Before we discuss how to write your term sheet, let’s start by defining a term sheet and explaining why it’s useful.
What’s a Term Sheet?
Technically speaking, a term sheet is a non-binding agreement that demonstrates a basic set of terms and conditions under which an investment is made, typically by either an angel or venture capital investor.
AS A NON-BINDING AGREEMENT, THE TERM SHEET SERVES AS AN OUTLINE OR A TEMPLATE FOR MORE DETAILED LEGAL DOCUMENTS TO BE DEVELOPED LATER IN THE NEGOTIATION.
Once the terms and conditions laid out in the term sheet have been agreed upon by both parties, a contract (or binding agreement) can be drawn up to confirm the details of the term sheet (typically in the form of a Private Placement Memorandum or PPM).
In layman terms, you can think of the term sheet as the prenuptial agreement between the entrepreneur (or current owners) and potential investors.
How Do I Write a Term Sheet?
Term sheets typically consist of three sections: funding, corporate governance, and liquidation.
When preparing your term sheet for negotiation with potential investors, it is wise to consider their goals and motivations as well as your own.
- Investors are looking to maximize the return on their investment.
- They are also looking to protect their investment in the instance that the company does not meet its expectations.
- Many investors enjoy the ability to force management to make decisions (such as when to liquidate) and/or retain veto rights to overturn certain action that could affect their ownership position.
- Lastly, many investors like to establish restrictions that ensure founders and key management remain committed to the longevity of the company and its performance.
- As an entrepreneur, you are trying to raise as much capital as possible while giving up as little of the company as possible.
- You want to ensure that you have not given up too much of the upside potential or assumed too much risk on the downside potential.
- You want to give up as little control as possible while protecting your position as a manager should the board not deem your performance inadequate.
Negotiation the Terms
What many first time entrepreneurs (and even unseasoned investors) don’t understand is that they have many tools for negotiating beyond the amount of capital requested and the amount of equity given in exchange.
As mentioned above, some of the following terms can help you sway a potential investor to compromise with some of the terms that you strongly desire:
- Offer to vest your shares at a later date upon completion of milestones. This not only reassures investors that you are committed to the longevity of the company, but it removes some of their downside risk.
- Similarly, offer to defer any potential salary or reward until the completion of certain milestones.
- Provide veto rights on specific areas of corporate governance that would be of interest to a potential investor (such as, when to sell the company or making key hires).
- Offer to include IP assignment agreements or non-compete agreements to show that you are committed to this company and will not take the technology or IP elsewhere.
Why Should I Write My Own Term Sheet
Traditionally, investors would propose a term sheet to you as an entrepreneur after you’ve pitched them, they’ve expressed interest, they’ve done their due diligence, and you’ve done some high level negotiation.
But, it doesn’t always have to work this way. There are several reasons why it is beneficial for you to write the term sheet as outlined below:
- Unless you are raising capital from VCs or sophisticated Angel Groups, many investors don’t fully understand that there are many other terms to consider beyond deal price and equity reimbursement (as outlined above).
- Many companies fail down the road or go through an expensive legal restructuring if they’re initial investment had the wrong capital structure. Don’t leave it up to your potential investors to make sure you have a sound capital structure for the current and subsequent rounds of funding.
- By presenting a reasonable term sheet with the typical terms and conditions and a fair valuation, you are not only showing investors that you are rational, professional, and serious, but you are also eliminating a lot of unnecessary back-and-forth with either flippant or “shark” investors.
- Similar to the point above, offering a term sheet will dramatically reduce the amount of time it would take for an investor to put together a term sheet and make you an offer. By presenting the term sheet, you can enter negotiations right away.
- Lastly, by presenting the term sheet to an investor it applies an implicit deadline, thereby preventing them from treading water and, more-or-less, forcing them to make a timely decision as the round may soon close.