Understanding a Term Sheet: A Beginner's Guide

A term sheet is a critical document for entrepreneurs looking to secure investment or funding for their business. It outlines the basic terms and conditions of the proposed investment or partnership. Think of it as a roadmap for the relationship between an entrepreneur and an investor. Let's explore why it's essential and what to include in a term sheet.

Why Does an Entrepreneur Need a Term Sheet?

A term sheet ensures that both parties—entrepreneur and investor—are on the same page. It helps:

• Avoid misunderstandings.
• Set clear expectations for responsibilities and returns.
• Provide a structure for the deal, making future negotiations smoother.
• Save time and money on legal fees by agreeing on major points upfront.

Key Points to Cover in a Term Sheet

1. Parties Involved

• Who is the investor?

Identify the person or entity making the investment.

Example: John Doe, a venture capitalist.

• Where is the investment coming from?

Specify the company or fund providing the money.

Example: Doe Ventures LLC.

2. Deal Style

• What type of deal is it?

Equity Investment: The investor owns part of your company.

Loan/Debt: You repay the money with interest.

Example: A $500,000 investment for a 20% equity stake.

3. Investment Amount

• How much money will be invested?

State the exact amount.

Example: $1 million for product development and marketing.

4. Disbursal

• When and how will the money be released?

Immediately after signing?

In stages? For example, 50% after MVP (Minimum Viable Product) completion.

Example: $200,000 after signing and $300,000 after MVP launch.

5. Tenure

• What is the tenure of the investment or loan?

Specify the period in years.

Example: The loan tenure is 5 years.

6. Interest Rate

• What is the interest rate? (For loans only)

How much interest will the company pay?

When will the interest be paid? Monthly, quarterly, or annually?

Example: 10% annual interest, payable quarterly.

7. Fees

• Who pays the fees?

Due diligence costs, lawyer fees, document charges—these should be clearly stated. Example: The entrepreneur pays $5,000 for legal fees.

8. Exit Order

• How and when can the investor exit?

After how many years can the investor sell their equity?

Options for exit: The company buys back equity, a third-party buyer, or an IPO (Initial Public Offering). Example: The investor can exit after 5 years via IPO.

Why is this important? If exit rules aren’t defined, disputes may arise, delaying progress.

9. Right of First Refusal (ROFR)

• What is ROFR?

It gives the investor the first opportunity to buy shares if the entrepreneur plans to sell.

Why is this important? Without ROFR, control of shares could go to an unwanted third party, leading to conflicts.

10. Board Seats

• How many board seats will the investor get?

Why does this matter? It allows investors to monitor decisions. Example: In a famous case, Steve Jobs lost control of Apple because of boardroom politics. Define this clearly to avoid such issues.

11. Voting Power

• How much voting power will each shareholder have?

Shares in the U.S. often come in two classes:

Class A: Voting rights.

Class B: No voting rights.

Example: Class A shares have 10 votes per share, while Class B shares have none.

12. Decision-Making Power

• What decisions can the investor influence?

Define which company decisions (e.g., hiring a CEO, mergers) need investor approval.

Why is this important? Prevents conflicts by setting expectations early.

13. Arbitration and Jurisdiction

• Who will resolve disputes, and where?

Specify the arbitration process and legal jurisdiction. Example: Arbitration in New York under U.S. law.

14. NDA & Exclusivity

• Why are these needed?

Non-Disclosure Agreement (NDA): Protects your business secrets.

Exclusivity: Prevents the investor from negotiating with your competitors during the deal process.

What happens without these? Your ideas could be shared or copied.

15. Duration to Sign the Final Agreement

• How long do both parties have to finalize the deal?

Typical timeline: 30-60 days.

• Why is this important?

Avoids delays and keeps the process efficient.

Example: The deal must close within 45 days.

16. Anti-Dilution Protection

• What is anti-dilution protection?

It ensures the investor’s ownership percentage is maintained if the company issues new shares at a lower valuation.

• Types of anti-dilution clauses:

Full ratchet: Adjusts the price of the investor's shares to match the new lower price.

Weighted average: Calculates a new price based on the number of shares and their value.

Example: If an investor owns 10% equity, this protection ensures they still own 10% after new shares are issued.

Why is this important? Without it, investors risk losing value in their stake.

17. Liquidation Preference

• What is liquidation preference? It determines how the proceeds from a company’s sale or liquidation are distributed.
• Why is it important? Investors typically want their money back (and sometimes extra) before other stakeholders.

Example: If an investor has a 2x liquidation preference and invests $1 million, they receive $2 million before others get paid.

• What happens without it? Investors may not prioritize your business if they feel unprotected in a worst-case scenario.

18. Drag-Along and Tag-Along Rights

• What are these rights?

Drag-Along: Forces minority shareholders to sell their shares if the majority decides to sell the company.

Tag-Along: Ensures minority shareholders can join the sale under the same terms.

Example: If the majority shareholder sells their stake, a drag-along clause allows the investor to force others to sell too.

• Why are these important? They simplify decision-making during significant events like a company sale.

19. Milestones and Performance Metrics

• Why include milestones?

It ties disbursements or rewards to specific achievements like revenue, product launch, or market expansion.

Example: Release $100,000 after reaching 10,000 active users.

• What happens without them? There’s a risk of money being misused or progress stalling.
• How can they help? Clear targets align both parties’ interests and track progress effectively.

20. Confidentiality and Public Announcements

• What is confidentiality in a term sheet? It ensures that the deal details and negotiations are kept private.
• Can the deal be publicly announced? Define who can make announcements and when. Example: Both parties agree to announce the deal only after signing the final agreement.
• Why is this important? Premature announcements can harm the company’s reputation or affect negotiations with other stakeholders.

How to Apply This to Your Startup

1. Be Transparent: Share all relevant information with the investor.
2. Get Professional Help: Hire a lawyer to draft and review the term sheet.
3. Negotiate Wisely: Balance investor demands with your business goals.
4. Think Long Term: Set terms that benefit both parties, even in the future.

Final Tips for Entrepreneurs

• A well-structured term sheet reduces risks and builds trust.
• Don’t rush—understand each term before signing.
• Remember, it’s not just about funding; it’s about finding the right partner for your journey.

By following these guidelines, you can create a solid foundation for a successful partnership.