You’ve endured a gruelling few months on the investor roadshow and at last VCs have agreed to splash the cash. Phew.
Now come the nitty-gritty details of the deal, beginning with a short document laying out what each side brings to the table — a term sheet. It can be one of the most important pieces of paper a founder will sign and have huge implications on the future of the business.
Sifted spoke to investors, startup lawyers and founders to find out everything you need to know about term sheets.
What is a term sheet?
A term sheet is usually a couple of pages — but can be longer — and sets out what an investor will get in return for their investment. It covers things like how much a startup is worth, who controls it and who will benefit from the company financially should it exit.
For startups, term sheets can be used to create FOMO among other investors and seduce them to join the round. For investors, issuing a term sheet often means they can persuade their investment committee to pump more resources into due diligence.
It’s the most important document in a funding round, according to Christoph Klink, partner at Antler. “Term sheets are a written statement of intent from both parties,” he tells Sifted. “Its purpose is to eliminate surprises and provide a clear understanding of the terms that will govern the investment documents (legally binding documents that follow a term sheet).”
A term sheet is the first step towards formalising an investment after a founder has convinced investors to part with their cash in principle. It will often be subject to a startup meeting certain conditions — like passing deeper due diligence.
It’s easy to feel like the deal is done once a term sheet is signed — but founders beware: a term sheet is not legally binding. Although an investor pulling out of a signed term sheet for no good reason is considered very poor form in the startup community, it does happen.
How do you put one together?
It’s almost always the lead investor that issues a term sheet, and most VCs have pre-prepared templates they then personalise for each investment.
For an early-stage investor like Antler — which is looking to make investments at pace — a term sheet tends to be short to ensure swift negotiations, says Klink. For a later-stage funding round it’s usually much more detailed and is typically open to more negotiation between the parties.
Sanne Fouquet, founder and CEO at edtech Melon, says that the term sheet for her pre-seed round was a four-page document. While there were few conditions to agree on apart from things like valuation and share vesting, the startup had lawyers involved at this stage.
While it’s not good practice to start negotiating details already agreed in discussions pre-term sheet, it’s perfectly reasonable for startups to negotiate certain parts, Fouquet adds. Melon went through one round of iteration.
Startups should always ask why certain points are included if they’re not sure, says Axel Nitsch, principal at High-Tech Gründerfonds. “Investors should be able to provide logical reasons. Responses such as ‘we always do it like this’ or ‘this is the market standard’ do not count.”
What’s in a term sheet? What does it all mean for you and your startup?
The terms in a term sheet vary from deal to deal. Here are some of the most common and what they mean:
Valuation
Valuation is maybe the most important detail in a term sheet, as it determines how much money anyone with a stake in the company — whether an investor, founder or employee with equity — will get on exit. The term sheet will mention both a pre-money (how much your startup is worth not including the most recent funding) and post-money (how much your startup is worth including the latest cash injection) valuation.
For more information, read our guide on how startup valuations work.
Pre-emption rights
These protect investors' shares from being diluted when new investors come on board in future rounds. They give current investors the right to buy additional shares before others can. Pre-emption rights are also known as the right of first refusal. They are a statutory right in the UK — meaning there are few UK deals where they wouldn’t be offered.
Tag-along and drag-along clauses
These clauses are about exits. A drag-along clause means that if a certain percentage of shareholders — usually around 75% — agree to sell the company, then all shareholders must agree to sell at the price laid out in the term sheet. A tag-along clause means that if a majority shareholder sells their shares, minority shareholders have the right to sell their shares at the same price.
Preference shares
There are two main preferential rights an investor can ask for on a term sheet. One is liquidation preferences, meaning an investor is issued a class of shares that ensures they are paid back before other investors holding “ordinary” shares should the company go into liquidation.
Another is anti-dilution rights. In the event of a downround — where a company raises money at a lower valuation than the previous round — an anti-dilution clause requires a startup to top up investors’ equity so they don’t lose out.
Leaver clauses
These can take the form of “vesting mechanisms” — where shares only become the founder’s after a certain period of time. Investors may include clauses that require the founder to forfeit all their shares if they leave the company within a certain time frame after the deal has been completed.
Terms around “bad leavers” can also be included, which penalise the founder if they depart the company for something like gross negligence. If this happens founders would generally lose all or at least part of their shares, says Mikael Nelson, partner at law firm Osborne Clarke.
Exclusivity periods and penalties
Some investors will demand exclusivity on their term sheet — meaning there’s a period of time during the fundraise where the startup can’t talk to other investors. There will often be a financial penalty for startups that break this. These are also known as “no-shop agreements”.
Voting rights and board seats
Some investors will ask for voting rights so they have decision-making power on board-level moves. Voting rights could refer to the number of votes an investor can cast or what matters they can vote on. These are also known as investor consent rights. Investors may also ask for board seats.
Due diligence objectives
Often, an investor will conduct deeper due diligence after a term sheet is signed. Due diligence objectives are the conditions that need to be met for the investment to go through.
What to watch for in a VC term sheet
The good old days of founders holding the cards in term sheet negotiations have come to an end, as the downturn has made VCs more stingy with their cash. With “predatory term sheets” on the rise, founders need to be more cautious than ever about agreeing to conditions they might later regret.
Valuations have taken a real hit and as a result, founders are having to dilute their shares during an investment round more than they had to 18 months ago. But negotiations around valuation can sometimes mean that less attention is paid to other important clauses like investor consent, board seats, liquidation preferences and pre-emptive rights, says Klink.
“These are the terms that will define who takes the decisions within the company, who will receive the profits of an exit and who will decide what happens to the company if it is underperforming,” he says.
Startups need to be careful when granting liquidation preferences, as it could put future investors off, Brigitta Naunton, partner at law firm Harper James, warns. “If agreed, later investors are likely to ask for the same or even better terms. Eventually the amount payable to holders of preferred shares on an exit may be so high that ordinary shareholders see little return in comparison.”
One crucial aspect to watch out for are the conditions around the vesting of founders’ own shares, which could mean they are left with nothing if they depart the company within a certain time period, says Fouquet.
“Investors need the founder's commitment to building the business, but it's important to balance this with the founder's personal circumstances, as unexpected events can occur in life,” she says. “Personally, I found it extremely helpful to have lawyers helping in this process as I myself knew little about what to expect or what the market standard is.”
While it’s normal to have terms relating to preferred shares, founder vesting and definitions around a “good” and “bad” leaver in a term sheet, founders need to invest time and resources in understanding the potential consequences, says Helene Lassen Nørlem, founder and CEO at ADHD planning app Tiimo. “I’d recommend always taking legal advice from a lawyer before signing a term sheet.”
What happens after a startup signs?
It usually takes about four weeks from signing the term sheet to completing the investment — although this can vary, says Naunton.
Comprehensive legal documents need to be drawn up and finalised. These contain more detail about things like the reports and insights the startup will share with the investor — and how regularly they’ll share them — and the structure of board meetings. Investors will also complete their due diligence during this time. If all goes well, it shouldn’t be long before a founder has cash in the bank.
But signing a term sheet isn’t the finish line, and there are two potential points of breakdown that can scupper a deal, says Nitsch. One is investors finding something significant during the in-depth due diligence. The other is a disagreement on the nitty gritty of the actual legally binding contract.
“From a process point of view, the ball is typically in the court of the lead investor,” he tells Sifted. “But startups should look for process timelines in the term sheet that are realistic but still short enough to motivate everyone to get things done.”
