Receiving an investment offer for a funding round represents a tremendous achievement. The offer also marks the beginning of a period of critical analysis and negotiations as you decide whether to accept or reject the offer. The interested investor issues a document called a term sheet, which articulates the details of the investor’s offer. Term sheets can appear nearly indecipherable due to their length, complexity, and technical vocabulary. Luckily, even without legal training, you can learn to analyze a term sheet and understand the most important elements of the proposed transaction. This article provides a basic description of term sheets, summarizes the term sheet negotiation process, and provides some useful negotiating tips.
Term Sheets 101
A term sheet is a document that outlines a proposed business agreement between two parties. This article focuses exclusively on term sheets relating to startup investments, but term sheets are also issued during mergers, acquisitions, and many other transactions. Term sheets act like letters of intent in that they signal the conditions under which an investor seeks to complete a transaction. Investors hoping to lead1 an equity round draft a term sheet and solicit your approval. Depending on the startup’s maturity, the investor issuing the term sheet may be a syndicate2 of angel investors (seed financing), a VC firm (early- to late-stage financing), or an institutional investor (late-stage financing).
The two main purposes of the term sheet are to 1) quantify the economics of the proposed investment and 2) articulate the investor’s rights. Some of the economics described in the term sheet includes the amount of capital raised, the pre-money valuation, the number of shares being issued, and the creation of stock option pools. (For more information on these topics, see our Valuation and Dilution and Stock Option Pools articles.) Some of the most important investor rights discussed during term sheet negotiations include representation on the board of directors, protective provisions, and liquidation preferences. (See our Term Sheet Provisions (Part 1)and Term Sheet Provisions (Part 2) to learn more about these investor rights.)
Term Sheet Negotiation Process
The process for receiving a term sheet begins during your first meeting with a potential investor, where you pitch your vision for the company and detail any initial progress you have made. If both sides are interested in a possible deal, you will begin preliminary negotiations with the investor. If you can reach a general agreement about the main points of an investment, the investor will draft a term sheet, which provides a more detailed description of the investor’s offer.
A term sheet offer denotes an investor’s interest in the startup but does not represent a legally binding commitment3. The non-binding nature of the term sheet allows you to negotiate the core aspects of a deal without having to pay costly legal fees. Although the term sheet is mostly non-binding, you should not underestimate the importance of term sheet negotiations. Most investors view the finalized term sheet as a commitment, and you may find it very difficult to change important characteristics of the deal after accepting the term sheet.
Successful startup companies may receive term sheets from multiple investing groups and can compare the offers to determine the best alternative4. Having multiple investors interested in your startup provides additional negotiating leverage, but even founders with a single offer should negotiate the terms of the deal. Matthew Bartus of Cooley LLP, a prestigious law firm specializing in VC investments, explains that most VCs expect founders to initiate negotiations. Founders may even lose credibility with investors if they do not negotiate the core aspects of the proposed deal.
If you negotiate a set of terms acceptable to both parties, you must formally accept the revised term sheet. The investors will conduct due diligence5 and prepare to make their investment. The term sheet then serves as the basis for drafting legal documentation6 for the new class of securities7 issued in the financing round.
The term sheet also includes an exclusivity clause, in which the startup agrees to pursue the proposed transaction in good faith and promises not to solicit term sheets from other investors. Reneging on a previously accepted offer can tarnish your personal reputation, as well as that of your startup. The startup community is very interconnected, and you may struggle to attract investors for subsequent funding rounds.
Term Sheet Structure
Although lawyers can take liberties when drafting the document, most term sheets typically follow relatively standard formats. The exact layout and terminology may vary from law firm to law firm and from deal to deal, but most term sheets include the same general elements.
As an example of a term sheet’s general format, the layout from Alex Wilmerding’s book Term Sheets & Valuations is provided below:
- Preamble – The preamble often states when the term sheet expires and explains the terms of the exclusivity clause.
- Opening Information – The opening paragraphs typically provide an overview of the proposed transaction, including the name of the investor and the potential investee.
- New Securities Offered Section – This section lists the type of securities that the startup will issue (usually convertible preferred stock), the total amount of capital raised, the number of shares to be issued, and the purchase price per share.
- Post-Financing Capitalization – This section shows the ownership structure of the firm after the financing round including the amount of stock issued to each major shareholder.
- Rights, Preferences, and Privileges – The lengthy provisions in this section describe the rights of the investors who will be receiving the new security. You can find information about provisions relating to dividends, liquidation preferences, redemption rights, conversion rights, voting rights, protective provisions, anti-dilution clauses, and more.
- Conditions Precedent – This section describes the level of due diligence that will be completed once the startup agrees to the term sheet.
- Employee Matters – This section provides details about employee stock option programs, key person insurance, and the hiring of new executives. Investors often insist on expanding stock option plans as part of their investment and require board approval of the hiring of key executives. (See our Dilution and Stock-option Pools article for more on stock option plans.)
- Closing Date, Legal Counsel, Expenses – This section identifies the deal’s closing date, the startup’s legal counsel, and who will pay the legal fees associated with the deal.
The National Venture Capital Association (NVCA) provides a sample term sheet for entrepreneurs to use as a reference during negotiations. After creating an account on the NVCA website, you can download and use this free resource - NVCA Model Term Sheet.
How to Analyze a Term Sheet
Analyzing a term sheet can be very difficult due to the legalese and the complexity of the arrangement. Term sheets mix economic considerations (like valuation) and control provisions (like board representation) into a single agreement, further complicating the analysis. As you prepare to analyze a term sheet, remember that you will be negotiating the offer in its entirety. During negotiations, you may need to compromise in some areas to win concessions in others.
Each provision in a term sheet is company favorable, investor favorable, or somewhere in between. Through research and consultation with experienced advisers, you can identify where along the spectrum of favorability each provision lies. After identifying the favorability of each term sheet, you should identify which provisions you would like to negotiate and what you are willing to sacrifice to realize those changes. Although each funding situation is unique, we have included some general guidelines to consider when preparing for term sheet negotiations.
- Consult a Lawyer – Although you should perform your own analysis, you should also consult an experienced lawyer upon receiving a term sheet. Your lawyer (general counsel or outside counsel) should be involved very early in the process because you want to clearly understand the investor’s offer before beginning negotiations with the investor. You may lose credibility and goodwill if you are not properly prepared to discuss any item in the term sheet with investors. At the end of the negotiations (but before you sign the term sheet), you should have your lawyer review the term sheet to make sure that no important provisions have been overlooked.
- Know Your Investors – Establish open, frequent dialogue with your investors to better understand their perspective. Ask about why they requested specific terms or how willing they are to negotiate8 on key provisions. You should consider which provisions are most important to the investor based on their risk appetite, investment horizon, and investment specialty. The better you know your investors, the better you will be able to negotiate.
- Prioritize Thoughtfully – Although many term sheet provisions can significantly impact your company, other conditions have a negligible effect on the overall transaction. Do not spend considerable time negotiating relatively insignificant aspects9 of the deal. Instead, focus on the central aspects of the deals, including the valuation, the stock option pool, liquidation preferences, and corporate governance.
- Raise Sufficient Capital – Funding rounds usually provide a means for startups to raise much-needed capital, so the size of the investment is of paramount importance. Not raising sufficient funds can put a startup’s growth plans in jeopardy and leave your startup financially insecure. If market conditions change and your startup cannot raise its next funding round as quickly as anticipated, your startup may face a life-or-death financial crisis. To avoid these issues, Alex Wilmerding recommends raising enough capital to fund the company for 12 – 18 months (Term Sheets & Valuations). You should also consider whether an investor would be able to contribute additional capital due to an urgent funding need.
- Be Realistic about the Valuation – The valuation is often the focus of negotiations between investors and founders due to its influence on the size of the investment and the post-financing ownership structure. If you can negotiate a higher valuation for your startup, you can raise the same amount of money with less shareholder dilution. During your negotiations, however, you should be realistic about your demands for the valuation. Many startups struggle to obtain financing because their founders are unyielding in their demands for an inflated valuation. Also, you must stay up to date on the state of the startup financing market. Valuations can fluctuate from year to year, depending on the state of the economy and availability of capital. Receiving an overly high valuation from investors can also be extremely detrimental to your company’s prospects in the long-run. A high valuation subjects your startup to intense pressure to live up to the lofty expectations set by investors. If investors perceive that your company is underperforming, you may struggle to raise additional capital in the next funding round. Even if you can obtain financing, the valuation will likely be lower than the previous round, diluting investors’ shares and damaging your startup’s reputation.
- Analyze Investor Protections – Term sheets can present extremely adverse conditions to founders, even when the size of the investment and the valuation appear acceptable. Term sheets nearly always provide the new investors with additional rights not available to common stockholders. Some of these rights significantly alter the economics of the deal under certain scenarios (see our Liquidation Preferences and Anti-dilution Provisions articles). Also, the amount of decision-making influence that investors receive over corporate governance (via board representation and special approvals) can hinder management flexibility. You should verify that the investor rights and corporate governance influence provided to new investors follow typical industry norms.
- Watch out for Red Flags – Some investor behaviors may suggest that the deal is not as good as the investor has indicated. If you see one of these red flags, investigate the investor’s motivation for acting in this way. With each of these warning signs, the investor may have a legitimate reason for pursuing that course of action, but you should always have a firm understanding of why the investor’s behavior is reasonable before accepting a deal.
- Restrictions on Syndicated Deals – If an investor protests the expansion of a funding round to include other interested investors, you should assess their motivation. This could be a sign that the investor seeks to amass control and influence by limiting the size of the offering. However, some benign reasons for this behavior include administrative costs and disagreements between investing groups.
– Milestones – Some investors commit funding over set increments, called tranches, based on the achievement of certain milestones10. Term sheets that include milestones may indicate an investor’s mistrust or lack of commitment, especially if the startup has a seasoned management team and a proven track record. For unproven startups seeking an ambitious growth trajectory, however, milestones may be appropriate.
- Any Non-standard or Overly Complex Provisions – Most investment agreements will resemble the investor protections, management requests, and structures used in other deals. If you or your lawyer recognize an extremely complex or unusual provision, you should ask for an explanation from the investor. Never sign off on a deal that contains a complex provision that you do not understand. Advisors and lawyers who have been involved in other funding rounds can alert you to any unusual provisions.
- Look Beyond the Term Sheet – Accepting an investment from an outside investor has long-lasting implications on the future of your startup. You should assess whether you will enjoy working with the investor and whether the investor’s vision for the company aligns with your long-term strategy. If you already have other outside investors from prior financing rounds, you should consider how well the new investor will integrate with the existing investors. Also, you should not underestimate the value that experienced investors will bring to your startup. Oftentimes, the “best” offer is not the most lucrative one, but the one led by investors that have the best fit with your company. (For more on this topic, see our Venture Capital article)
Term sheets serve as a powerful tool for investors and entrepreneurs to negotiate the details of a proposed investment. Understanding the purpose and structure of these agreements can enhance your ability to negotiate the best financing arrangement for your startup’s long-term prosperity. As you consult trusted legal advisors and consider the repercussions (financial and non-financial) of a proposed investment, you will be able to make an informed decision regarding your financing alternatives.
- Tech Crunch: How Top Founders Juggle Term Sheets
- Cooley: Negotiating Term Sheets: Focus on What's Important
- Morgan Lewis: Preparing a Venture Capital Term Sheet
- Harvard Business Review: How to Negotiate with VCs
- Term Sheets and Valuations by Alex Wilmerding
- Venture Deals by Brad Feld and Jason Mendelson
- The lead investor usually provides most of the capital in the equity round, coordinates with the other investors in the round, and represents the other investors during funding negotiations. The lead investor typically receives a seat on the startup’s board of directors.
- A syndicate refers to a group of investors who contribute capital as part of a joint investment.
- The confidentiality provision (or exclusivity clause), no-shop provision, and provisions discussing fees and out-of-pocket expenses resulting from the fundraising are typically the only other legally-binding aspects of the term sheet. For more information on these provisions see our Term Sheet Provisions (PartII).
- After a relatively short period of time term sheets expire (become invalid). If your startup attracts interest from several investors, you should try to have the investors issue their term sheets at about the same time, allowing you time to compare the offers.
- Due diligence describes the process by which investors verify that management fairly represented the startup’s financial, operational, and legal standing during negotiations. If management has been untruthful during negotiations, the investors can terminate their offer.
- The new financing often requires lawyers to redraft or amend the startup’s articles of incorporation. Lawyers must also draft a Purchase and Sale Agreement for the incoming investors and the startup to officially sign off on the deal.
- Incoming investors at each funding round often receive new classes of stock. Each class of stock possesses a different conversion ratio (based on the associated company valuation) and different investor rights/protections such as voting or board rights.
- Some investors purposefully extend investor-friendly term sheets with the expectation that these terms will change during negotiations. Other investors issue term sheets and are unwilling to negotiate further. Understanding the level to which investors are willing to negotiate can help you know when to push for more concessions and when to accept an offer.
- Certain industry-standard terms will be nearly impossible to change via negotiation.
- Instead of receiving a $5 million Series A round up front, a startup might receive $2 million upon closing the deal, and the next $3 million upon achieving a revenue target.