How to negotiate a term sheet? With startup culture on the rise, more and more entrepreneurs and small businesses are seeking investment to either launch or grow their businesses. However, investors aren’t just going to give away their money for the sake of growing your business. Instead, they expect certain benefits in return for their investment.
So, while it is important to have an agreement between the startup and the investor prior to the investment, it is not necessary to have a legally binding agreement during the initial negotiation phases, that is where a term sheet comes in. A term sheet is a non-legally binding agreement that outlines the key components of the investment deal without involving the legal aspect of the mix.
Since term sheets mostly concern startups it is important for founders to know how to negotiate a term sheet. Not to mention, most startup founders aren’t even sure what a term sheet is and how it works if they are raising funding for the first time. So, if you are going to enter negotiations with an investor and aren’t sure how to negotiate a term sheet, then keep reading.
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Here is the content that we will cover in this post. Let’s get started.
- 1. What Exactly is a Term Sheet?
- 2. Benefits of a Term Sheet
- 3. What are Some Key Terms of a Term Sheet?
- 4. Information about the parties:
- 5. Board privileges:
- 6. Protections for investors:
- 7. Valuation:
- 8. Miscellaneous terms:
- 9. Investor’s commitment:
- 10. Nondisclosure requirements:
- 11. Closing date
- 12. Total invested amount
- 13. Key Tips for Negotiating a Term Sheet
- 14. Try to get multiple investors to provide a term sheet:
- 15. Find the right investor
- 16. Don’t rely on standard terms of the term sheet for your protection
- 17. Don’t accept a long due diligence period
- 18. Getting the valuation wrong
- 19. Conclusion
What Exactly is a Term Sheet?
Before moving on to the negotiation tips for negotiating a term sheet, it is important for a startup owner to understand what a term sheet actually is. While we have already mentioned at the start that a term sheet contains the key aspects of an investment deal.
Think of it as an offer of an investment in your company. It is the basis for negotiations, and for the investor to begin their due diligence to ensure your company is all you pitched it to be.
The term sheet is used as a template that comes into play in investment negotiations. Once everyone agrees on the details in the term sheet, a contract is later made that formally enforces the terms of the term sheet.
The purpose of the term sheet is to make sure that everyone involved in an investment deal agrees on the most important points involving the investment. The term sheet makes it less likely that there will be a misunderstanding or a disagreement that can prevent the deal from materializing.
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Also, the term sheet makes sure that the expensive legal fees that come with making a binding agreement or contract are not spent too soon during the negotiations.
All term sheets have information about the assets, the initial purchase price, and any factors that could change the investment amount. They also have a time frame for a response and other important details.
An investor finds a few companies that need to raise money and shortlists them as targets. Then, they look at the business model, read the business plan, and do their homework. After making the shortlist, they have the necessary talks and negotiations to choose the target company. The term sheet comes into play when a financial provider wants to make an offer to invest.
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Benefits of a Term Sheet
The benefits of using a term sheet include:
- You can use the term sheet as a guide when negotiating with other companies, so you’ll know what your options are and how much to ask for
- A term sheet will help you avoid any confusion or miscommunication, which could lead to problems
- A clear understanding of what each party expects out of the relationship
- An opportunity for both parties to have input on how they will work together
What are Some Key Terms of a Term Sheet?
The previous sections have covered the key features and benefits of a term sheet and how it works alongside the investment negotiation process. Even though a term sheet is a non-legally binding document, it still covers quite a few different aspects of an investment deal. So if you are going to negotiate a term sheet, you should first learn the most common terms that are included in the document.
With that being said, here are the key terms included in a term sheet that you might need to know during the investment negotiations process.
Information about the parties:
The names of the parties involved in the investment deal are included in this section. So in short this section specifies the business that needs investment and the investor who is offering the investment.
The investor often seeks the right to appoint or vote for people that make up the company’s board of directors. Investors can usually choose a small number of board members, but they may insist on being able to choose independent board members who will hold power.
Protections for investors:
Some decisions related to the business often need investor approval. Most of the time, these decisions include issuing new shares, taking on debt, buying back shares, and paying dividends on shares. Investors may also want control over things like hiring and firing senior management and making big changes to the business operations.
This section specifies the estimated value of the startup, which investors can use to decide whether or not to invest in the business. You will have a pre-money and post-money valuation.
This part contains additional terms related to the investors’ and founders’ rights. You may negotiate the term sheet while focusing on the following key parts of this section:
It tells investors what is expected of them in terms of the investment and any other duties they may take on. The founder’s duty: This part shows the founder’s liabilities and responsibilities toward the business.
This clause tells both sides what they need to do to keep the information they learned about each other during the deal a secret after they’ve signed it.
This gives the closing date, which is usually a few days after the due diligence is done.
Total invested amount
The amount of investment should be clearly specified in the document. Most of the time, the investment amounts change a lot during the investment deal and negotiations.
Even as you’re learning how to negotiate a term sheet, you might want to learn more about what is a term sheet in detail. Check out this video I have created explaining everything you might want to know. It’s sure to help you.
Key Tips for Negotiating a Term Sheet
By now, you should know the important details about a term sheet that will give you leverage when negotiating the document with potential investors. With that said there are still some ways you can make sure to get a better deal out of the term sheet.
Try to get multiple investors to provide a term sheet:
Even though it may seem hard enough to find just one investor, it is in your best interest to build relationships with several investors at the same time.
This will give you leverage when negotiating a term sheet for many reasons. First, you may find that you need a group of investors instead of just one to raise the amount of funding you seek. So, from a financial point of view, it may make sense to look for a group of investors.
Second, investors tend to follow other investors, so once you get some investors on board, it is easier to get the next one to join. A potential investor will be more likely to agree to the terms proposed by the founders if they know they are competing with others.
It’s normal to be eager to start negotiating a term sheet after getting your first investor. But working with an investor is about a lot more than just getting money from the investor in exchange for a stake in your business, you need to find the right investor.
Find the right investor
Your business will grow a lot faster with the help of a good investor. You should work with investors who can give you both money and advice. So, it’s important to do your homework to make sure that the investors you’re thinking about have the right credentials and experience to help your business succeed.
Not to mention when you have a good relationship with an investor, they are much more likely to agree to favorable terms. In the end, it comes down to this: the more time you spend choosing the investors and forming a good business relationship with them the better terms they may be willing to agree upon.
Don’t rely on standard terms of the term sheet for your protection
‘Standard’ terms might sound harmless, but agreeing to them without knowing what they are is asking for trouble.
Before you sign the term sheet, you should ask questions and make sure you know exactly what the terms mentioned in the previous section are and how they affect you. If you aren’t sure how the terms of a term sheet affect the outcome of the investment deal, you should consult a legal expert to provide the necessary help during the negotiation process. They will direct you on how to negotiate a term sheet.
Don’t accept a long due diligence period
Term sheets usually have special clauses, which say that the company can’t talk to other investors while the interested party does its research about the company before deciding to invest.
Some investors might want more time to perform due diligence. Long periods do more than just give investors time to do their research. It gives them time to see how well your company does before they decide to commit.
Because term sheets aren’t legally binding, it’s important to know that your investor could renegotiate terms that aren’t favorable for you, or maybe just walk away if your business goes downhill during the due diligence time.
Getting the valuation wrong
Valuation is a way to figure out how much a company is worth. Valuation is important when negotiating how much equity an investor gets for their investment. We often talk about pre-money and post-money valuations when negotiating the term sheet.
Both the company and the investor must be on the same page when talking about valuation. Make sure you are both using either “pre money” or “post money” valuation terms.
One of the most common causes of a deadlock in a term sheet negotiation will be the valuation of the startup.
A high value can put a lot of pressure on a founder to live up to expectations and make future rounds harder. Getting the valuation wrong can make it harder for a company to get more money in later funding rounds. You want to avoid a ‘down round’.
Be honest about how much your company is worth, and keep your eye on the end goal. A smaller share of a bigger company is often much better than a larger share of a smaller company.
At the end of the day, the major goal of using a term sheet is to make sure an investment deal reaches a favorable end for both parties. The only way to achieve this goal is by knowing how the term sheet works, what it contains, and how to negotiate a term sheet’s key conditions. By reading this article, you should now be in a better position to negotiate a term sheet.
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