Venture Capital Term Sheet: What You Need to Know
When a fund wants to invest in a startup, they send the founders a term sheet. As the name suggests, this short document details the terms and conditions upon which the fund intends to invest. To date, Hustle Fund has reviewed over 500 term sheets—many of which have led to formal investments.
Through the experience of preparing and negotiating term sheets with founders, we’ve learned many lessons around how VCs should approach the term sheet process. Here’s our deep dive into venture capital term sheets, starting with the basics.
What is a Term Sheet?
Financial institutions issue term sheets to indicate interest in making a financial commitment. A lender might issue a term sheet when making a loan offer, or private equity fund might use a term sheet to lay out the provisions of a proposed acquisition. In venture capital, a VC fund issues a term sheet to a startup when it wants to make an investment in the business.
The venture capital term sheet explains to founders all the major details of the proposed investment, and kicks off a broader due diligence and negotiation process that will (ideally) conclude with an actual legal agreement to invest.
In this way, a VC term sheet can be thought of as the road map for what an eventual deal could look like. It’s largely nonbinding, meaning neither party (VC or founder) is committed to follow through on the proposed terms. A good term sheet should mitigate disputes between the two parties and help save time (and legal fees) in drafting up the actual investment documents.
What’s in a Term Sheet
Every term sheet is different, as every investment offer is different. However, every term sheet can largely be boiled down to a few categories of information:
Terms that influence the economics of a deal include:
- Investment amount: The proposed investment amount.
- Pre-money valuation: The valuation of the startup before any new financing. This number is key for founders, as it reflects what the investors think the company is worth. This valuation is entirely subjective, and is based off the investors’ due diligence.
- Share price: The value of the individual shares, as determined by the pre-money valuation.
- Post-money valuation: The valuation of the startup after receiving the financing, which dictates the investors’ ownership stake.
- Dividends: Details the income distributions investors are entitled to.
- Liquidation preference: Explanation of how the proceeds from a liquidity event will be distributed amongst investors. Generally, a 1x non-participating preferred liquidation preference is the standard. This means the investor is guaranteed at least 1x return on their investment in the event the company is liquidated or sold.
- Registration rights: These rights, if exercised by majority shareholders, can force a company to list its shares on the public market (i.e., file for an IPO) so that the investors can sell them.
To protect their investment, VC firms often ask for some amount of say in the operations of the business. Terms that influence an investor’s control include:
- Protective provisions: Protective provisions give investors the power to veto certain business decisions they feel could jeopardize their investment. Protective provisions may come into play when a company issues new shares, amends its charter, sells the company, or changes the size of its board. They are some of the most heavily negotiated parts of a financing round, because they have an outsized impact on control of the company.
- Board seats: A lead investor may try to negotiate a seat on the company’s board of directors. The board of directors makes key strategic decisions on behalf of the company. Along with protective provisions, board seats help align the interests of the company with that of their investors.
- Anti-dilution provisions: How an investors’ ownership stake will be protected in the event the company sells new shares at a lower price than what the investor originally paid (such as in a “down round”).
- Drag along rights: A control term that allows majority shareholders to force the decisions of minority shareholders. This might include approving and participating in a sale of the company that is approved by the majority.
- Pro rata rights: Pro rata rights give investors the option to participate in future financing rounds (so as to maintain their ownership stake).
- Option pool size: Investors can influence the size of the employee option pool, which is the portion of equity reserved for a company’s employees.
- Right of first refusal: Provides investors the right to match any third-party offer on the shares of other key shareholders (i.e., management and founders).
- Information rights: Entitles investors to receive updates on the financial performance of the company, as well as access to the company’s facilities and personnel. Information rights are fairly customary in VC deals.
- No-shop agreement: A clause stipulating the founders can’t use the term sheet to leverage other investors into participating in the round.
- Exclusivity: A condition that requires founders not to talk to other investors for a stated period of time after the term sheet is signed (while the investors are doing their due diligence).
The investment structure details what is being purchased, and how.
- Investment instrument: Most venture investments are structured as equity investments or convertible debt. A convertible note term sheet will include a valuation cap, which is the valuation at which the debt will convert to equity. Alternatively, some early-stage deals are structured as SAFEs, which is an investment instrument used to expedite the fundraising process for pre-product or pre-revenue companies where a valuation may not be apparent. SAFEs are typically issued by the company in lieu of a term sheet.
- Share class: Most investors will ask for preferred shares. This class of shares comes with various rights and protections not afforded to other shareholders (founders and employees).
Term Sheet Template
Term sheets come in all different flavors, but the bones of every term sheet is similar. Here are three term sheet examples you can use to form the foundation of your term sheet:
- National Venture Capital Association term sheet template
- Y Combinator term sheet template
- Silicon Valley Bank term sheet template
Term Sheet Best Practices
While every term sheet is unique, there are some best practices to keep in mind to ensure your term sheets are well received by founders.
- Optimize for clarity / succinctness: Founders are busy, and if a deal is hot, your term sheet won’t be the only one they’re reading. One way to stand out is to cut out as much jargon / legalese as possible and summarize your proposal at the top of the term sheet.
- Transparency is key: At Hustle Fund, we take great effort to make sure founders are aware of what they’re signing when they work with us. Transparency is an important element of establishing trust with partners.
- State binding / non-binding terms: Be clear about which terms are binding, and which are non-binding (e.g., a no-shop clause is often binding). This will help ensure none of the information is misinterpreted.
- List all important terms: You should aim to include all the major economic, control, and deal structure terms in the term sheet. Withholding information that could have a material impact on the deal will only serve to create delays and confusion later on.
- Provide an expiration date: An expiration date ensures founders can’t sit on an offer for so long that the terms become unfavorable.
- Reread and edit: Given you’re aiming for clarity and succinctness, it’s always a good practice to review your completed term sheet for opportunities to tighten language and make the information clearer.
- Encourage feedback: A venture investment is a collaborative process. Encourage the founders to review your terms and share their honest opinion. This signals to founders that you’re willing to work with them. If you’re far apart on terms, finding out early can save both parties a lot of back and forth.
Term Sheet FAQs
What happens after a term sheet is signed?
Once the term sheet is signed, the lawyers for both parties can get to work hammering out the details and drafting the formal investment documents. Documents that are drafted based on the information contained in the original term sheet include:
- Stock purchase agreement (SPA)
- Investor rights agreement (IRA)
- Certificate of incorporation
- Right of first refusal & co-sale agreement
- Voting agreement
Who prepares the term sheet?
A term sheet is prepared by the VC firm to be given to the founders. A VC firm’s legal counsel often has a hand in writing and reviewing the term sheet.
How do you negotiate a term sheet?
A startup and its legal team will review your term sheet and usually come back with some amendments to your provided terms. For the company, leverage is the greatest prior to signing the term sheet and agreeing not to shop the deal around. Most VCs anticipate some level of pushback from founders. The most common points of contention are the pre-money valuation and protective provisions, as both have an outsized impact on economics and control.
Your negotiating leverage as a VC can depend on the popularity of the deal (e.g., if the founders are weighing multiple offers), your firm’s reputation, and the macroeconomic environment. While the term sheet is only the starting point of negotiation, it’s important to be firm on terms that’re most important to you, and flexible elsewhere. A fair term sheet will make everyone happy.
Mark Kahn, a startup attorney at Sheppard Mullin Richter & Hampton and Angel Squad member, provided some additional pointers founders and VCs should keep in mind when negotiating a term sheet:
- Market conditions can affect terms. In an economic downturn, it’s not unusual for VCs to ask for a 2x liquidation preference (i.e. a guaranteed 2x return on investment) or a participating preferred liquidation preference (i.e. a guaranteed multiple return on investment prior to any additional pro rata portion of liquidation proceeds). Founders might also tack a “pay-to-play” provision onto the anti-dilution provision. Pay-to-play require investors to participate in future financing rounds or risk losing their preferential rights (including their anti-dilution protections). When faced with the need to raise a down round, pay-to-play provisions encourage investors to step up when founders need them most, while also reshuffling investor control in favor of the parties that step up to back the company in the down round.
- Option pool sizing matters. The size of the available option pool is a core part of the pre-money valuation negotiations. Most VCs will require that a company top-up its available option pool prior to the financing (typically in an amount equal to 10% of the company's post-money fully-diluted capitalization). This simultaneously has the effect of reducing the company's pre-money valuation and minimizing the VC's dilution risk from future employee equity grants. VCs should ask founders to come to these negotiations with an option pool budget based on their projected hiring and equity compensation needs between the current financing and their next anticipated financing.
- Founders will want to keep control of the board. When granting an investor a board seat as part of a financing round, a founder may ask for sunset period on that right. A typical sunset provision will rescind an investor's board seat if they cease to own a certain number of shares (typically that number is tied to the investor's original investment amount). An alternative sunset might be triggered by a subsequent financing round, which has the effect of ensuring that your lead investor continues to back the company at each financing stage. Generally, an effective sunset provision will help ensure the board does not become too large and unwieldy after multiple rounds of financing.
- Be specific about protective provisions: Because they’re so contentious, protective provisions should be addressed at the term sheet stage rather than kicking the can down the road. In later-stage financings, protective provision negotiations can become even more complex. For example, the Series B investors may want their own veto right rather than a veto right exercised by all investors (new and old) collectively.
Is a term sheet legally binding?
The only binding terms in a term sheet are typically the no-shop clause and exclusivity rights. No other terms are binding, meaning if they sign, neither party is obligated to act on the given terms. In this sense, a term sheet is unlike a contract, which is legally binding. Once the term sheet is signed, both parties work to draft up legally binding documents.
Term Sheets: Part and Parcel in Venture Capital
Many of us at Hustle Fund are former founders, meaning we believe strongly in the value of the partnership between founders and investors. Founders should feel supported by their investors, not at odds with them, and that starts with a reasonable and fair term sheet.
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