A venture capital term sheet is the blueprint for an investment. Although term sheets have a set of formalized components, terms are generally undefined. The parties involved may have different understandings of what the terms mean. Nonetheless, the term sheet does require everyone to forecast the likelihood of various outcomes for your business, including its value as well as the timing and terms of future financing.
The term sheet is also not a legal promise to invest. Typically, the term sheet is simply a contract that requires you to keep negotiations confidential and, in some cases, may prevent you from soliciting any other investors for a period of time.
These are five documents that more definitively spell out the obligations of the relationship with your investor and are negotiated later. They are based on the initial term sheet:
A venture capital term sheet is essentially the same from one VC firm to another. So, it may be surprising to see that often the terms can fit on a single page, making the document relatively user friendly, though the terms can be confusing.
You should confirm that your potential investor is trustworthy.
Before you sign a term sheet, however, you need to do due diligence. Although it is exciting to have someone interested in your company, you should confirm that your potential investor is trustworthy. You should also try to limit the number of conditions outlined in the term sheet and define terms as precisely as possible to avoid misunderstandings and confusion.
Certain terminology in a term sheet is common. Here are ten terms you'll likely encounter and should be familiar with.
1. Money raised
Your investor will likely require that you raise a minimum amount of money before they disburse their funds. You'll be responsible for raising this money, so the amount must be realistic from your point of view.
2. Pre-money valuation
You and your investor will need to determine the value of your company before they make the investment. These negotiations will revolve around the value of all issued stock and anything that can be converted into common stock. This will set the valuation used to compute your investor's percentage of ownership.
3. Non-participating liquidation preference
Liquidation preferences will always specify that investors have a higher priority than common shareholders when calculating returns at exit. However, you can negotiate for a 1X plus interest non-participating liquidation preference. 2X means preferred investors are in line to get double their money back if the proceeds allow.
4. 1:1 conversion to common
Conversion to common stock is a non-negotiable item in term sheets. It enables preferred stockholders to convert to common stock if it's better for them to get repaid on a pro-rata common basis instead of simply taking their liquidation preference.
5. Anti-dilution provisions
If you need to sell stock at prices lower than what the investor paid, this clause stipulates that the investor receives additional stock to preserve their original percentage of ownership without additional investment.
6. The pay-to-play provision
Usually, companies and investors seek this arrangement. The provision requires investors to participate in future financing rounds to avoid having their preferred stock converted to common stock.
7. Boardroom makeup
This designates who has control of the board seats and therefore the company. The most founder-friendly structure is 2-1. On the other hand, 2-2-1 - two seats for the founders, two for the investors and 1 outside member - could lead to the founders losing control of their own company.
8. Dividends
These are not a main focal point. They are simply a modest deal sweetener and usually range between 5% and 15%. There are two kinds, cumulative and non-cumulative. Cumulative dividends sometimes create economic obstacles that require solving before founders can realize any value.
9. Voting rights
Investors need to have protection from some actions that founders could take that may be harmful to their investment. To prevent this, investors receive voting rights that generally equal the number of common shares the agreement allows them to convert anytime.
10. Drag along
A drag along assures investors that founders and the common-stock majority will not block the sale of a company. You should try to increase leverage by negotiating a sales trigger point that is as high as possible to protect your interests.To help you understand how to negotiate your deal with a prospective VC investor, use this VC Capital Term Ranking survey. It can help you identify terms that are most important and that you should focus on.
There is a trend toward making VC term sheets shorter, more transparent with clearer definitions and easier for founders to understand. Whereas VC firms work with term sheets every day, for first-time founders a full understanding of what's at stake facilitates better discussion and negotiation. While one-page term sheets exist, some can extend to dozens of pages.
Y-combinator, one of the world's most respected accelerators, has shared what they believe to be a good term sheet template. And here is SVB's VC term sheet template to reference if you were to build your own term sheet.
Although a VC term sheet is non-binding in many respects, it may be filled with unfamiliar terms that require definition because this plan will serve as a guide for your investor agreements going forward. Therefore, you need to protect your interests and the interests of your business. Although it is imperative to have legal representation, you also need a working knowledge of terms to ensure you can negotiate effectively.
Work with your partners and advisors to identify the most important terms to you and your team and focus on those. Not only are you negotiating for favorable terms, but you are also building credibility with the VC. If you take the term sheet "as is" or inversely argue every point without strong rationales, you're creating a negative image for yourself and your team going forward.
Identify terms that are most important to you and your team and focus on those.
Be willing to stand up for the important issues - and show that you know what the most critical issues are. Then, the VC will understand what is important to you and will respect you for trying to strike a good and fair deal.
If you are uncertain about which terms to prioritize, work with a trusted advisor or an experienced startup lawyer to identify those that will help you the most. Typically, however, the most salient points are:
When you get your first term sheet, remember that it is only a starting point. So, before signing, be sure you have done your best to negotiate advantageous terms:
When negotiating a term sheet, it's easy to think that the investor has all the power. But if you are confident in your vision and team - this is the opportunity to demonstrate your value. With a solid knowledge of the issues, a reasonable approach, and a desire to negotiate fairly, you'll be able to get favorable terms and respect from your new VC partner.
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