Fundamentals of Term Sheet: The Purpose & Nature new entrepreneurs should know

Photo by Tim Gouw

The Purpose & Implications

• The term sheet’s objective is to outline the key terms of an investment for mutual understanding between the founders and the investors. The definitive agreements (e.g., shareholders agreement and share subscription agreement) that define the actual terms will be negotiated and executed later based on the term sheet.
• Two key elements of the term sheet are economics and control. Economics defines not only the valuation of the company but also other important financial aspects such as how will the money be paid out once the company is sold. Control focuses on the level of power the investor may have regarding critical management decisions of the company.
• Despite most term sheets look like a contract to invest in every way, they are not a legal promise to invest. Generally only the confidentiality and no-shop provisions are the binding clauses once the signatures are completed, meaning the founders have a responsibility to keep the deal confidential and not take the current offer to shop with other investors. However, it is important to note that term sheets are made to be taken seriously and in good faith by both sides to get the deal done together.

The Nature

• Term sheet can be considered a real chemistry test between the founders and investors. Working together on the opposite sides of the table provides a great assessment opportunity if one can trust and will actually enjoy working together once they are on the same side.
• Level of details can vary a lot depending on the investor. Some term sheets can be very high-level, only a few pages with expectation to dive into finer details later in the full agreement drafting process, while some may choose to be detailed upfront, covering almost every provision thoroughly which in turn take less time in the actual agreement drafting.
• Most VCs will only issue a term sheet when they have made a major decision (i.e., getting approval from the partners in VC fund or the investment committee in CVC) but in competitive market some VCs might issue it earlier in the process just to lock the founders up from talking to other investors. In some more extreme cases, some VCs also do tricks such as backloading, i.e., giving high-valuation term sheet before hammering the price down later.

Some common vocabs

• ‘Exploding term sheet’ means a term sheet which the validity period to sign is very short, e.g., 24–48 hours with an intention to put pressure on the founders to sign. Generally this can be a red flag entrepreneurs should be avoiding as it’s something decent investors never do.
• ‘Pulling term sheet’ means when an investor back out of a signed term sheet. VCs who refuse to invest after signing a term sheet without any good reason will not be well received in the community, so this rarely happens unless there are justified cases such as fraud or hidden litigation issues.
• ‘X on Y’ describes the round size and the current valuation. For example, ‘1 on 3’ means a round size of $1M investment at $3M pre-money valuation of the company, resulting in a post-money valuation of $4M.

This post is a part of my Venture Fundraising Basics series where I will try to share the fundamentals of raising venture capital for entrepreneurs and some local perspectives from my experience in Southeast Asia. For the complete outline and links to other posts, please visit here.