Term Sheet Definitions Explained
It’s tough to make it in any industry without adequate funding, and before you start dreaming about early retirement, you have a few term sheets to deal with first. Term sheet definitions and specifics can be tricky, so you’ll want to come in prepared.
As the founder of a startup, there are likely a number of objectives you have for your company. From becoming a household name to making a substantial profit, you have your eye on the end goal and are working diligently to get there. However, it’s tough to make it in any industry without adequate funding, and before you start dreaming about early retirement, you’ll have a few term sheets to deal with first. Term sheet definitions and specifics can be tricky, so you’ll want to come in prepared.
Those two words hold a lot of weight in the startup world, and when you’re working tirelessly to perfect your pitch deck and schedule meetings with investors, it’s the primary objective at the end of your presentation. It’s important that you understand exactly what a term sheet may and may not include, so let’s explore the basics of this document and what to look for.
The Term Sheet: Things To Remember
If a VC hands you a term sheet, it might feel like the perfect opportunity for a celebration. While receiving an interest in funding is a huge win for any startup, you must remember that a term sheet is not legally binding. Even if both parties have agreed to its contents and have signed on the dotted line, either of you can walk away before the final documents are drafted.
It’s also important to remember that every round is different. For example, a term sheet for a Series A round is more likely to require board seats than a Series Seed round.
Term sheets are often confused with a letter of intent or a memorandum of understanding, and while all three tend to have similar roles within the funding relationship, a term sheet utilizes a longer format to specifically detail a variety of conditions in legal parlance. While there is no singular term sheet template that VCs use, there are some key commonalities we’ve found, which should be addressed within this type of document for early-stage tech investments.
Term Sheet Details
Every term sheet will look slightly different depending on your company and the investor interested in you, but there are some important elements that should be included to make sure everyone is on the same page. Common term sheet information includes:
- Company valuation: probably the most important part of the term sheet, this is often a sticking point when it comes to funding and, in some cases, can make or break your negotiations.
- Funding amounts: again, you’ll find this to be another crucial portion of a term sheet that will influence your final decision. This amount should roughly equal the capital you need to hit your next product, revenue, or traction milestone (don’t ignore the other elements of the deal, however, see the points below for further considerations).
- Board seats and voting rights: startups may or may not be in a position to give up partial control of their company, so it’s important to think about how much ownership you’re looking to retain. We typically don’t see board observers as being harmful, this is more a consideration for training younger VCs.
- Non-disclosure requirements: in any industry, it’s essential that company information is kept private. It’s standard legal practice and shouldn’t be overlooked.
- Pro-rata: a Latin term used to describe a proportionate allocation, this is something that a term sheet should cover and addresses the potential for investors to continue to reinvest into the company
- Option pools: this outlines the pool of shares or equity that’s available for future investors or team members. It might not seem like an important consideration at the moment, but it affects your valuation and is critical to consider at this early stage especially as it relates to compensation. When cash is tight equity is often a form of compensation founders lean on for key hires. Be sure to have one if you’re growing fast and need talent!
- Liquidation and participation: this is another critical clause in the term sheet, laying out how much shareholders will receive in the event of a sale. A 1x preference means they’ll get their money back, higher rates mean they’ll receive additional compensation. Sometimes this clause includes participation rights as well, for an even higher return in the event of liquidation or other significant transactions.
Some founders view a term sheet’s contents as solely the responsibility of the VC, and while it’s often potential investors who are presenting them and not the other way around, it’s best to keep in mind what your requests look like from their perspective. Startups that seek to retain a very large share of their company in exchange for large funding rounds can often raise a red flag in the eyes of others, as it sometimes communicates a message that your funders are disposable or your valuation is unrealistic. On the contrary, if a VC is asking for a large stake in your company, it’s fair that you may have worries around being replaced or not having room to grow.
Term sheets should attempt to present a fair deal for all parties involved and in no way should be structured to limit future fundraising attempts. It’s common for seed fundraising rounds to utilize rather basic term sheets and, as funding becomes more substantial, the need for more detailed documents will be obvious.
Your Next Steps
If you’ve been meeting with multiple investors then it’s possible to receive several term sheets. It’s critical that you carefully evaluate all of them and, if necessary, don’t be afraid to negotiate. Startups in their seed funding phase should exercise a fair amount of due diligence when it comes to accepting their first term sheet, as it can set the tone for the future of the company.
Not sure if the term sheet you’ve been presented is the right choice for you? Or, are you preparing to meet with several VCs and want to perfect your pitch before you step foot into a boardroom? airCFO is here to help startups in all aspects of their finances to ensure success from seed to scale.