The Ultimate Guide to Venture Capital Term Sheets

he great dream of many an entrepreneur is to advance to the point of signing a term sheet. It is the event that signifies the beginning of a business relationship with a venture capitalist. But as the saying goes: Do you really know what you’re getting into? When entrepreneurs deliberate about a term sheet, they are moving from the world that they understand (their technology, their industry, etc.) into a world of the venture capitalist where they are likely to initially understand little. 

In economic terms, there is typically asymmetric information as one party (the venture capitalist) will usually be in possession of more information than the other (the entrepreneur) in the transaction. This can have catastrophic consequences. Successful, enduring relationships between venture capitalists and entrepreneurs are based on trust and it is difficult to foster trust if there is a lack of understanding about something as basic and foundational as a term sheet. Consequently, exploring the dynamics of term sheets and what can be done to make great ones is imperative.

Term Sheets: Explained

What is a term sheet? To be specific, a term sheet is a nonbinding agreement that delineates the basic terms and conditions between a startup, its founders and a prospective seed, angel or venture capitalist. It is usually the first time that an investor is formally declaring their interest in investing in a particular startup so it is usually cause for great excitement by the entrepreneur. 

The term sheet serves as a template and basis for more detailed, legally binding documents to follow. One way of viewing a term sheet is to consider it as an opening position in a negotiation between the startup founders and investors. As the relationship evolves, the terms of relationship will evolve as well but things have to begin somewhere. In addition, the term sheet is also important because:

• It is the first document that spells out important details
• Creates a cordial channel of information exchange and limits miscommunication
• Presents opportunities for re-negotiations before drawing the final legal contract
• Saves cost on premature legal expenses
• Gives both parties the right to exit the deal with ease

Although the term sheet is not completely legally binding, it may include legally binding conditions such as confidentiality and exclusivity provisions. The purpose of the confidentiality and exclusivity provisions is to allow both the startup founders and prospective investors to keep the terms of negotiations confidential and then, once the term sheet is signed, ensure that the founders cannot shop around until a definitive agreement is either finalized or not. 

Once the parties involved reach an agreement on the details laid out in the term sheet, a binding agreement or contract that conforms to the term sheet details will be drawn up. Term sheets are normally negotiated after a decision is made by the venture capital firm’s investment committee following a pitch meeting with the entrepreneur.

The process to arrive at a term sheet can take 6 to 12 months and typically less than 5% of those who connect with a venture capitalist obtain a term sheet. It is generally as follows:

• Connect: Obtain an introduction to a venture capitalist, preferably through someone that the VC knows such as an entrepreneur in its portfolio or an academic/industry contact. In the world of venture capital, networking, recommendations and personal contacts are essential. Marketing one’s ideas and one’s startup at industry events and entrepreneurship competitions where venture capitalists attend is a good way to interact with venture capitalists. Part of the value of startup accelerators is that they are designed to place promising startups in contact with venture capitalists at “demo days.”
• Proposal: After the initial contact, if the VC is interested in the business idea, the startup will be invited to present its proposal in the form of a pitch deck, which is a concise presentation of the important aspects of the startup.  The purpose is to excite the investor and push them to grant further appointments to discuss the business plan and funding options at length.
• Pitch Meeting: A select few of those who submit proposals will be invited to pitch their startup to the venture capitalist in a brief (30 minute) but formal and important meeting. This will give the venture capitalist the opportunity to assess not only the idea and the entrepreneurs understanding of the market that they propose to enter but most importantly who they are as leaders. The latter, intensely human consideration is the most important aspect of the pitch meeting.
• Decision: After the pitch meetings which may be followed by additional meetings to gather more information, the venture capital investor and their investment committee will meet to finalizes the decision as to whether or not to fund the startup. At this time, a due diligence process will be commenced or continued to ascertain the authenticity of the startup. A VC funding round moves to the next stages of negotiations only after the startup’s background checks out.
• Term Sheet: After the decision is made, the venture capital shares the term sheet with the startup. The first official communication clarifies a venture capitalist’s intent to fund a startup. It outlines the terms and conditions that would govern the funding deal. A startup must review this document thoroughly and get back to the investors for further edits or negotiations. Once mutually agreed upon, this will become the reference document for a legal contract. Since it is not legally binding yet, founders can choose to exit the deal at this stage.
• Final Documentation: Based on the venture capital term sheet, a legal contract is created by the investor. Both parties sign this, and the deal is sealed. Meanwhile, further due diligence is carried out to ensure all processes have been double checked for accuracy. Before releasing the funds, both parties must ensure that all the necessary government filings are in order as well.
• Fund Release: This is the final stage. Venture capitalists usually release funds on a schedule that is determined by the meeting of certain milestones or dates. 

Term sheets are most commonly used in Series A funding rounds but they may also be used in seed rounds or follow up financings after Series A. They may also be used for SAFE or convertible note rounds which are an instrument commonly used by accelerators. The startup will be seeking to raise a round of financing at a specific valuation, which is known as priced round. During this proposed transaction, the investor will be seeking to exchange money for preferred stock in the startup at a price per share determined by the valuation and delineated in the term sheet.

The Components of a VC Term Sheet

As indicated, a term sheet is a summary of the major aspects of a proposed investment agreement between the founders, investors and other related stakeholders who may initially be involved in the negotiations. Aside from an outline of the terms of the agreement, it will likely also define what the startup will be giving up (usually equity) in exchange for the investor’s financing at an agreed upon level. It will also typically explain the investment’s benefits and risks as well as how those will be divided between the founders and investors. 

Again, it is a necessary and foundational starting point and will likely evolve over time. It lays the groundwork for ensuring that the parties involved in the proposed business transaction are on the same page at the outset and that they agree on the major aspects of the proposed deal. Most term sheets incorporate several major categories: the economics of the deal; investor rights; governance and oversight; and exit terms. 

The trick is balance. The term sheet, which is typically about 10 pages long, must communicate enough about the proposed deal to be insightful for both the entrepreneur and investor without being excessively comprehensive and overly detailed. It will cover significant aspects of the proposed deal without detailing every minor contingency as is covered in a binding contract. The term sheet may also contain information regarding what, if anything, is excluded from the proposed deal or any issues that may be considered requirements by one or both parties. 

A simplified Series A term sheet will typically include the following:

• Company Name 
• Securities
• Funding/Investment (total dollar amount from lead investor)
• Amounts (total dollar amount from other investors)
• Company Valuation 
• Liquidation Preference
• Dividends
• Participation Rights 
• Conversion Rights
• Anti-Dilution Clauses
• Voting Rights
• Liquidation and Exit
• Corporate Governance/Board Representation
• Founder and Employee Vesting
• Exclusivity Provision 

While this seems like a considerable amount of information, there are actually a few major components that will comprise the bulk of the term sheet and require most of the time and energy from the founders and investors. The most important is funding which after all is why the startup and venture capitalist are interacting. The key funding issues to be clarified in the term sheet are: 

• How much money will be granted in exchange for how much equity?
• What will happen to the investors’ money?
• How long will the financial agreement last?

Of particular importance in the funding aspects of term sheet is the investment structure. There should be a section that clearly delineates which financial instruments are being used in the funding deal. Most venture capitalists desire convertible preferred shares that eventually convert into equity at a milestone event such as an initial public offering (IPO) and offer the prospect of massive profits. 

Convertible preferred shares include a liquidation preference over common shares, and are, in accordable with a formula, convertible to residual value common shares. A liquidation preference is the right for an investor to receive their money back first in an exit event such as an IPO or liquidation/wind-down of the company. 

Venture capital investors will also want to know the order in which owners are paid out in the event that the company is sold/acquired. This is a key part of how venture capitalists mitigate risk and risk management is major part of the art of venture capital. Understanding how convertible preferred shares operate as a financial instrument is essential for entrepreneurs. 

Valuation is also essential. The term sheet will delineate a valuation for the startup along with the price per share associated with the proposed investment. The methodology for how that valuation was determined will also be explained. The valuation of the startup is critical as it determines the value of investors’ equity and hence the upside of their investment. It is also controversial as there are many different ways to determine the value of startup each of which has plusses and minuses. Intelligent entrepreneurs will study the art of valuation and hire strong financial personnel who understand the dynamics of valuation. Being the Chief Financial Officer of a startup can be particularly challenging because valuation factors into so many aspects of what the startup will be able to do and how it appeals to current and future investors as it seeks to grow. Likewise, valuation can be impacted by revenue and the type and number of customers so understanding that dynamic is also essential.

Among the most important aspects for the funding section of the term sheet are “preferred returns” and “accruing returns.” Preferred returns are the amount that the startup must return to the venture capitalist before it distributes any assets (payments) to the holders of common (residual) equity shares. 

It is the amount of funds that the startup owes investors before distributing profits among other stakeholders. By default, the preferred rate of return is the original investment amount. If the startup has a particularly high valuation, sometimes investors will require an additional sum to be paid on liquidation. 

This can be expressed as a multiple to the investment amount (i.e. 2X or 3X), or as a “double-dip”—the investor’s right to get their money back, plus an amount equal to the as-if-converted value (that is, the amount the investor would receive on liquidation had they converted their preferred shares to common shares). In contrast, with convertible preferred shares, accruing returns take the form of accrued dividends. In practice, it is rare that such dividends would actually be payable in cash but rather, such amounts accrue and are converted into common shares on the same terms as the preferred shares. Accruing return rates most commonly range from 4% to 8%; and rates in excess of 10% rarely occur.

With regards to the funding sections of the term sheet, it should delineate how long the investor and the entrepreneurs are required to remain vested. Details regarding participation rights—the right to invest in a future round of financing to maintain or increase their ownership level—are increasingly important to venture capitalists as many understand that higher levels of investment in a successful investment are better than making new investments. Conversely, anti-dilution protections, which are price adjustments in the event of a future down round will likely be part of the risk mitigation strategy of most venture capitalists. Moreover, since term sheets are increasingly utilized with debt agreements as the primary financial instrument, in such cases, the term sheet should explain such matters as:

• Economic Details: This includes the term, loan size, interest rate, and other financial matters common to debt.
• Risk Mitigation Preferences: The lender will often require specific conditions be met or specific information be provided on a recurring, timely manner. 
• Extension Rights: The borrower is often allowed to extend a loan, but the term sheet identifies the conditions and cost of extension.
• Due Diligence at Closing: As part of the term sheet, the lender may stipulate what they require when the loan agreement is drafted. This can include a list of requirements the borrower must prepare to be approved for the loan. 

There is ample room for flexibility in how term sheets are utilized based upon the financial instruments involved.

Corporate governance and board representation will also be a major issue to be addressed in the term sheet. The investors will want to know how much control they will have in the startup. There are a number of things regarding the corporate governance and board representation aspects of the term sheet that entrepreneurs must consider. 

Firstly, entrepreneurs must be willing to accept that venture capitalists require significant formal control over their portfolio company. Being an entrepreneur is a very personal endeavor with a profound emotional commitment. Many entrepreneurs seek both financial freedom and personal freedom. But entrepreneurs must be willing to sacrifice at least some financial and political control over their ventures in order to successfully do business with venture capitalists. 

Venture capitalists are in the business of maximizing returns for their investors and this cold-blooded reality needs to be understood from the outset. If one is determined to obtain venture funding, the key is to find the right one for your startup in terms of your business, its commercialization model, the aims of both your enterprise and that of the venture capitalist and even the personalities of the investors who will be serving on your board. Once the money is invested, a venture capitalist is essentially an employee that you can’t fire because as an entrepreneur you are accountable to the equity holders in the enterprise.

Relatedly, with regards to corporate governance, it is important to assemble a well-balanced set of stakeholders. The term sheet should delineate a proper broad structure that includes appropriate influence from independent directors. The term sheet should also make an effort to establish voting thresholds for key corporate events that involve a range of stakeholders—including founders, angels and institutional investors. As part of the term sheet’s corporate governance aspects, the entrepreneurs should begin with a clear understanding of what it will take to change the shareholders’ sections of the agreement and the share capital structure in the future. One can be sure that the venture capitalist will have that knowledge. It should be understood from the outset that staged investment strategies—funding that is based upon the achievement of certain milestones—is a major political tool that venture capitalists use to extract concessions from entrepreneurs in terms of increased amounts of equity. 

Understanding whether or not milestones are realistically attainable has governance implications. It is also important to carefully consider the pre-emptive rights provided to investors as part of the term sheet or any other consent rights concerning future financing rounds. Entrepreneurs should embrace the imperative to design a corporate governance regime that includes an independent evaluation of the best available alternatives and offers some protection against investor misfeasance or opportunism.

With these considerations in mind, there are some basic commonalities in corporate governance in the world of venture capital. For an initial investment, venture capital term sheets usually require that there must be an odd number of directors who represent both the founders and institutional investors. The board’s swing votes will typically be held by independent directors who do not have a formal employment relationship or affiliation with either the entrepreneurs or the venture capitalists but possess strong expertise in the industry. With regards to the venture capitalist, the lead investor from the firm will usually take a board seat. The term sheet will also delineate the proposed manner in which founders and investors nominate and approve independent members. It will also list the standard financial reports required by the institutional investor including annual audited statements, monthly or quarterly prepared management statements, and immediate notice of certain material events (such as litigation). These reports are critical since they determine whether or not milestones are being met. 

Liquidation and exit provisions are also a part of the term sheet. These are the terms that spell out the liquidation and exit scenarios for the venture capitalist, who is the entity that is most interested in financially extricating themselves from the startup as soon as possible or more specifically as soon as it is most profitable—i.e. immediately after IPO or acquisition. The term sheet will define what each party receives from company profits in the event of liquidation or exit. The entrepreneur should understand how the form of liquidation or exit can impact what each party receives so that they can decide how best to proceed strategically.

Tips For Term Sheets

In view of these term sheet dynamics, there are a number of strategies that entrepreneurs can deploy to get the best deal for their startup. Firstly, they should always talk to more than one venture capitalists. Pitch meetings are not just learning opportunities and investment presentations, they also allow the entrepreneur to obtain leverage over other venture capitalists. Venture capital is a small community and the best way to get a great deal is to establish a bidding war amongst others in the venture capital community. 

VCs do gossip about the “hot startup” and they are competitive by nature so meeting with as many of them as possible is essential to motivating them to give you the best term sheet for your startup. Secondly, exclusivity clauses should only be entered into on an extremely selective basis. Entrepreneurs should do their homework on the venture capitalist to be sure that they have the commitment, resources and especially money to warrant such a clause and it should never be too lengthy. 

Expertise matters in the world of venture capital so it is healthy to invest in obtaining the advice of experienced professionals and especially entrepreneurs who have negotiated term sheets with that particular venture capitalist. Finally, a good entrepreneur is willing to walk away from a bad deal. Before negotiating the term sheet, it is imperative for the entrepreneur to have strong knowledge of the issues that are deal killers versus those on which one is willing to be flexible.

There are also some helpful tricks intrinsic to the actual writing of a strong term sheet. It is a good idea to summarize the overall conditions of the term sheet at the beginning of the document by drafting a paragraph that identifies the overall purpose of the agreement and intended outcome. Although the term sheet is largely non-binding, it should clearly state which elements such as exclusivity are binding and for how long. 

Moreover, all timeframes with their expiration dates should be clearly stated in the term sheet. It is also a good idea to list and define all key terms so as to be completely transparent and avoid confusion. Finally, the document should encourage feedback and make it clear that both parties are open to change and input from the other.

According to venture capitalist Andrew Beebe, “The most important term in the term sheet is not a legal one — it’s really who you’re working with…Who’s the firm, and who’s the partner or lead on your deal? Choose wisely.” This is true but it is also true that a term sheet is a roadmap in the relationship between entrepreneurs and venture capitalists. Unless both parties invest heavily in producing a good one, they can easily get lost in this dynamic world where change is ever constant. The term sheet is the first effort to establish the trust that will be required to overcome the immense challenges involved in building viable businesses in a world where 90% of startups will fail. 

Just as a good house is built brick by brick, so too it is critical to pay attention to every word in a term sheet and be willing to meet every commitment even if one knows that those commitments will change over time. The key is the willingness to keep one’s word and the term sheet is the first metric of whether each party will be able to do so. As such it is enormously important for the few startups that reach the stage of being offered the opportunity to negotiate one. 

It is critical that both parties but especially the entrepreneur for whom term sheets and financial machinations are likely a very new game be on the same page with regards to expectations and more importantly obligations. Many an entrepreneur has floundered because they just did not understand what they were getting into. In that sense, the term sheet is a major test of the entrepreneurs’ ability to learn about the arcane world of finance and act to use it to their advantage while mitigating against the damage that insufficient knowledge can do to their ability to realize their dreams.