What is a Term Sheet?

A term sheet is a non-binding document that outlines the key terms and conditions of a potential investment or business transaction. It serves as a roadmap for negotiations and provides the foundation for drafting definitive legal agreements. Understanding term sheets is crucial for both entrepreneurs seeking investment and investors evaluating opportunities.

What Is a Term Sheet?

A term sheet is a preliminary agreement that summarizes the material terms of a proposed investment or transaction. While typically non-binding (except for certain provisions), it establishes the framework for negotiations and serves as the basis for creating binding legal documents such as stock purchase agreements and investor rights agreements.

Key Characteristics

Non-Binding Nature: Generally not legally enforceable (with specific exceptions)
Negotiation Framework: Provides structure for investment discussions
Key Terms Summary: Outlines essential economic and control terms
Due Diligence Trigger: Initiates formal due diligence process
Time-Limited: Usually includes expiration date for acceptance

Purpose and Benefits

Efficiency: Avoids costly legal drafting until terms are agreed
Clarity: Ensures all parties understand key deal points
Speed: Accelerates negotiation process
Commitment: Demonstrates serious intent from both parties
Risk Reduction: Identifies potential deal-breakers early

Key Components of a Term Sheet

Basic Deal Structure

Essential Deal Terms

• Investment Amount: Total capital being invested
• Valuation: Pre-money and post-money company valuation
• Security Type: Preferred stock, convertible note, or SAFE
• Price per Share: Cost per share for investors
• Ownership Percentage: Investor's resulting ownership stake

Economic Terms

Liquidation Preference: Priority and amount in liquidation scenarios
Participation Rights: Whether preferred stock participates in upside
Dividend Rate: Preferred dividend rate and cumulative nature
Anti-Dilution Protection: Protection against down rounds
Conversion Features: Mandatory or optional conversion triggers

Control and Governance

Board Composition: Board size and investor representation
Voting Rights: Matters requiring investor approval
Protective Provisions: Veto rights on key decisions
Information Rights: Reporting and inspection rights
Consent Rights: Approval requirements for major actions

Valuation and Pricing Terms

Pre-Money vs. Post-Money Valuation

Concept	Definition	Example
Pre-Money Valuation	Company value before investment	$8 million
Investment Amount	New capital being invested	$2 million
Post-Money Valuation	Company value after investment	$10 million
Investor Ownership	Investment ÷ Post-money	20%

Option Pool Considerations

Pool Size: Percentage of company reserved for employee options
Pool Timing: Whether pool comes from pre-money or post-money
Pool Refresh: Plans for expanding option pool
Dilution Impact: Effect on founder and investor ownership

Price Per Share Calculation

Pricing Example

Pre-money valuation: $8,000,000
Existing shares: 8,000,000
Price per share: $1.00 ($8M ÷ 8M shares)
Investment amount: $2,000,000
New shares issued: 2,000,000
Investor ownership: 20% (2M ÷ 10M total shares)

Liquidation and Exit Terms

Liquidation Preferences

Preference Multiple: 1x, 2x, or higher liquidation preference
Participation: Whether preferred participates in remaining proceeds
Seniority: Order of payment among different investor classes
Conversion Option: Right to convert and participate as common

Common Liquidation Structures

Liquidation Preference Types

• 1x Non-Participating: Get money back OR convert (choose better)
• 1x Participating: Get money back AND share remaining proceeds
• 1x Participating Capped: Participation up to certain multiple
• Multiple Non-Participating: 2x-3x preference before others

Drag-Along and Tag-Along Rights

Drag-Along: Majority can force minority to sell in qualified transactions
Tag-Along: Minority can participate in sales by majority holders
Threshold Requirements: Minimum ownership levels to trigger rights
Fair Value Protection: Ensuring minority receives fair consideration

Control and Governance Provisions

Board of Directors

Board Size: Total number of board seats
Board Composition: Investor, founder, and independent seats
Board Election: How directors are elected and removed
Board Meetings: Frequency and procedures for meetings
Board Committees: Audit, compensation, and other committees

Protective Provisions

Protective provisions give investors veto power over key company decisions:

Major Corporate Actions: Mergers, acquisitions, and dissolutions
Capital Structure Changes: New securities issuance and modifications
Budget and Financial: Annual budgets and major expenditures
Management Changes: CEO hiring/firing and key employee matters
Related Party Transactions: Deals with founders or affiliates

Information Rights

Typical Information Rights

Monthly financial statements
Annual budgets and business plans
Board meeting materials and minutes
Annual audited financial statements
Right to inspect company records
Customer and operational metrics

Employee and Founder Terms

Vesting and Employment

Founder Vesting: Vesting schedules for founder shares
Acceleration: Vesting acceleration upon termination or change of control
Key Employee Retention: Employment agreements and incentives
Non-Compete Agreements: Restrictions on competing activities

Stock Option Pool

Pool Size: Percentage allocated for employee equity
Pool Management: Authority to grant options from pool
Exercise Provisions: Vesting schedules and exercise periods
Pool Expansion: Conditions for increasing option pool

Restrictive Covenants

Non-Solicitation: Restrictions on hiring employees or customers
Confidentiality: Protection of proprietary information
Assignment of Inventions: Company ownership of work product
Non-Disclosure: Restrictions on sharing confidential information

Other Important Provisions

Anti-Dilution Protection

Weighted Average: Broad-based or narrow-based adjustment
Full Ratchet: Adjustment to lowest price of new issuance
Carve-Outs: Exceptions to anti-dilution protection
Pay-to-Play: Participation requirements to maintain rights

Preemptive Rights

Pro Rata Rights: Right to maintain ownership percentage
Super Pro Rata: Right to purchase more than pro rata share
Right of First Refusal: Right to purchase before third parties
Co-Sale Rights: Right to participate in founder sales

Registration Rights

Registration Rights Types

• Demand Rights: Force company to register shares for sale
• Piggyback Rights: Participate in company-initiated registrations
• S-3 Rights: Right to use simplified registration process
• Expenses: Company pays registration costs

Negotiation Process and Timeline

Typical Term Sheet Process

Initial investor interest and preliminary discussions
Management presentation and initial due diligence
Term sheet proposal from investor
Negotiation and revision of key terms
Term sheet execution (usually non-binding)
Comprehensive due diligence process
Legal documentation and final negotiations
Transaction closing

Timeline Considerations

Term Sheet Stage: 1-4 weeks for negotiation and execution
Due Diligence: 4-8 weeks for comprehensive review
Legal Documentation: 3-6 weeks for drafting and negotiation
Total Process: 2-4 months from initial term sheet to closing

Best Practices

Negotiation Tips

Focus on most important terms first
Understand market standards for your stage/industry
Consider long-term implications of terms
Work with experienced legal counsel
Maintain good faith negotiations
Document all agreed-upon changes

Common Mistakes and Pitfalls

Founder Mistakes

Overvaluing Company: Setting unrealistic valuation expectations
Ignoring Control Terms: Focusing only on economics, not governance
Poor Legal Advice: Not engaging experienced startup attorneys
Rushing Process: Accepting terms without proper consideration
Multiple Term Sheets: Managing competing offers poorly

Investor Mistakes

Over-Negotiating: Demanding terms that kill entrepreneur motivation
Standard Terms Assumption: Not explaining rationale for terms
Incomplete Due Diligence: Insufficient investigation before term sheet
Unrealistic Timelines: Setting unreasonable deadlines for decision

Red Flags to Watch

Unusual or overly aggressive terms
Unreasonable timelines or pressure tactics
Lack of reference checks on investors
Unclear or ambiguous term definitions
Major deviations from market standards

Term Sheet Templates and Standards

Industry Resources

NVCA Model Documents: National Venture Capital Association templates
Series Seed Documents: Simplified seed-stage documentation
Y Combinator SAFE: Simple Agreement for Future Equity
Legal Firms: Many law firms publish standard terms

Market Terms by Stage

Stage	Liquidation Pref	Participation	Anti-Dilution
Seed	1x	Non-participating	Weighted average
Series A	1x	Non-participating	Weighted average
Later Stage	1x-2x	Varies	Weighted average

Conclusion

Term sheets are critical documents that establish the foundation for investment transactions. While non-binding, they represent serious commitments from both investors and entrepreneurs and set the stage for all subsequent negotiations. Understanding the key components and implications of term sheet provisions is essential for successful fundraising.

Both entrepreneurs and investors benefit from approaching term sheet negotiations with preparation, transparency, and a focus on long-term partnership rather than short-term advantage. The best term sheets create aligned incentives that support company growth while protecting investor interests.

Working with experienced legal counsel and understanding market standards helps ensure that term sheets reflect fair and reasonable terms for all parties. Remember that the goal is not just to complete a transaction, but to establish a foundation for a successful long-term partnership between investors and management teams.