Term sheets: everything you need to know

Trying to get venture capital for your business can be both exciting and overwhelming. 

If you’re a startup owner however, understanding the intricacies of any documentation involved in the process is really important to know. Securing an investment deal can further your company’s mission, but you’ll want to set out an effective agreement with your investor. That’s what a term sheet is for.

A term sheet is a document forged to make the complicated terms and conditions in your money deals easier to grasp, and faster to close. 

In this article, we’ll talk about term sheets, explaining why they’re used, how they work, the legal essentials, and the common problems that can arise. 

Whether you’re just starting your own business or have been running one for a while, think of this as your guide to steer you through the tricky world of term sheets.

What is a term sheet?

A term sheet, in plain terms, is a non-binding document that outlines the critical terms and conditions of a proposed investment. 

While it’s commonly associated with venture capital and other private equity deals, it can also find its way into various other types of transactions, such as mergers and acquisitions.

How are term sheets used?

A term sheet serves as a starting agreement between all parties involved in a deal, ensuring everyone is on the same page and reducing the chances of nasty surprises later on. 

“Nasty surprises” in a business sense can range from unexpected financial liabilities and undisclosed risks, to future disagreements on key terms or obligations. 

You never want to get yourself into a “if it wasn’t written down, it didn’t happen” kind of situation, where you’re arguing with your potential suppliers or investors because they now disagree with your memory of previous conversations and what was agreed within them.

Are term sheets legally binding?

Surprisingly, term sheets themselves are not legally binding. However, they carry a substantial moral weight, and most parties involved usually honour the terms once they’ve been formalised in this way.

Despite their non-binding nature, they establish a framework of trust and understanding among the parties. When signed, they create a strong obligation to adhere to the agreed-upon terms, which is often respected in practice.

Opting for a term sheet over a full-fledged contract often happens in the initial stages of a business deal when parties are outlining the key terms and conditions. It expresses intent, but still allows a little time and flexibility for changes. Some people need to see all the expectations and monetary information outlined before they can fully process it and make any further decisions – or get their legal teams more fully involved.

A term sheet is a “shall we do it like this?” while a contract is a final “we’re doing it like this.”

What do term sheets cover?

Term sheets are versatile documents, and they typically encompass several vital details:

• The nature of the investment or transaction
• The amount involved
• The company valuation
• Conditions that must be met before finalising the deal, such as due diligence
• Specific terms of the industry and the required legal terms, as explained in further detail below

15 common terms to include in a term sheet

When crafting a term sheet, it’s crucial to include key terms and conditions that pertain to the particulars of the proposed financial deal. Here’s a breakdown of each term, along with an example of when it may be used:

1. Purchase price: the amount of money someone’s willing to pay

“The purchase price for the acquisition of the tech startup has been set at £10 million.”

In everyday terms: this one is pretty straight-forward, it’s simply the phrasing you use to outline how much parties are willing to spend for a slice of the company pie, or whatever you are brokering a deal on.

2. Equity ownership: how much of the company each person gets to claim

“The venture capitalist will gain a 30% equity ownership stake in the company in exchange for their investment.”

In everyday terms: dividing up the metaphorical pie again – according to the agreement in the term sheet, how big of a slice will you get?

3. Anti-dilution provisions: protect current investors from losing their percentage if more shares are issued

“The early investors included strong anti-dilution provisions in the term sheet.”

In everyday terms: one more time with the pie analogy. Imagine you bought 10% of a bakery, and suddenly they make more shares. Anti-dilution helps make sure your portion of ownership stays the same.

4. Information rights: a promise to keep investors in the loop

“The acquirer insisted on information rights to gain full transparency to the company’s financial data.”

In everyday terms: stakeholders aren’t just going to invest emotionally, spiritually and financially into your business, then never want to hear about it again – most won’t be those rare golden hand shakers. It should be in your interests to keep them in the know as your company and profit grows!

5. Voting rights: who gets a say in important decisions

“With majority voting rights, the founder could maintain their influence over important decisions for the company.”

In everyday terms: this takes the previous term one step further. Everyone will have opinions, but which shareholders will you allow to have rights to vote? 

And of your stakeholders and investors, while everyone gets a vote, do any of the votes (hint: yours) carry more weight than the rest? You might want to add that in.

6. Liquidation preferences: who gets paid first if the company is sold or liquidated

“The liquidation preferences state that all the money left over is mine.”

In everyday terms: you might prefer it that some stakeholders (usually the people who invested the most) get their share of anything left, before others do, in the case of company liquidation. 

7. Dividend preferences: who gets paid first when the company distributes profits

“Jenny now gets a 5% dividend preference due to the stage of her investment, as we all agree in this term sheet.”

In everyday terms: under the same principle as the previous term, this usually goes again to the people who invested the most or the earliest. (Note: you don’t have to do it this way, it’s just an example)

8. Conversion rights: allow investors to turn their ownership into a different type

“Shareholders can exercise their conversion rights if the company goes public, allowing them to convert to common shares.”

In everyday terms: imagine trading in your regular season pass for a VIP one. Investors at specific stages in the lifecycle of your company’s journey will want to either upgrade or downgrade for a variety of reasons – those reasons being anything from deeply personal like wanting to sell, to financially motivated like cashing out if your business reaches exponential success and is in line for an initial public offering (IPO).

9. Rights of first refusal: existing owners get the first chance to buy other investors’ old shares

“The ROFR clause grants the existing shareholders the first opportunity to purchase additional shares offered for sale.”

In everyday terms: it’s like calling dibs on a cool gadget your friend wants to sell before they offer it to others. It’s only fair.

10. Drag-along rights: (aka majority rules)

“Since the founders maintain their drag-along rights, they get the final say.”

In everyday terms: it’s like convincing your friends to go to the same restaurant – if most agree, everyone goes.

11. Financial covenants: financial benchmarks that the company must meet

“The term sheet includes financial covenants requiring the company to maintain a minimum EBITDA level each fiscal year.”

In everyday terms: if you promised your investors that they would have enough to spend on a holiday in your next quarter, you better believe that’s something they’re going to want to hold you to in the term sheet. It’s also great motivation for you!

12. Termination provisions: the conditions under which the agreement can be ended

“The termination provisions specify that either party can terminate the agreement if due diligence uncovers undisclosed material issues.”

In everyday terms: it’s the escape route in case the investors or shareholders decide not to pursue the deal after all, or one of the parties has not been forthcoming with information for example.

13. Confidentiality and non-disclosure: to ensure that sensitive information doesn’t leak.

“Both parties agreed to strict confidentiality and non-disclosure clauses to protect sensitive financial information.”

In everyday terms: it’s like agreeing not to spill the beans about a surprise project you’re working on – whether that’s the details of your business venture, or the topic of your best friend’s new podcast.

14. Dispute resolution: how disagreements will be settled

“In case of disputes, the term sheet outlines a dispute resolution process that includes X, Y and Z.”

In everyday terms: it’s creating a plan for what the final decision method will be when the parties can’t agree – rock-paper-scissors, maybe?

15. Exclusivity: no shopping around for better deals while in negotiations

“During the exclusivity period, the investor has the sole right to negotiate with the startup without interference from other potential investors.”

In everyday terms: It’s like agreeing not to check out other shops after you’ve already badgered the sales assistant to find you a pair of boots in your size. 

Term sheet mistakes to avoid

There are a couple of term sheet mistakes business owners and investors must steer clear of. These include:

1. Rushing into signing without fully comprehending the terms: rushing into signing a term sheet isn’t quite as risky as signing a contract while blindfolded, but it’s not a good idea. Take the time to grasp every nuance of the terms, ensuring you’re not inadvertently tying your business into unfavourable conditions (like the ones we mentioned in the introduction above).
2. Omitting key terms from the sheet: a comprehensive term sheet is the foundation of a solid agreement; and leaving out critical terms will only create ambiguity and potential disputes down the road. 
3. Neglecting to have a lawyer or financial advisor review the document: neglecting legal review is a risky venture. Having a lawyer scrutinise the document can unveil potential pitfalls and provide valuable advice, serving as a shield against unforeseen complications.
4. Overestimating the company’s valuation: talking up your company’s valuation might sound optimistic, but it could set unrealistic expectations and hinder potential investment. Striking a balance between ambition and realism is crucial for a successful term sheet negotiation.

Who prepares a term sheet?

In the case of small startups with limited staff, founders often draft the term sheet, which is why we’ve emphasised in this article how crucial it is to have a clear understanding of the terms and their implications. 

Do you need a lawyer to draw up a term sheet?

While not strictly necessary for a non-binding document like a term sheet, seeking legal advice or assistance is always a smart move. It ensures that the document aligns with your goals and protects your interests. A lawyer’s scrutiny can be a safeguard that can protect you from costly misunderstandings down the line.

How to negotiate a term sheet

Negotiating a term sheet is an art in itself, so it’s essential to be well-prepared.

Before diving into negotiations, make sure you have a good handle on your goals. Be upfront about what matters most to you, and don’t hesitate to walk away if the terms don’t match up with the clear and well-thought-out must-haves you’ve set for yourself.

It’s a powerful stance to be ready to walk away if the terms don’t align with your vision. This demonstrates conviction and ensures you don’t settle for a deal that may hinder your long-term objectives.

But at the same time – be aware of areas where you can compromise. Flexibility can open doors to more favourable terms while still aligning with your overarching objectives.

Conclusion

As a small business owner, familiarising yourself with the ins and outs of term sheets as you have today may help you make informed decisions and protect your interests in critical transactions in the future.

Term sheets might not be legally binding, but they hold significant weight in the business world. They are invaluable tools for small business owners embarking on financial transactions, as they offer a clear roadmap to a deal, helping to align the parties involved and prevent surprises later on. 

By understanding their purpose, learning the common terms and avoiding the pitfalls, you should now be able to confidently navigate the world of term sheets and secure the right funding and deals for your company.