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Term Sheet for Startups: Concept, Template & Format

Written by:
Mehak Sharma
Published on
27-Aug-19

From the name itself, we can make a guess that a term sheet might be a document containing the terms of anything; be it a deal or contract between two or more parties. So, now we will discuss what a term sheet agreement actually means. A term sheet is a written document, usually of non-binding nature, providing the blueprint of a proposed business deal by detailing out the important terms and conditions.

It is exchanged between the probable parties to a future business agreement to make further modification in the terms. A term sheet is very significant before entering into a contract as it lays down the foundation for any business contract. It details what the startup is giving and what it is getting in return. We have listed all the details about term sheet format in India in the information below.

Salient Features of a Term Sheet

From the short introduction regarding a term sheet pointed out above, we can list the following salient features of a term sheet format:

  • It is a written document

  • It is in bullet-point format

  • It is of non-binding nature

  • It is subject to modifications

  • It is prepared before the final agreement of a business deal is actually prepared

  • It is a document referred to while drafting the final agreement

  • It serves as a template to develop a more detailed, legally binding agreements

 

Advantages of a Term Sheet

A term sheet is not compulsory to make; however, making startup investment term sheet can prove to be really advantageous for both parties for the prospective business deal. Some of the significant advantages of a term sheet can be listed as follows:

  • It displays the intention of parties to enter into an agreement such as an acquisition or funding or financial arrangements.

  • It establishes a preliminary relationship between parties such as among investors, venture capital providers, startups and other firms.

  • It is open to modifications through further negotiations before the final agreement is actually prepared.

  • It ultimately reduces the time required to negotiate a business agreement.

  • It precludes the possibility of a misunderstanding and lessens the likelihood of unnecessary details.

  • It ensures that expensive legal charges involved in drawing up a binding agreement are not incurred prematurely and thereby saves the cost of parties.

  • Since a term sheet is not executed deal or even a promise, both parties can walk out and it does not necessarily impact the reputation of either party.

A term sheet can be prepared to fulfil various kinds of purposes such as for the purpose of acquiring another business, a merger of businesses, for raising funds from investors by startups, etc. However, the most common purpose for which a term sheet is prepared is to attract investors, often venture capitalists, as well as angel investors, having sufficient capital to fund their enterprises i.e. newly set startups looking for funding to establish their business.

Therefore, the content and clauses of a term sheet may vary depending upon what purpose it is going to serve.

A term sheet for business acquisition is therefore different from an investment term sheet template although they may serve the same purpose of briefing about the terms and conditions of an agreement. You can find sample term sheets for startups online or consult an expert to help you with a standard term sheet for startups. 

Venture capital is financing that investors provide to startup companies and small businesses that are believed to have long term growth potential. It generally comes from well-off investors, investment banks and other financial institutions. 

An angel investor is usually a high net worth individual who provides financial backing for small startups or entrepreneurs. Often, angel investors are found among an entrepreneurs’ family and friends. The fund that angel investors provide may be a one-time investment to help the business get off the ground or on an ongoing injection to support and carry the company through its difficult early stages.

Who actually Generates a Term Sheet?

The answer really depends on the circumstances. When a startup is seeking a traditional round of funding from a venture capitalist with a lead investor, typically the lead investor generates a term sheet for the startup to review, negotiate and sign. On the flip side, when a startup is doing a rolling closing with multiple small angel investors (often convertible debt), the company typically draft term sheet and show it to the early angels to get some consensus around the terms before legal counsel drafts the documents.

It is not common that angel investors generate term sheets in this type of situation. Also, while this type of funding is not new, it has been recently popularized by AngelList, Y Combinator and other such companies promoting and funding startups.

Term Sheet Template: What is Included in a Term Sheet for Startups?

There are two most important issues which are broadly addressed in a term sheet. These are:

  • Economics of the investment i.e. issues related to the funding and liquidation of the startup company, and

  • Control of the company i.e. issues related to the corporate governance of the startup company

Each term sheet is going to be different from others depending upon the specifics of the startup and the needs of both the company as well as the investors. However, the most basic elements that you need to know about to figure out how to draft a term sheet has been explained as follows:

Economics of the Investment

  • Term Sheet Company Valuation

This section concerns what an investor believes the company is worth. Valuation issues addressed in the term sheet will include:

  1. Pre-money valuation: the investor’s estimate of what the company is worth before his or her investment of funds.

  2. Post-money valuation: the expected value of the company after the investment of the proposed funds.

  3. Capitalization table: it indicates the ownership of the founder and the investor, equity dilution and equity value in each round of financing. This is required to ensure against any misunderstandings regarding share issuance and valuation, including options and warrants.

  4. Price per share: the per share value of the company stock.

  • Anti-Dilution Clause

Anti-dilution clause concerns how future investment will dilute the ownership percentages of the founder and the investor. Typically, venture capital firms require an anti-dilution clause to protect them from future sales of shares at a lower value. Thus, a clear understanding of the anti-dilution clause is very critical to avoid being bound by unreasonable terms. There are two types of anti-dilution rights:

  1. Full-ratchet: This type is best for preferred stockholders. It allows for the conversion of the price of the preferred stock to be set based on the price of the new round of shares and does not take into account how many new shares are issued.

  2. Weighted average: This type is more favourable to common stockholders than full-ratchet. It considers both the share price of the new stocks issued as well as the number of new stocks issued.

  • Option Pool Clause

An Option Pool Clause concerns the amount of the stock that a company sets aside to be used for a number of purposes such as:

  1. Compensation of employees 

  2. An offering to service providers

  3. An incentive to attract new employees to the company, etc.

In most cases, it is usually advisable to reserve at least 10 percent of the stock for use in the option pool.

  • Shares Offered Explained on Term Sheets

'Shares offered’ refers to the type of shares to be taken by the investor. A company may issue preferred shares and/or common shares. Preferred shares give certain rights to its holders that are not available to the holders of common stock. In most cases, an investor will choose for preferred shares in the term sheet to avail those exclusive rights.

  • Liquidation Preferences

To help ensure their investments against business failures, venture capital investors commonly request what is known as a “1x” invested capital liquidation preference. This simply means, an invested capital liquidation preference entitles the investor to receive, upon company liquidation, the return of the amount of money it has invested in the company, at a minimum, before any other shareholder receives any payout from the liquidation funds.

Any more than 1x means the investors will get more than their investment returned. Investors may additionally have the option to convert their preferred stock shares to common shares; thus allowing them to receive their percentage ownership payout in cash. Investors typically exercise this option when it results in a better return than under the 1x invested capital liquidation option.

  • Additional Financial Aspects of Term Sheets

There are additional financial clauses that can be found in a term sheet. These clauses are important as they impact share conversion, liquidation and other aspects of financing. Some of them include control rights (co-sale and right of refusal drag along), conversion clause, cost of counsel, drag-along clauses, pay to play, registration and piggyback rights, warrants, etc.

  • Pro Rata Right

It is the right of an investor to participate in additional funding. This allows the investor to maintain the same level of ownership in a company when further funding is sought. Pro rata rights are usually good for the company in that they provide a level of security regarding further funding.

  • Voting Rights

Voting rights are very important to investors in this case. These are the rights given to a shareholder to participate in decision making of the company. In most cases, voting rights are vested only in common stock shareholders. Some of those decisions include whether to accept or reject actions taken by the founders such as sale, additional financing and other matters that should be approved through a certain percentage by venture capitalists i.e. investors.

  • Information Rights

It refers to information that a venture capital investor requires to be provided to it by the company on a regular basis, including financial statements, budgets and other documents. The right to physically visit the company from time to time may also be included.

Company Control

In most cases, founders wish to retain as much control as possible over the day-to-day operations and decisions of their companies. On the other hand, investors also wish to possess similar control over the companies they invest in. Therefore, issues of company control are of great concern and play a large part in the language of term sheets.

Some of the specific company control issues which must be included in term sheets are:

  • Board of Directors

The board of directors exercise immense power over the operations of the company such as setting company policies, approving financing and the vesting of company schedules, etc. Usually, a board of directors include both company founders as well as independent directors such as accountants, lawyers possessing specialised training or knowledge beneficial to the company.

Also, a venture capital investor wants to add at least one member to the company’s board to look after its interests in return for its capital investment.

  • Protective Provisions

These are some of the provisions included by the venture capital investors to have certain control in the operations of the company such as veto power on dividend declarations, financial restrictions, and amendments to the company’s certificate of incorporation. These provisions can have serious after-effects for the company.

  • Exclusivity Clause

This clause is usually the only clause binding on the company. It places restrictions on the founders’ ability to seek financing from other sources for a particular period of time and thus allows the investor to perform due diligence before making a final decision on its investment.

Some of the miscellaneous but substantial terms which must be included in a term sheet are:

  1. Legal Fees: In most cases, an investor requires the company to pay certain legal fees and other fees associated with a venture capital deal such as professional fees, due diligence, advisory support, negotiation, etc.

  2. Confidentiality/Non-disclosure Clause: This provision prohibits the founders from discussing the terms of the proposal with anyone other than the co-founders and legal counsel.

Conclusion

There have been a large number of failed cases of founders who have been forced out of their own companies and there is even more number of companies realising that they have lost control over their own companies. Therefore picking up the right investor is very significant. And the Term Sheet plays the most important role in choosing the right investor.

Just as founders do not want difficult or greedy investors, investors also do not want to hassle or invest in founders who only want to take the money and run. Thus, the term sheet should be such that it facilitates a win-win situation for both sides.

A good term sheet aligns the interest of the investors and the founders in such a way that it is beneficial for everyone involved in the long run whereas a bad term sheet digs a pothole for both the investors and the founders and also, against each other.

You can find a sample term sheet here.