As described in my book The Art of Startup Fundraising, term sheets can be really scary for new start-up founders. More than anything, it’s the fear of the unknown, or of making a mistake that founders may regret later, as the business grows. Term sheets are important, and can be complex, but they don’t necessarily have to be. The key is knowing what to expect, knowing what you want out of a term sheet, knowing what you won’t bend to, and of course having good representation to review all of the fine print.
The term sheet is the document that lays out the terms of the investment and collateral. It details what you as the start-up are giving, and what you are getting in return. Then it lays out the guidelines of how both parties will act to protect the investment.
When dealing with venture investors such as angels or even Venture Capital firms the term sheet will be provided after presenting during a partners meeting. This will be the time when all the partners of the firm get together in a conference room in order to have the founder present her pitch deck. If the presentation satisfies all concerns then a term sheet is presented to the founder. In this regard, not long ago I covered the pitch deck template that was created by Venture Capital investor and Silicon Valley legend, Peter Thiel (see it here), where the most critical slides for VCs are highlighted.
Term sheets can vary depending on what type of funding round you are in, and how much is at stake, as well as who is involved. Generally term sheets for seed rounds are going to be much lighter and shorter than for series A or beyond. The less at stake, the less complex it should be, as no one wants to unnecessarily splurge on extra legal fees, or burning time. The process can be significantly simplified when using a third-party funding portal.
In a seed round, the investor will typically be the one providing the term sheet. This may change, especially when there are multiple investors in later and larger rounds.
Common items in a term sheet include:
- Who is issuing the note or stock
- Type of collateral being offered
- The valuation
- Amount being offered
- Shares and price
- What happens on liquidation or IPO
- Voting rights
- Board seats
- Conversion options
- Anti-dilution provisions
- Investors rights to information
- Founders obligations
- Who will pay legal expenses
- Non-disclosure requirements
- Rights to future investment
A term sheet might just be one page, or it could be 10 pages long. Generally speaking simplicity is often preferred by founders, but it pays to have clarity and make sure all bases are covered.
When a founder is reviewing a term sheet proposed by a potential investors, they should specifically look out for:
- Harsh debt financing and convertible note terms that could bankrupt you
- Asking for too large of a controlling stake, which may suggest you’ll be replaced
- Terms that can limit further fundraising
- Investors that simply want a short and hot exit, and don’t have realistic expectations of timelines
Investors may aim to tire a founder who’s eager to wrap things up. If you see this is happening to you, hang in and be patient. Every single provision included on documents may not make sense today, but one of them may be triggered in the long run and put you, your cofounders, and other employees in a bad space.
Just as founders don’t want difficult or greedy investors on board, investors don’t want hassle or founders that only want to take the money and run. The term sheet should facilitate a win-win for both sides.
The rule of thumb is that you will be receiving a dilution of around 20% per round of financing. You do not want to go over that amount. The life of a start-up is long. Even if you are at a seed stage and you feel it is ok to give up a good amount of equity, you need to know that equity will not come back to you.
A term sheet itself (without signatures) is not an executed deal, or even a promise. There is still due diligence to be done. So both sides can walk away, and it doesn’t necessarily impact the reputation of either side.
They made an offer, you made yours, and you couldn’t meet in the middle. But don’t talk badly about the investor just because you didn’t like the terms. The next prospective investor in line might question what you’ll say about her if she sends you a term sheet. So be mindful. And once you do shake hands on a deal, remember that your word and reputation is really the most valuable thing you’ve got. It’s the only thing you’ve got.
One investing nightmare that tends to recur is when founders receive a term sheet and think the deal is done. They start increasing expenses, thinking the money will be transferred. I’ve personally witnessed instances where a founder with a term sheet ended up not closing the deal, and the founder had to shut down because it was assumed that the money was already in place. Do not be one of this cases.