What is a term sheet?

A term sheet is an initial, non-binding agreement that lays down the basic terms and conditions of the investment relationship between startups and investors. A term sheet is the first document initiating the investment relationship and forms a template for development of later legal documents. It lays down bullet points of terms that will form the basis of the detailed contract that will be drawn up later to finalize the investor-startup relationship. It usually consists of funding, corporate governance and liquidation section.

A term sheet is very important as it lays ground for the basic understanding between the involved parties that would grow into a proper legal relationship later. It helps avoid misunderstanding and legally binds a deal which until then was just a word of mouth agreement.

Entrepreneur and Financier Mitch Thrower says, “A term sheet is like a prenuptial agreement and a coach’s playbook. Spend the time to understand the plays, and what happens should you ever separate from the business.”

There are a few key term that every entrepreneur needs to understand and keep in mind while drafting a term sheet. First amongst these is the ‘pre-money value’, which is the ratio of ownership between the investors and the founders. The second term is the size of the ‘unallocated option pool’, which is the available stock for attaining employees. These two together determine the ownership structure and must be paid special attention to.

The governance rights are covered by terms like ‘structure of board and voting rights’ and ‘participating preferred’. The board structure is the ratio of seats held by the investors and the founders and the consequent voting rights. Whereas, participating preferred is the way investors generate extra returns from their ownership and the proceeds they retain in case of a sale. You can learn more about these important points in this video -

Negotiating a term sheet.

While negotiating a term sheet, keep in mind the following considerations to make an informed decision. Remember that there is no straitjacket formula to determine the terms of a term sheet. It depends on various factors such as company valuation, type of investment etc.

1. Pay attention to the valuation method which is being negotiated. Minor manipulation of various terms can lead to surprisingly different ownership stakes and valuations. Make sure you negotiate your valuation carefully. It can make or break your venture.
   
   But, you must also be cautious not to focus too much on valuation and haggle too much in the matter as it can have detrimental effects. You can read more about the ill-effects of this practice here.

1. Try to raise as much capital as possible without giving up too much of the ownership. Pay attention to the exit options. Many bitter disputes in the past have stemmed from the varied interpretation of exit options.

1. The investors will try to negotiate guaranteed returns of their capital and dividends. This is something you will have to negotiate with your team and will depend heavily on your negotiating power. This is referred to as ‘Liquidation Preference’.
   
   In a nutshell, it lays down what will be returned first in case of liquidation. Mostly, it is the money which was used to buy the stocks by the investor. Such clauses are inserted to ensure that the investor’s investment is protected in case a company goes into liquidation.

1. Give up as little control as possible over the company’s actions. Do not be taken aback if the investor tries to negotiate retention of veto power over corporate actions of your company, instead negotiate cautiously. It is a usual business practice. Keep an eye on the Board Representation as well.

1. A major chunk of the negotiations will focus on how to align investor’s interests with the entrepreneurs’ expectations and goals. This can be done by rewarding the founders and key executive personnel in both monetary and non-monetary forms.

1. It is very important to give up as little control as possible. The investors always try to ensure that the founders do not attempt to sell the company before sufficient value has been created. This is done through vetoes and tag-along rights. So you have to ensure they don’t get such benefits.

As Mitch Thrower puts it, “When landing and negotiating a term sheet, spend the time to understand all of the implications.”

1. Include non-compete agreements and intellectual property assignment clauses. They are keys to efficient risk management.

1. Anti-Dilution clauses are important. There is no long term implication of anti-dilution rights. It provides that if the number of shares changes in a non-economic way, the proportion of shares that investors have, will change accordingly. For instance - if shares are split into 2:1, the investor’s shares will also double.
   
   Make sure you learn enough about intricacies such as this before finalizing anything. Consulting a lawyer about such matters is the best way to go about these things.

1. The ‘Drag along’ provision. It allows the majority shareholders to force minority shareholders to sell the company. Such provisions are usually beneficial to the founders. It ensures that minority shareholders do not become a roadblock in case a company is being sold.

1. Do not ignore the resulting capital structure. Evaluate the implications the present deal will have on your capital structure. If you mess up the capital structure today, you will face difficulty raising money tomorrow.

1. Ask yourself if you want investors to have the right of first refusal and co-sale. Such rights provide for the provision that if any shareholder wants to sell his/her shares, the investors will have the first right to buy those shares.
   
   Tread carefully since this may lead to an investor acquiring more ownership slowly. Make sure to take proper legal advice to avoid losing control through this later.

Listen to Mitch Thrower when he says, “Even slight nuances that appear in term sheets tend to address things far out into the future.”

1. Make sure that you are aware of all Representations and Warranties. Representations and warranties describe the statements that a party makes and pledges that they are true. These underlying statements represent past or present facts and are usually relied upon while entering into an agreement.
   
   For instance- A buyer pledging his financial soundness and a seller pledging that he has the authority to sell the products. You must be careful with these provisions as breach of representations and warranties may lead to money going down the drain.

1. The terms and conditions of the term sheets vary significantly, depending on the many factors that influence them. Factors such as the company’s product, revenue model, the competition and the industry affect the terms to a large extent.

In order to not risk losing your business to the whims of your investor later, it is very important to draft a fool-proof term sheet laying down all your proposed points. Understanding the legal implications of all these provisions and their subsequent breach will go a long way in this endeavour. This can only be done with the help of a startup lawyer. So make sure you lawyer up.