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What Is a Terms Sheet?
A terms sheet is a nonbinding agreement between yourself as the company owner or representative and an investor that outlines the broader terms and conditions of an investment deal. Parties frequently use it as a template and starting point for the more detailed and legally binding documents that'll come in the future. Once the involved parties agree on the term sheet details, they'll move into the next step of forming the legal documents that facilitate the investment in the company.
Terms sheets are typically associated with startups because it's these companies that most often need more investment dollars to start the business or expand operations, but many companies planning on a merger or acquisition use it too. Having a term sheet actually attracts investors and venture capitalists to your company with the means to contribute financially to assist with growing your business.
It's obvious that investors find it appealing to be a part of a company that they believe will bring them a solid return on their investment for years to come. What's even more enticing is when that company has everything in order and the terms of a potential agreement laid out in a way that's clear and doesn't leave much room for misinterpretation or confusion.
While the term sheet doesn't have to go into every single detail or contingency of a deal, it should include the more important parts so investors can read through it and know exactly what they are getting into. Venture capitalists may have many deals in front of them, so as a business owner, you may find it easier to attract the funds you need when you make the process easy on your investor.
What to Include on a Terms Sheet
If it's time to draw up a terms sheet, it means you're at a place in your company when you could use extra funds. This is usually when you're doing really well and just need some investment dollars to expand operations or keep them going at the level and pace you're used to. Here is what most term sheets should include:
- Identification information: You should share your information as the business owner and the investor's information. This will show exactly who is a part of the terms sheet.
- Valuation: This is how much the company is worth, and something that investors will definitely want to know before investing their money to fund your enterprise. The valuation calculation can also include how many shares of the company have already been distributed and at what cost.
- Investment amount: The investment amount should be laid out clearly, so there is no confusion as to how much you're expecting as an investment.
- Percentage stake: The percentage stake is the percentage the investor will own of the company if the deal goes through. For example, if the percentage stake is 20%, then the investor will own 20% of the company, which could make them a majority shareholder depending on how the other 80% is broken up.
- Time frame: It's standard practice to allow for a certain period of time where the investor can go over the terms sheet and make a formal decision.
- Voting rights: Venture capitalists want to maximize their return on investment potential, so they may ask you as the business owner to give up some part of the voting rights in the company. While this can go any which way depending on the agreement, you may want to outline exactly how much voting rights the investor will have if they provide much-needed funding.
- Other provisions: It's typical to include additional provisions for items such as who is responsible for legal fees, an investor's right to company information and future investments, nondisclosure details, and founders' obligations.
A terms sheet should also clearly state that it is a nonbinding agreement, giving both the entrepreneur and the investor the ability to withdraw before legal paperwork is completed. If you want some additional tips on how to understand your term sheet, head to this article .
What to Be Wary of in a Term Sheet
While it would be ideal to have an uncomplicated investment process, you may come upon an investor who tries to institute a variety of provisions in the term sheet that don't benefit you as the company founder. Here are some things to be on the lookout for:
- Unfair financing: If part of your investor's dollars will serve as a loan for your business expenditures, make sure that the note details aren't so harsh that your company could become bankrupt in an attempt to repay it.
- Large controlling stake: Investors want to have some stake in the company, but some investors may ask for a large stake that would give them the biggest share and, therefore, the controlling portion of your company.
- Limiting terms: There are certain things that an investor may ask of you, but they may also want to limit how much fundraising you can go after in the future. Consider if this is beneficial for your business before agreeing to it in the terms sheet.
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Common Terms Found on a Term Sheet
Term sheets can include a lot of jargon that you may not be familiar with when you're just starting out as a business owner. Here are some common terms and their definitions:
- Valuation: You likely already know what the valuation of your company is, especially if you're at the point of needing investors, but you may see the terms pre-money valuation and post-money valuation listed. The pre-money valuation is the value of the company before you've received the new investment, while the post-money valuation refers to the value of the company that includes investment dollars.
- Drag along clause: This clause allows a major shareholder to require a minority shareholder to follow their lead in business decisions, particularly in the sale of a company.
- Dividends: Dividends are what is paid out to shareholders on a regular basis, usually quarterly, based on the company's profits.
- Pro-rata rights: These rights are given to an investor so they can also be a part of additional funding rounds later on. You may even see pay-to-play provisions that require investors to participate in future investment rounds or pay penalties if they don't.
- No-shop agreement: This agreement limits your relationship with other investors after you sign the term sheet. It's normal to have to wait a certain amount of time after signing the term sheet before starting another fundraising round, but the term sheet should outline an expiration date after which it's okay to seek additional investments.
Here is an article that shares additional term sheet terms to become familiar with.
Although a term sheet is not a binding contract , it's still important to know how they work and why they are beneficial for your business. Remember that without one, or even with one that's limiting and confusing, you'll spend more time, effort, and money in coming to an agreement with your investors.
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