Elements of a term sheet: Funding, liquidation and corporate governance
If you think of the ongoing relationship between you and a venture capital investor (VC) is a marriage, then you can think of the term sheet at the prenuptial agreement.
The term sheet is a document that outlines the terms by which an investor will make a financial investment in your company. Term sheets tend to consist of three sections:
- Corporate governance
The funding section details:
- The valuation
- The amount of the investment
- Who the investor will be
- Whether the financing will be in a single lump sum or in tranches (typically triggered by pre-determined milestones)
- The type of security issued, which may be equity in the form of convertible preferred stock or debt
- The protection from dilution—protection from dilution includes anti-dilution, pre-emptive rights and right of first refusal
The corporate governance section includes:
- Distribution of the decision-making powers
- Board composition
- Voting rights
- Revisions to the by-laws
- Information rights
The liquidation section details how investors will be able to get their money back out from the investment. It includes:
- Exit strategy
- Redemption rights
- Registration rights
- Drag-along and tag-along rights
- Participation rights
What else you should know about term sheets
- Term sheets are not binding. If an investor presents you with a term sheet, it does not mean that you are going to close on the financing. The investor is still completing its due diligence. If the investor discovers something that he or she does not like, then the investor may step away from the transaction.
- If the deal does not close in the late stages of negotiation, you are responsible for the fees (legal and other) incurred to date, which will likely include the investor’s fees. This will be detailed in the term sheet. When you negotiate the term sheet, try to get the investor to agree to a cap on expenses.
- If you have not done so already, engage a lawyer who is knowledgeable about this type of transaction. The lawyer who helped close the purchase of your house is not the right person. If you have counsel with deep experience, he or she can review the term sheet quickly and outline the key points for negotiation. Having strong legal representation provides you and your company with additional credibility.
- Key advisors can also provide guidance on terms that are (and are not) negotiable.
- Try to raise money before you run out of cash. This will put you in a much stronger bargaining position.
- If you have two or more competing term sheets, consider keeping the names of other investors to yourself. The venture capital community is small and they will contact one another. This could lead investors to partnering and presenting you with one term sheet. You will have lost the opportunity to better the offered terms through a competitive situation.
- All term sheets should include a current and future (pre- and post-financing) capitalization table. This helps to clarify any potential misunderstanding relating to the present and future issued and fully diluted shares (including options and warrants) in the company.
- Negotiate a clear and precise term sheet in advance. This will save time and money during the process of drafting and finalizing the legal agreements.
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Cardis, J., et al. (2001). Venture Capital: The Definitive Guide for Entrepreneurs, Investors, and Practitioners. Toronto: John Wiley & Sons.
Berkery, D. (2008).Raising Venture Capital for the Serious Entrepreneur. New York: McGraw-Hill.