Term sheets outline the parameters of a potential transaction between two parties. Often, this document is created by one party and then negotiated with the other party. You will learn what a term sheet is in venture capital in this blog.
What Is a Term Sheet in Venture Capital?
A term sheet is a document that outlines the key terms and conditions of a proposed investment. It is typically used in venture capital transactions but can also be used in other types of investments.
Quite often, term sheets are associated with the startups. The founders of these startups understand that this term sheet is more of a lucrative document to attach venture capitalists (VC) who have deep pockets to invest in the companies.
The term sheet is not a binding contract, but it sets forth the basic terms of the proposed transaction and serves as a starting point for negotiation between the parties. The term sheet may be modified during negotiation, and the final terms of the transaction will be set forth in the definitive agreement.
The key terms that are typically included in a venture capital term sheet include:
-The amount of money to be invested
-The valuation of the company
-The preferred stock rights of the investors
-The liquidation preference of the investors
-The board seat rights of the investors
-The management rights of the company
-The rights of first refusal for future financing rounds
-The exit strategy
A quick look at the key sections in a term sheet. A term sheet must have the offering terms, charter, stock purchase agreement (SPA), investor rights, co-sale agreement, voting rights, confidentiality clause, and the expiration date of the term sheet.
What to Include on a Term Sheet?
You will likely face many term sheets from venture capitalists (VCs) as a startup. A term sheet is a document that outlines the key terms and conditions of a proposed investment.
While every VC has their own preferences, there are some key elements that should be included on every term sheet. Here are a few of the most important things to remember when negotiating your next term sheet:
- The amount of money invested: This is probably the most important part of the term sheet for startups. Make sure you know how much money the VC is willing to invest and that this number is clearly stated in the document.
- The type of investment: There are different types of investments, such as equity or debt financing. Be sure to know what type of investment the VC is proposing so you can understand the implications for your company.
- The valuation of your company: This number can have a big impact on how much ownership stake the VC will end up within your company. Make sure you understand how the valuation was determined and that you are comfortable with it before agreeing to anything.
- The dilution: This refers to how much your current ownership stake in the company will be diluted
- Pre-money valuation: You and your investor will have to figure out the value of your company. The negotiations will revolve around the value of all stocks and anything that can be converted into common stock. Your investor’s ownership percentage will be based on this valuation.
- Non-participating liquidation preference: When calculating returns at the exit, liquidation preferences will always specify that investors receive a higher priority than common shareholders. You can, however, negotiate for a non-participating liquidation preference of 1X plus interest. If the proceeds permit, preferred investors will be able to receive double their investment.
- Boardroom makeup: This designates who controls the company’s board seats. A 2-1 structure is most founder-friendly. However, 2-2-1 – two seats for the founders, two for investors and one outside member – may result in the founders losing control over the company.
Why Are VCs So Particular About Drafts of the Term Sheet?
VCs want to see a well-drafted term sheet because it shows that the entrepreneur is serious about the deal and has thought about the key terms. A well-drafted term sheet also makes it easier for the VC to understand the deal and allows them to provide feedback more quickly.
How Long Should a Term Sheet Be?
There’s no one answer to this question – it depends on the particular venture and the amount of money raised. However, a term sheet should be around ten pages long as a general rule of thumb. This gives enough room to include all the important details without becoming too cumbersome.
A Few Key Takeaways:
A term sheet is an important tool in venture capital. It is a document that outlines the terms of an investment and is used to negotiate the final details of an investment. A term sheet can be a helpful tool for both startups and investors, as it can help establish clear expectations and avoid misunderstandings down the road.
- A term sheet is only a plan for the transaction and not a contractual commitment
- From one venture capital firm to another, terms sheets are fairly consistent, and the trend is to make them shorter and more transparent
- Focus on the terms that are most important when negotiating and make sure that your position has been carefully considered and is reasonable.