How to read a term sheet? Every business transaction comes with a set of terms and conditions that are agreed upon by both parties. Since startup funding is one of the most important transactions, especially for startups, there should be no surprise that it comes with a set of terms as well.
Before the funding is finalized, it is normal for both the startup and the investor to avoid entering a legally binding agreement. That is where term sheets come in. This document contains the terms and conditions of the investment.
A term sheet serves as a reminder for both parties (investor and the startup) of the terms that have been agreed upon, as well as laying out what must be done or verified for the funding to be completed.
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This non-binding agreement has the potential to result in more detailed and legally binding agreements that eventually make the investment a successful transaction. So it goes without saying that both parties should give importance to this document and pay close attention to the terms it contains.
If you are an investor trying to invest in a startup for the very first time, it is essential that you are familiar with the term sheet and can read it properly. Similarly, startups should also know how to put together a term sheet and add important information to it. So if you are an investor or a founder trying to learn more about the term sheet, then this article is for you.
Here is the content that we will cover in this post. Let’s get started.
- 1. What exactly is a term sheet?
- 2. Why is a term sheet important during the investment process?
- 3. What are the key components of a term sheet?
- 4. Identification
- 5. Valuation
- 6. Investment amount
- 7. Percentage stake
- 8. Time frame
- 9. Voting rights
- 10. Other clauses
- 11. Drag along clause
- 12. Dividends
- 13. Pro rata rights
- 14. No shop agreement
- 15. What are the differences between an LOI and a term sheet?
- 16. Benefits of a term sheet
- 17. Nonbinding
- 18. Helps prevent disagreements:
- 19. Shows that both sides are interested:
- 20. Helps set expectations:
- 21. Conclusion
What exactly is a term sheet?
A terms sheet is an agreement between the business and an investor that doesn’t have to be legally binding. It explains the main terms and conditions of an investment deal. Parties often use it as a starting point and model for the more detailed and legally binding documents that will come later. This is normally the format of the offer that investors provide.
Once everyone agrees on the details of the term sheet, they’ll move on to the next step, which is putting together the legal documents that make the investment in the company possible.
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A term sheet can also be used for mergers or when acquiring another company by larger firms. This contract is a very important part of being an entrepreneur and an investor, and you will likely come across it quite often. This document also helps investors understand where to put their money and how much they can expect to get back.
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Why is a term sheet important during the investment process?
A term sheet is not always an easy-to-understand document. Investors and company founders can negotiate and agree on the important terms of their agreement without the fine detail or permanence of a binding document. This document holds significant importance during an investment negotiation process. This is why you should know how to read a term sheet.
The term sheet makes it less likely that there will be a misunderstanding or a dispute between the investor and the founder during the negotiation and funding process. In addition, the term sheet makes sure that the expensive legal fees that you have to incur when creating a binding agreement or contract, are not spent too soon or unnecessarily during the negotiations.
It is like a ‘letter of intent’ or a ‘memorandum of understanding’ because it merely notes down the agreed-upon terms between the two parties. However, while the letter of intent and memorandum of understanding might be used during the M&A process, the term sheet is used more often during financing.
A private equity provider finds a few companies that need to raise money and chooses them as targets. Then it looks at their business model and business plan, and when the negotiations between the two parties start, the term sheet comes into play.
What are the key components of a term sheet?
Now that you know what a term sheet is and why it holds so much importance, it’s critical that you are familiar with the components of a term sheet. Now a term sheet may contain varying sections depending upon the requirements of a specific investment, however, some sections are a part of most term sheets.
The first step to being able to read and understand a term sheet is to familiarize yourself with the key components. So, without further ado, here is a list of some commonly used sections of a term sheet that you might come across when reading or drafting one. Understand them carefully since they are critical to learning how to read a term sheet.
In this section, both the investor and the startup provide all the information about themselves that is necessary for the transaction. This will let you know who is involved in the term sheet and who you will be negotiating with. So, in short, the “Identification” section lists the names of the people involved in the investment deal and any other details that may be related to them and the transaction.
This is how much the company being invested in is worth. Investors will want to know this before putting money into a business. The valuation can also take into account how many shares of the company have already been given out and how much they were sold for.
The amount of investment should be laid out clearly so that there is no confusion about how much money the startup is looking for. This part of the term sheet will almost always be different from one startup to the next because the amounts of investment vary.
This is the amount of the company that the investor will own if the deal goes through and the money is given to the startup. For example, if the percentage stake is 10%, the investor will own 10% of the company. This section of the term sheet is often the most debated one, so it is best that both parties take time and carefully decide the percentage stake to make sure everyone is on board.
It is standard practice to give the investor a certain amount of time to look over the term sheet and make a formal decision. So, if you are an investor, now is the time to carefully read all the terms and learn what they mean.
Venture capitalists want to get the most out of their investments, so they might ask the business owner to give up some of the company’s voting rights. Depending on the agreement, this can go in any direction, but you may want to spell out how much voting power the investor will have if they give you the much-needed money.
It’s common to include clauses about who pays for legal fees, the investor’s right to company information and future investments, details about non-disclosure, and the founders’ responsibilities. If you know how to read a term sheet, you’ll find it easier to identify these clauses.
Drag along clause
The drag-along clause holds great importance for investors as it lets a major shareholder force a minority shareholder to go along with their business decisions, especially when a company is being sold.
Dividends are payments made to shareholders on a regular basis, usually every three months, based on how much money the company made. The term sheet covers these payments, and investors should pay close attention when drafting this section of the sheet.
Pro rata rights
An investor gets these rights so that they can also take part in future funding rounds as well. You might even see “pay to play” clauses similar to pro rata, which means investors are required to take part in future investment rounds or pay penalties.
No shop agreement
Once you sign the term sheet, this agreement limits how the startup can work with other investors. After signing the term sheet, it’s normal for startups to have to wait a certain amount of time before starting another fundraising round. However, the term sheet should include a date after which it’s okay for the startup to start seeking more investors.
As mentioned earlier you don’t necessarily have to use all these sections stated above when creating your own term sheet. In addition, these are also not all the possible term sheet clauses that you might encounter. However, now that you know the basic components of a term sheet, you can move on to understanding other sections that might be related to the above-mentioned ones.
If you’re ready for more information about what is a term sheet, check out this video I have created. You’re sure to find it more helpful when you’re reading the document.
What are the differences between an LOI and a term sheet?
Most investors and founders think that LOI and Term Sheet are the same thing. But even though they might look the same, they are not.
A term sheet can be as short as 500 words in length.
An LOI is more commonly used in M&A or acquiring something. It is a preliminary offer, which spells out the potential terms that a buyer is interested in. Before spending money on more detailed documents or investing too much time in a deal that may not be accepted.
When investors sign a term sheet, they are only agreeing to the basic terms of a possible investment deal. These are the name of the company, the amount being invested, what they get in return, the due diligence required, and how long they should stay vested.
Most of the time, the term sheet is only about two pages long. Both can talk about many parts of the deal, such as the money, who owns what, the conditions for completion, and how long the investment will last. So, take the time to understand how to read a term sheet.
Benefits of a term sheet
While it should be clear by now that a term sheet is a key part of an investment deal. However, to sum it all up, here are the benefits of using a term sheet in your investment transaction.
Term sheets are usually not legally binding, so you can show that you are serious about the deal without being locked in or risking too much. On the other hand, you can also include binding obligations in your term sheet if you think that would help negotiations.
Helps prevent disagreements:
A term sheet lists the terms and requirements of a deal that both parties have agreed to in principle; this helps to avoid disagreements. By writing up a term sheet, you can point out disagreements and focus your negotiations on those areas. The term sheet will help make sure that everyone knows what to expect and what needs to be done to make the deal happen.
Shows that both sides are interested:
Even if the term sheet doesn’t have any legally binding terms, just signing it can make both sides feel more committed to the deal at hand. When you sign a term sheet, you have a moral obligation to keep your word, which can help steady a deal that would otherwise be shaky.
Helps set expectations:
A term sheet that has all of the important terms and information about the deal will help make sure that everyone knows how the deal will work. This will help you avoid misunderstandings that could be very bad for you if you find out about them later in the process.
Knowing what a term sheet contains and how to interpret that information is important for both investors and founders. Now that you know what this document is and what it contains, you should be able to confident about how to read a term sheet and draft one for your own investment transactions.
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