Term Sheet Overview: Guide to Understanding and Negotiating Term Sheets

Pro Business Plans
Jul 1 · 8 min read

Term Sheet Overview: What it is and when it is used

As business owners, many of us will have to raise some degree of equity investment. While raising capital, we will have to keep track of the upside risks, as well as keep control over downside risks and try to limit them.

Most Common Clauses

Economics of Term Sheets by A16Z

Capitalization Table

This table gives an overview of the capitalization of the company. It is important to have this documented in a term sheet, particularly if the transaction is going to affect or change the capitalization structure of the business. The capitalization table is a key document for a company, as it details the equity breakup of the company. This table lists the rights and values for all classes of shares and security. It is also designed to report the value for each category of shares and securities.

Valuation

Term Sheet Valuation

Some basic terms related to valuation are:

Pre-Money Valuation — Value of the business or its shares before the transaction.

Security types

Many transactions use different forms of securities for investment purposes. These are usually listed in the capitalization table in detail. It is normal for share-related term sheets to list information about the common stocks, preferred stock, and stock options of the business.

Most Common Mistakes in Term Sheet

Some basic problems to avoid in term sheets are as follows:

Top Three Mistakes Startup Founders Make

The impact of share preferences on common shareholders

Many business owners make the mistake of assuming that if they sell a 20 percent share of their business to a new partner, the partner will just be entitled to 20 percent of the business once when the company is sold.

Other deal sweeteners for bridging valuation gaps

When an investor feels that the value of your business is high, but is still interested in making a deal, it tries to mitigate risks. This risk mitigation is usually done by adding some clauses into the term sheet to protect them from lower value transaction ends.

Losing the balance of power through the protective provision

At times new investors can ask for the right to place their chosen representatives on the board of directors. Most companies that are adding on new investors are run by their founders and find it difficult to manage their leadership team being held answerable to a board of directors that have been nominated by outsiders. Most management team members find it hard to adapt to more stringent board control.

Prolonged due diligence periods

Term sheets are usually signed before the investor starts its comprehensive due diligence. It is common for term sheets to have exclusivity provisions. This means that the company agrees not to approach other investors or purchasers for some time. This is meant to allow the investor to complete their assessment and evaluation process. This is known as its due diligence.

Investor is not contributing

If an investor has committed to bringing in resources or contacts, or to help increase funding, or help the business in any form there should be quantifiable measures. If the investor fails to deliver on the commitment, it can be a permanent reason for conflict. If you have such a commitment on the term sheet, make sure that the terms are clear, measurable, and time-bound. In addition, make sure to do your due diligence about the investor’s capability to fulfill the committed value addition before you sign off on the term sheet.

How to Negotiate a Term Sheet

How to Negotiate a Term Sheet Video

Commonly Asked Term Sheet Questions

Below are a few questions you have to ask when considering any term sheets for any form of transaction:

Do both parties have sufficient capital to support 6 months delay in the business plan?

An affirmative answer will mean that both parties are not financially desperate and will be able to sustain delays and hiccups. This will make the relationship easier to run and manage funds better.

How quickly can you execute the transaction in light of changing market conditions and depleting funds?

Delays in the execution of the transaction can impact its efficiency and at times means the difference between the first mover and a runner-up in product launches and new ideas.

How soon will the investors get a return on their money and will the returns percentage be ratable?

You must be aware of terms like preference stocks, split rates, redemption ratios, and right ratios, and double dips. Even more importantly, what these terms would signify for the deal and your business is also key to a good transaction.

What will happen if more rounds of financing are needed? Will it be possible to add in a new investor to the company?

For a growing business, adding in new investors is a standard practice, having a reluctant investor or restrictive clauses can make this a long and difficult process.

How interested are the new investors in the board structure and how much control will they have over the decision-making?

How much control new investors have over running the company and appointing new management can make the difference between sound strategy and the difference between an investment and an acquisition.

If the investors want to exit how can they exit their investment and at what rates and terms?

In case there is a need for a split or divestment, who will stand to lose more? Can the new investor pull their financing without flooring your business? And will they be penalized for doing so? An exit may be mutually agreed upon and all such clauses waived then.

Pro Business Plans

Insights | Resources | Market Intelligence