More often than not, most startups and businesses go through this phase of intensive idea pitch-ins and venture capital investor scrounging. Some take several months to successfully bag one or a few venture capital investors, while some take only a few. So after going through all the turmoil and hullabaloo of actually finding investors, numerous questions pop up.Which one will be the best fit? What do the good investors do that the not-so-good ones don’t? Will this one even help to turn the startup or the business into a major player in the industry? And the questions keep coming.
What is a Term Sheet?
An investment term sheet is a non-binding agreement which sets forth the basic and finalized terms and conditions that have been set upon discussion. It is more like a formal blueprint document which later allows the company’s lawyer to draw up a detailed legal document.
Term sheets are not usually legally binding contracts, almost like letters of intent. They are a great way to prevent a permanent drain of capital due to the expensive legal charges involved in drawing up a legal agreement. Term sheets generally cover the most important aspects of a pact without going into every minor detail from every nook and corner. A binding or a legal contract mostly covers this type of detailing and contingency.
Key Components of Term Sheet
Here are the key components typically included in an investment term sheet:
| Components | Description |
|---|---|
| Valuation | Specifies the pre-money and post-money valuation of the startup, determining the percentage of equity that investors will receive for their investment. |
| Investment Amount | The total amount of capital that the investors are committing to the startup. |
| Equity Stake | The percentage of the company that the investors will own post-investment. |
| Investor Rights | Details the rights granted to investors, such as voting rights, information rights, and anti-dilution protections. |
| Board Composition | Specifies the structure of the company’s board of directors and the number of seats allocated to investors, founders, and independent members. |
| Liquidation Preference | Determines the order and amount of payouts to investors in the event of a liquidation or sale of the company, often including a multiple on the invested amount. |
| Dividend Rights | Outlines any dividends that investors are entitled to receive and the terms under which they are paid. |
| Conversion Rights | Specifies the conditions under which preferred shares can be converted into common shares. |
| Voting Rights | Details the voting power associated with the shares, often giving preferred shareholders certain voting privileges. |
| Anti-Dilution Provisions | Protects investors from dilution by adjusting the conversion rate of preferred shares in the event of future equity issuances at a lower price. |
| Vesting Schedule | Outlines the timeline and conditions under which founders’ and employees’ shares will vest, often including acceleration clauses in the event of certain triggers. |
| Exit Provisions | Specifies the conditions under which investors can exit their investment, including IPO, sale of the company, or buyback arrangements. |
| Protective Provisions | Grants investors certain veto rights over key business decisions, such as issuing new shares, changing the company’s structure, or significant capital expenditures. |
| Confidentiality | Ensures that all parties involved agree to keep the terms of the agreement and any sensitive information confidential. |
| Exclusivity | Prevents the startup from negotiating with other potential investors for a specified period during the negotiation process. |
| Conditions Precedent | Lists any conditions that must be met before the investment is finalized, such as due diligence findings and legal compliance. |
8 Basic Elements of an Investment Term Sheet
An investment term sheet format typically includes several key elements that outline the terms and conditions of the investment. Here are 8 basic elements commonly found in an investment term sheet:
1) Price and Valuation Negotiations
Valuation is a highly debated issue that goes on between a business owner and a venture capitalist. It’s not something that one can list and confirm on their own. Agreement of both parties is essential. In plain terms, the net worth of a company is the driving factor that fuels the investors to pay a high price for a piece of the action.
Valuation also depends on how much capital would it take for a company to be an absolute success. Therefore, to set up a high price, it is important for the company to have a strong management team, market potential, as well as a great financial return.
2) Dilution and Anti-Dilution Clauses
A proper understanding of the dilution and anti-dilution clauses is crucial as these clauses mention how the future investments will dilute the percentage of ownership of the business owner as well as the investor.
Generally, to be able to protect future shares from being sold at a lower value, venture capital firms most essentially need an anti-dilution clause in the investment term sheet. The anti-dilution clause is usually a very standard element of a term sheet. Therefore, it is only wise for the business owners to negotiate the terms stated under this clause rather than arguing upon eliminating this clause.
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3) The Option Pool Clause
An option pool clause deals with setting aside the amount of stock that a company can use for a number of purposes in the future. These purposes include stock as compensation for employees, stock to offer to the service providers, stock intended as an incentive for the employees, etc.
4) The Drag-Along Rights Clause
This clause allows the majority shareholder, which is usually the investor, the right to drag the minority shareholders, which is usually the business owner, along with them in case the former decides to sell their stakes off.
This also allows the majority shareholders to make it compulsory for the minority shareholders to sell their stakes on the same terms as that of the majority shareholders. The consent of the minority stakeholders is irrelevant as per this clause.
5) The Tag-Along Rights Clause
Clearly just opposite of the drag-along clause, this clause works in favour of the minority shareholders or the business owners. This clause allows the minority shareholders to sell their shares along with the majority shareholders or the investors. This clause ensures that the minority shareholders are not forced to work with someone against their will.
6) The Liquidation Preferences
When the company is sold or liquidated, the preferred stockholders as per the term sheet receive a certain amount of money before the distribution of an asset to the other stockholders. This clause is one such clause which can have a great impact on the business owners. This clause does not work in favour of the equity of ownership. There can be two kinds of preferences, multiple liquidation preferences, and a participation or non-participation preference.
7) The Voting Rights
A venture capital investor sitting on the board of directors is allowed with voting rights which are in favour of the company and on certain critical resolutions in the future. However, whether the venture capital investor will have one vote to cast or more totally depends on the terms laid down in the term sheet post-negotiation.
8) The Cost Of Counsel Clause
Most investors ask the business owners to compensate or pay for all or any legal cost that has been incurred while conducting due diligence and developing an investment proposal. This is one of the few non-negotiable clauses in a term sheet.
Besides all such clauses and terms, a term sheet also sets an outline of the total commitment that is expected from the investors. These commitments are mostly valid for 10 years. However, the term sheet is the debut point of the discussions that are about to happen between the investors and business owners.
Term Sheet Template – Example
Here’s an example of a simplified term sheet template:
The investors are mostly professionals who have years of experience in the field along with proper legal networks. Therefore, it is only wise for the business owners to come to the table fully equipped.
FAQs on Investment Term Sheet
An investor term sheet is typically created through negotiation between the company seeking investment and the potential investor(s). It outlines key terms and conditions of the investment, such as the investment amount, valuation, securities issued, investor rights, and other relevant details.
When a company receives a term sheet from an investor, it signifies that the investor is interested in providing funding under the proposed terms. The company typically reviews the terms outlined in the term sheet, and may proceed to due diligence and finalizing the investment agreement.
A VC (venture capital) term sheet is a document outlining the terms and conditions of an investment proposed by a venture capital firm. It includes details such as the investment amount, valuation, investor rights, liquidation preferences, and other terms specific to venture capital investments.
A term sheet is a non-binding document that outlines the key terms and conditions of a potential investment or transaction. It serves as a basis for negotiation and discussion between the parties involved. In contrast, a contract is a legally binding agreement that sets forth the rights and obligations of the parties once it is signed.
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