What is a Term sheet?

A Term sheet is essential when you are negotiating for investment from a VC or Angel investor. 

It provides both sides with a snapshot of what is being negotiated, such as the company’s valuation, the amount being invested, and what the investor is getting in return (typically, equity).

In this article we explain its importance and provide an overview of the various areas it covers, as well as detailing potential pitfalls for the inexperienced.

What is a Term sheet?

A Term sheet is typically a non-binding document outlining the basic terms and conditions of an investment. 

It is a template for more detailed, legally binding documents that will follow. 

Although the document as a whole is non-binding, some clauses within a Term sheet may be legally binding. For example:

• Confidentiality: an agreement not to disclose details of the negotiations may be binding from the outset.
• Governing law or jurisdiction: procedural clauses can begin immediately.
• Exclusivity or the ‘no shop’ clause: a clause stating you won’t negotiate with competitors for a set period can be legally enforceable if clearly worded.

It’s important to clarify if any aspects of a Term sheet are legally binding, usually within the document itself. 

Ambiguity can be costly in the event of a dispute.

It should also be noted that it’s considered inappropriate to sign a Term sheet without the intention of progressing the deal once the paperwork and due diligence are completed.

Why is a Term sheet important?

A well-executed Term sheet is important for the following reasons:

Valuation

A Term sheet establishes the key terms of the investment and a valuation for the business.

The company’s valuation is essential for determining how much equity an investor will receive for their investment.

Clarity

It provides clarity and sets out expectations. 

By clearly setting out what the early-stage company and investor expect from the deal it should reduce misunderstandings going forward.

Negotiation

It should provide a good negotiating framework, allowing both parties to discuss and modify terms until an agreement is reached.

Further funding

It is likely to influence further funding rounds as it sets a precedent for the terms and valuation of the company.

Provides a foundation

It provides a good foundation for drafting legally binding documents. 

It therefore saves time and legal expenses by resolving complex issues upfront.

Reputation

It demonstrates professionalism and boosts investor confidence. Indeed, the fact you are developing a Term sheet with an investor may give other potential investors and business partners a reason to come forward.

What does a Term sheet contain?

Broadly speaking a Term sheet has five key components:

1. Valuation: how much the company is worth before you raise any money.
2. Equity stake: this is the portion of the company being given to investors in exchange for their money. Note that different investors may have different types of equity stake (such as ordinary, preferred, voting, non-voting etc.) which will give the investor different powers.
3. Board structure and governance rights: these are the governance rights being granted to investors so they can vote on important decisions in your company.
4. Liquidation preference and exit terms: this determines how proceeds are distributed when a company is sold or liquidated. 
5. Anti-dilution provisions: these are bespoke and can fall into categories such as conditions precedent, conditions subsequent as well as warranties, representations, and covenants.

However, there’s a lot more detail contained within the Term sheet that can impact the business and the founders.

What is equity dilution?

Equity dilution refers to the reduction in ownership percentage of existing shareholders when the company issues new shares — typically to raise funding, expand the option pool, or bring in new partners.

How does equity dilution work?

Equity dilution can appear complicated if you’ve never seen it before.

Below is a worked example that helps shed light on how it works in practice:

Before investment the original founders of a business own:

100% of the business, which for the purposes of this example, equates to 1m shares.

An investor then invests £1m for 20% of the business post-money, remember this is the valuation of the business that occurs after money has been invested.

The business now has a post-money valuation of £5m and the total number of shares has increased to 1.25m, as 250,000 have been issued to the investor.

Although the founders still have 1m shares, they now represent only 80% of the shares issued, so their holding has effectively been diluted.

Note that the number of shares the founders hold didn't change, but the size of their shares relative to the total number of shares in the business got smaller, because the overall number of shares in the business grew.

Dilution isn't necessarily bad — if the company’s value increases, the smaller slice can still be worth more than the larger slice the owners had before they took on investment.

Still, it's crucial for founders to track dilution to protect their long-term control as successive rounds of fundraising would be likely to further dilute their holding.

What does a typical Term sheet contain? 

Here we’ll look at the various sections of a Term sheet and important clauses in more detail. 
Never forget that in a Term sheet the devil is always in the detail.

Offering terms

The first main element of the deal sheet focuses on the offer terms. This includes: 

• The valuation of the company. There will be two valuations; one for the value of the company before the investment, known as the ‘pre-money’, and another that includes the value of the amount invested, known as the ‘post-money’
• The amount being raised.

Learn more about how to value a business with our guide.

Economic terms

The second part of a Term sheet focuses on the economics of the deal and includes:

• the type of equity stake being offered, for example: common stock or preferred stock
• the cost per share
• information about dividends (if any) and whether they will be paid out to investors and under what circumstances
• the Option pool (if applicable). This is a clause showing how much will be allocated to new employees who will join after the investment round closes.

To learn more about Option pools, read our guide to Cap tables.

A key tool to attract talent in the start-up world is by sharing equity with employees. 

Investors know this and often ask the business to organise a sizeable option pool before their investment. 

By doing this prior to investing, it will not be dilutive to the investors. 

Instead, as it comes out of the pre-investment cap table, it will have a dilutive effect on the shareholding of the founders.

Board structure and governance

This section includes information on control and governance and might cover:

• how the board is constructed and who will have board seats
• the right of shareholders to vote on certain corporate matters, or what percentage of shareholders votes are required in order to pass certain measures
• certain rights (known as protective provisions) reserved for investors to protect their investment. For example, anti-dilution provisions preventing the issuing of new shares that would dilute existing shareholders, or a veto on the hiring and firing of senior executives
• the Liquidation preference and exit terms of shareholders. This determines how proceeds are distributed when a company is sold or liquidated. It gives investors priority over common shareholders to recover their investment before anyone else gets paid.

A Term sheet is intended to protect investors from losing money and a founder needs to pay close attention to the terms agreed as, to those unfamiliar with these matters, 
the implications might not be clear.

Anti-dilution provisions

These are designed to protect investors from dilution in future financing rounds. 

Typically, they include ‘pro-rata’ rights. 

These are the rights to invest in a future round of financing to protect an investor’s current ownership percentage.

Redemption rights 

These are conditions under which an investor can require the company to repurchase their shares. 

It’s certainly an element that can be negotiable and the management team of the business should consider pushing for payment terms and a timeline that will suit them.

No-shop clause

The no-shop clause included on the Term sheet is there to prevent the company from asking for investment proposals from other parties.

This gives the investor leverage, as it prevents the company from shopping around for better terms.
Whilst a no-shop clause is standard, it is important to be careful with the duration. 

You don’t want to have too long a no-shop clause, as it could allow the investor to take a long time to conduct their due diligence and to potentially drop out at the last moment (don’t forget that a Term sheet is non-binding).

Given the fact that any serious investor will want to conduct their due diligence prior to investing, most no-shops can last for around 30-90 days.

Expenses or ‘deal fees’

This effectively outlines who will pay for what in terms of expenses incurred in connection with the deal. 

Typically, the smaller the investment round the more likely it is that each party pays their own legal and professional fees.

Duration and expiration

A Term sheet typically includes a validity or expiration clause that defines how long the agreement remains in effect, during which time a definitive legal contract must be signed or else the Term sheet expires.

Typically, a Term sheet is valid for 30-90 days.

Common pitfalls when creating Term sheets

There are numerous potential pitfalls when negotiating a Term sheet.

Here are the four of the most common ones.

Overvaluation

While this might seem beneficial at first, it is likely to have a negative impact as the business may create unrealistic expectations for further growth and performance. 

If the business isn’t able to grow into the valuation it may then struggle to attract further investment.

Giving away too much equity

This is akin to undervaluing the company and as a consequence founders risk losing control of the company when seeking to obtain investment. 

Moreover, if too much equity is given away too early, it may leave insufficient equity for further rounds of investment, or to incentivise staff and founders.

Learn more about how much equity to offer investors with our guide.

Not understanding certain clauses

Not having a full grasp of the implications of liquidation preferences, anti-dilution provisions, or voting rights can result in unexpected consequences when making crucial business decisions, exits, or further investment rounds.

It’s always a good idea to seek independent specialist advice if you’re unsure.

Failing to negotiate

It’s important to push for what’s important to your business. 

Don’t just accept what’s on offer, negotiate critical points of a Term sheet.

Who can help you create a Term sheet?

Many founders of early-stage companies are unlikely to be familiar with the legal jargon used within a Term sheet and their potential implications.

It’s therefore crucial to seek independent specialist legal advice from a law firm experienced in creating and negotiating Term sheets for early-stage companies before signing a Term sheet with an investor.

A law firm experienced in this area should also be able to help you create one from scratch.

Term sheets do also differ according to the jurisdiction.

A term sheet that works in the UK may not work for a company whose legal headquarters is in France.

Therefore, you must ensure you obtain expert legal advice, particularly if you’re unsure about the terms and how they apply to your jurisdiction.