The importance of a term sheet in the context of raising funds through venture capital should not be overlooked. If you think of the ongoing relationship between you and the investor as a marriage, then you can think of the term sheet as the antenuptial agreement.
The term sheet is the document that outlines the terms by which an investor (angel or institutional), will make a financial investment in your company. The term sheet is crucial as it usually determines the final deal structure with your investor – it outlines the terms by which your investor will make a financial investment in your company.
Finding an investor can be complex and time consuming. Once you’ve found one with the right strategies and values, you may be tempted to rush through negotiations to access the promised cash injection. There can be serious ramifications if the details of the deal are not negotiated on a level playing field, and this is where the importance of a term sheet comes in.
A term sheet exposes the bare bones of the fundamental commercial terms of the investment. Due to its concise nature, the involved parties are less likely to miss essential details.
The term sheet
The term sheet is intended solely as a summary of terms for discussion and agreement between the parties. Except for the confidentiality provisions, nothing should create any legally binding obligations on the part of the parties until they execute the definitive written agreements, obtain all the corporate and legal approvals, and successfully close the deal by meeting all the conditions precedent.
The advantage of the term sheet in this respect is that it expedites the investment process by outlining the material terms and conditions, and guides legal counsel in the preparation of the proposed final agreements. It also allows you and your investor to get to grips with the terms quickly and provide input from each of your unique perspectives.
What to look out for in a term sheet
Your investor will place a valuation on your start-up company based on, among other things, comparisons to other companies in the marketplace and recent transactions. It is common to set the valuation of the start-up company as a “pre-money” valuation (i.e. the value of the company before the investors in the funding round participate). This is, however, not always the case – so be sure to get clarity on this, as investing pre-money or post-money can make a big difference in the equity stake you are giving away in your company.
If the parties are not in agreement about the valuation of the company, consider making provisions for claw-back provisions in favour of the start-up company or payment by the investor in tranches, which will be determined as and when the company’s audited financial statements indicate its valuation.
Type of shares offered to the investor
You will want to understand the type of shares you are giving away to the investor in return for the investment. Will you be giving the investor ordinary shares or preferred shares? Large investors are often only concerned with two things: Control and economics. As such, investors will often insist on acquiring a separate class of preferred shares which entitles them to fixed returns, the payment of which often takes priority over ordinary share dividends.
This is what is used to determine how the money is shared once the liquidity event happens. The preferred shares might have a liquidation preference of 1x the ordinary shares. That means that when the company is sold, the preferred shareholders will be paid first and then the ordinary shareholders.
As a start-up founder, you need to know what you are promising your investor.
Employee share ownership
These are shares which are set aside to be issued to employees, advisors and others during the investment round. Having available shares for this purpose is important, as they are needed to bring in new talent. This pool of shares is typically part of the pre-money valuation of the business. You need to understand this concept because these shares can dilute pre-money shareholdings.
The vesting period for founder shares is ordinarily three to four years. From an investor’s point of view, they want to make sure that you, as the founder and key members of the management team, are locked in and stay invested in the company.
It’s worth noting that many of the vesting provisions are subject to the founder meeting pre-determined performance milestones and continuously adding value to the company. After all, the investor took interest and invested in the venture because they believed in the founder team.
This is an important provision to look out for as it protects the investor’s investment if the start-up company raises an additional round of funding at a lower valuation.
Your investor may allude to this in the term sheet and require you to include an anti-dilution clause in the final agreements. Venture capital investors take significant capital risks and they will always seek to minimise their investment risk however they can. It’s important that you understand the effect of anti-dilution clauses on both future capital raisings, as well as your interests generally.
Raising venture capital is a crucial, and often fragile, step in any start-up business’ journey to success. Make sure you get guidance from a legal team that is specialised in commercial and start-up law from the start.