A term sheet is a non-binding agreement that outlines the basic terms and conditions under which an investment will be made. It serves as a template to develop more detailed legal documents and helps ensure both parties are aligned on the key economic and control terms before incurring significant legal expenses.
A term sheet is essentially a roadmap for an investment transaction. While legally non-binding in most respects, it establishes the fundamental framework for the relationship between investors and the company. Think of it as a letter of intent that outlines who gets what, when, and under what circumstances, before lawyers draft the final legal documents.
Term sheets typically range from 2-8 pages and focus on the most important economic and governance terms rather than detailed legal provisions. They're crucial because they allow both parties to negotiate and agree on key issues before spending $25,000-$100,000 on legal documentation for a financing round.
The term sheet specifies the total investment amount and the company's pre-money valuation. These two figures determine the investor's ownership percentage. For example, a $2M investment into a company with an $8M pre-money valuation results in 20% ownership ($2M ÷ $10M post-money).
This determines the order and amount of payments in a sale or liquidation scenario. A "1x non-participating preference" means investors get their money back first, then remaining proceeds go to common shareholders. A "1x participating preference" means investors get their money back AND share in remaining proceeds with common shareholders.
Most term sheets include cumulative dividend provisions (typically 6-10% annually) that accrue but aren't paid unless declared by the board. These dividends are usually paid before any other distributions and increase the liquidation preference over time.
This protects investors from dilution in down rounds. "Full ratchet" protection adjusts the investor's conversion price to the lowest price in any subsequent round. "Weighted average" protection (more common) adjusts based on both price and number of shares issued.
Term sheets specify board size and composition. Common structures include equal representation (e.g., 2 investor seats, 2 founder seats, 1 independent) or investor control (e.g., 3 investor seats, 2 founder seats). Board control often matters more than ownership percentage for decision-making.
These give investors veto power over major decisions like:
Preferred shares typically vote with common stock on most matters, but may have separate class voting rights on specific issues. Some term sheets specify drag-along and tag-along rights that affect how shares can be sold in future transactions.
These allow investors to maintain their ownership percentage in future funding rounds by investing their proportional share. Major investors typically receive pro rata rights, while smaller investors may only get them above certain investment thresholds.
Investors typically receive monthly or quarterly financial reports, annual budgets, and other company information. The level of detail and frequency often depends on investment size and board representation.
These govern how investors can sell their shares, including "demand rights" (forcing the company to register shares for sale) and "piggyback rights" (participating in company-initiated registrations).
Term sheets typically specify the size of the employee stock option pool (usually 10-25% of the company) and whether it's carved out of pre-money or post-money valuation. Pre-money carve-outs dilute founders more than investors.
Investors usually require founder shares to vest over 3-4 years with a 1-year cliff. This protects investors if founders leave early and ensures commitment to the business plan.
These specify what happens to vesting if founders are terminated without cause or resign for good reason ("single trigger") or if these events occur around an acquisition ("double trigger").
This is often the most contentious area. Founders want higher valuations while investors seek meaningful ownership percentages. Market comparables, traction metrics, and growth potential heavily influence these negotiations.
While 1x preferences are standard, investors sometimes push for higher multiples (2x, 3x) in later stage or higher risk deals. Participating vs. non-participating preferences can significantly impact founder returns.
Investors often seek board control or influence, while founders prefer to maintain control. Compromise structures include equal representation with independent directors or investor-friendly supermajority voting requirements.
Once a term sheet is signed, the due diligence process typically takes 30-90 days. This includes:
During this period, lawyers draft definitive agreements based on the term sheet, including the Stock Purchase Agreement, Amended Articles of Incorporation, Stockholder Agreement, and other closing documents.
Term sheet preparation and negotiation costs vary significantly by transaction complexity:
The investment amounts typically covered by formal term sheets range from $1M-$50M+, though some investors use term sheets for smaller amounts ($500K+) in competitive situations.
$5M investment, $15M pre-money valuation, 1x non-participating preferred, 2-2-1 board structure, 15% option pool, standard protective provisions. Resulted in 25% investor ownership with founders maintaining board control through independent director.
$15M investment, $35M pre-money, 1x participating preferred with 3x cap, investor board control (3-2), full anti-dilution protection. Complex deal reflecting competitive market and high growth metrics.
$2M convertible preferred with 1.5x liquidation preference, automatic conversion in next qualified round, investor protective provisions but no board seat. Structured for speed while providing downside protection.
Term sheets are generally non-binding except for specific provisions like confidentiality, exclusivity (no-shop), and expense reimbursement. However, they create strong moral and business pressure to complete the transaction on agreed terms.
Initial term sheet negotiations typically take 1-4 weeks, depending on deal complexity and how aligned parties are initially. More complex deals or first-time founders may take longer as education and alignment occur.
While possible, term sheet changes after signing are difficult and often signal problems. Material changes may require renegotiation and can delay or kill deals. Minor clarifications are more acceptable than major economic changes.
Depending on severity, issues can result in term sheet modifications (usually price adjustments), additional conditions to closing, or deal termination. Disclosure of known issues upfront prevents surprises and deal breakdown.
Absolutely. Even "standard" term sheets contain complex provisions that can significantly impact founder control and returns. Legal review typically costs $5K-15K but prevents costly mistakes in a $1M+ transaction.
Non-participating: investors choose between liquidation preference OR conversion to common. Participating: investors get liquidation preference AND share remaining proceeds. Participating preferred significantly reduces founder returns in moderate exits.
No-shop periods typically range from 30-90 days, giving investors exclusivity to complete due diligence and documentation. Shorter periods favor founders while longer periods provide investors more certainty.