors: The individuals sitting on a company’s board of directors wield tremendous power over the operations of the company, including setting company policies, approving financing and the vesting of company schedules, and much more. In most cases, a board of directors will include both company founders and independent directors. Independent directors are often individuals, such as lawyers or accountants, who possess specialized training or knowledge that is beneficial to the company. Unlike the company’s founders, independent directors typically hold no personal financial interest in the company. As a result, a venture capital investor will want to add at least one member to the company’s board to look after its interests in return for its capital investment. Before agreeing to this, it is important that you make sure the investor understands your goals and agrees with the basic plan for governing the business going forward. 

  • Protective Provisions: Venture capital investors often include provisions in their term sheets designed to instill tremendous power and leverage in the operations of the company. Examples include veto rights on dividend declarations, financing restrictions, and amendments to the company’s certificate of incorporation. These provisions can have serious repercussions for company and even cripple your business. It is therefore strongly recommended that founders review these protective provisions very carefully with the assistance of an attorney to determine whether they can be negotiated out of the final investment contract. 

  • Exclusivity Clauses: An exclusivity clause is typically the only clause in a term sheet that is binding on the company. The exclusivity clause places restrictions on the founders’ ability to seek financing from other sources for a specified amount of time, thus allowing the investor to perform due diligence before making a final decision on its investment. It is to the founders’ advantage to limit the clause’s time period (to 45 days, for example) to allow the company enough time to locate other investors, if necessary. 

Investor Rights in Term Sheets 

Investor rights play a part in both the economic and company control subject matter of a term sheet. Three investors rights issues typically included in a term sheet are: 

  1. Pro Rata Rights : the right of an investor to participate in additional funding. This allows the investor to maintain the same level of ownership in a company when further funding is sought. Pro rata rights are usually good for the company in that they provide a level of security regarding future funding. 

  2. Voting Rights : the right given to a shareholder to participate in decisions made by the company. In most cases, voting rights are vested only in common stock shareholders. While preferred stock owners (most venture capitalists) do not generally have voting rights, they may nevertheless insist on a say in board decisions. 

  3. Information Rights : refers to information that a venture capital investor requires be provided to it by the company on a regular basis, including financial statements, budgets and other documents. The right to physically visit the company from time to time may also be included. 

Legal Fees

In most cases, an investor will require the company to pay certain legal fees associated with a venture capital deal.

Confidentiality Clauses

Term sheets typically include a provision that prohibits the founders from from discussing the terms of the proposal with anyone other than co-founders and legal counsel.

Miscellaneous Provisions

Term sheets will additionally include standard “representations and warranties” language, as well a stated date for closing the deal.

Other important financial and company control issues may be addressed in the language of a term sheet. It is therefore critical that you have a skilled attorney review all aspects of any term sheet you consider before you agree on a deal with an angel investor or venture capital company.  The successful future of your company depends on it. 

Should You use Term Sheets?

Although in most cases, it is the investor that will present you with a term sheet regarding investment in your company, it is important to recognize that you do not have to wait until this happens. You are fully within your rights to draft a term sheet of your own. Just be sure to consult with an attorney when drafting your company’s term sheet. Here are some tips for when to, and when not to, use a term sheet:

Use a Term Sheet:

Avoid Use of a Term Sheet:

When you are a first-time business owner uncertain about how to proceed to secure funding.

If your goal is to determine what several investors may offer you for an investment.

When you lack experience with venture capital firms.

When privacy regarding potential investments is not important.

 

Using Term Sheets: Advantages and Disadvantages

Here are some important advantages and disadvantages to the use of term sheets for a company:

Advantages

Disadvantages

Allows you to discuss funding deals with a potential investor in greater depth.

May impose limitations on your ability to work with other investors.

Allows you to push the potential investor to value your company at a higher amount.

Outside of your legal counsel, you cannot discuss the details of a term sheet.

Helps you to avoid overly aggressive contract terms.

 

Allows you to walk away more easily from a deal if you cannot reach an agreement.

 
 

Seeking Investors Without Term Sheets: Advantages and Disadvantages

Here are some important advantages for a company seeking investors without the use of a term sheet:

Advantages

Disadvantages

You can work with numerous investors at the same time until you find the one you are comfortable with.

Potential legal problems resulting from a lack of written proposed terms.

You may be able to force a potential investor to accept terms you are interested in including in the term sheet.

Without a review of the proposed terms you could be signing an agreement you will regret later.

 

Preparing to Meet Investors

As a company owner, the first step in seeking new funding for your business should always be to consult with your attorney for an honest evaluation of your business goals and to determine exactly what you are willing to sacrifice in order to procure new investments. The process of discussing your goals with an attorney allows you to determine ahead of time where you are willing to make concessions to an investor and where you intend to hold firm. This will allow you to negotiate from a position of strength. Once your consultation is completed, you are ready to invite investors to present you with their term sheets or to draft at term sheet of your own.

Negotiating the Terms in a Term Sheet

Regardless of whether you are taking a prepared term sheet to a venture capital company or you are in receipt of one from a potential investor, further negotiations will be required. Some clauses will be non-negotiable on the part of the investor, while others will be non-negotiable on your part. Remember, however, that flexibility in a negotiation is key. You will have to determine where you can and where you cannot afford to compromise. Here are some of the areas you will want to take a look at to determine what is important to you and to your business:

  • Dilution and Valuation: A clear understanding of valuation and dilution clauses is extremely important. Make sure you fully understand their language and how they will impact your company in practice. Don’t forget to discuss all potential issues and ramifications with your attorney.

  • Preferences for Liquidation: Liquidation preferences often carry over from one round of financing to the next. Be sure to review all liquidation preference language with your attorney to determine if they require further negotiation.

  • Board of Directors Arrangements: Venture capital investors will want a say in the governance of the company going forward. Since the investor’s insistence on placing a new member on the board of directors will likely be non-negotiable, it is particularly important to make sure that the investor's vision for your company is in line with your own.

  • Veto Rights of Investors: Discuss any and all veto rights terms with your attorney as they could significantly impact additional funding rounds, the declaration of dividends, and even your company’s rights and ability to issue additional stock.

  • Founder Vesting Schedule: Be sure to carefully review any and all clauses that could impact your rights as a founder to have your ownership in the company vested on-schedule. Look out for provisions regarding change in control, acceleration, and double trigger acceleration, all of which could negatively impact your rights.

  • Exclusivity Clauses: Exclusivity clauses concern the length of time a prospective investor has to complete its due diligence before agreeing to invest in your company. In most cases, you will not want an exclusivity period longer than 45 days.

  • Legal Fees: Although how legal fees associated with your negotiations are paid is itself negotiable, you, not the investor, will likely be required to pay those legal fees.

Frequently Asked Questions

  • Can term sheets be modified?

Like most other legal agreements, terms set out in a term sheet may be modified at any time prior to signing the final funding agreement. Remember that, with the exception of exclusivity and (possibly) confidentiality clauses, all contents of a term sheet are non-binding. You will likely be negotiating with your prospective investor until either the parties reach a final agreement or until the time limit date stated in the term sheet is reached.

  • Can a term sheet be canceled?

If you find that your are no longer interested in having an investor invest in your company, you may be able to contact that investor and cancel your negotiations prior to the final date stated in the term sheet. Keep in mind, however, that the investor may still hold you to the exclusivity clause in the term sheet, preventing you from meeting with other investors until the stated expiration date.

Resources

Sample Term Sheet