Approaching any business deal without a term sheet is like taking a road trip without your maps app. Founders should leverage term sheets any time capital or business value is exchanged. Essentially, the term sheet lays out the big picture of any pending deal.
Investors and VCs are professionals at negotiations. For founders, especially during the early stages of their business, term sheets can ensure deal specifications keep their business protected, set precedence for future deals, and demonstrate their own negotiation fluency.
At this stage, it is critical for founders and all parties involved to have a clear understanding of all deal terms. Even before the official contracts are drafted, having an attorney review the term sheet for potential vagueness or misunderstanding is helpful. Clear term sheets guide discussions and agreements, and once all parties are on the same page, crafting official binding legal contracts is much easier.
Let’s take a deeper look at what term sheets are, when they are used, and what they should include.
What is a Term Sheet?
A term sheet outlines every term and condition of various business deals before legal documents are drafted. Similar to a Letter of Intent (LOI), Memorandum of Agreement (MOA), or Memorandum of Understanding (MOU), a term sheet is a non-binding document. In fact, these are often interchangeable terms.
Whichever phrase used to refer to the term sheet, this early non-binding agreement serves as the roadmap or blueprint for final investment agreements. It’s the preliminary outline for goals and intentions, setting the framework for business transactions or cooperative agreements.
In addition to establishing a deal framework, these documents signal serious commitment and guide negotiations. Involved parties work together to review the term sheet, which streamlines discussions and saves time when drafting binding legal documents.
When is a Term Sheet Needed?
Depending on the nature of the startup and the partnership or deal in question, the timing can vary. The key is that term sheets are drafted, reviewed by an attorney, and discussed with all involved parties ahead of signing any legally binding contracts.
While sometimes skipped at pre-seed stages, any priced round should absolutely involve a term sheet. Any major capital or equity transactions need this sort of thorough documentation, including but not limited to:
- Mergers and Acquisitions
- Investments (VC, Angel, Private Equity, etc.)
- Loan or Debt Agreements
An important note to remember is that signing a term sheet does not conclude the deal. It simply indicates that involved parties have agreed on the overall structure, though certain terms could still shift before the final contract is signed.
What Should a Term Sheet Include?
The National Venture Capital Association (NVCA) created a template widely-used in startup investment deals: the Enhanced Model Term Sheet. While this template is leveraged in the majority of venture deals, no two term sheets are identical. The template serves as a baseline structure, but each deal will require specific adjustments to included items.
Every term sheet will outline the structure of the deal, as well as the startup’s general business information. Details will include incorporation location, founder information, number of shares, and any outstanding obligations. The deal value and the timeline for action are also key items appearing in every document.
From here, various types of term sheets become more specific.
Mergers and Acquisitions
When approaching a merger or acquisition, term sheets will specify the type of deal: stock sale, asset sale, or a statutory merger. This leads to specifying the historical, known, and unknown liabilities that may be assumed once the deal is closed. Term sheets can also outline terms for key employees, helping to determine their trajectory within the new version of the company.
Transition periods are typically outlined in term sheets. It will be important to note what noncompete agreements should be included, and what transition services will be provided. There should also be a list of any and all needed approvals, conditions, and contingencies that could shift the direction of the deal during the negotiation process.
Investments
For each fundraising round, founders and investors alike should ensure term sheets cover transaction details thoroughly. Obviously, the document will include the equity stake and funding amount. The existing stock option pool and vesting schedule should also be included. Investors will want some future projections outlined, including ownership appreciations and equity dividends. They will also want to outline visibility into how their funds are being used by the startup.
Founders should look carefully at the governance and control section, as this defines how the company will run once the investment deal closes. It also can determine how much control founders maintain as the startup grows. Ensure all parties agree who will sit on the board, which decisions are management’s responsibility, and which will require investor approval.
Investment term sheets typically include a section focused on what happens should the company close or sell. Liquidation preferences, pay-out provisions, and pro-rata rights outline how proceeds are to be distributed, how future fundraising rounds are to be conducted, and what ownership ratios investors can expect to maintain moving forward.
Debt Agreement
Sometimes founders consider a venture loan or a venture debt agreement. While similar to investment term sheets, these documents also include specifics regarding loan size, interest rates, and repayment terms. The duration of the loan, maturity date, and any loan fees should be clear, as should payments on interest versus principle.
Should a debt agreement be violated, covenants should be outlined to guide repayment. There may be collateral in the form of stock shares or other assets, and founders should ensure comfortability with these terms. Likewise, founders should do their homework to ensure venture lenders are trustworthy and reputable, and worthy of their business relationship.
Why Should a Lawyer Review Term Sheets?
While founders are generally intelligent individuals, so are investors and venture capitalists. Many have negotiated multiple investment contracts — sometimes dozens or more — and understand the importance of protecting their investment. Rightfully so.
As startups move through various stages and fundraising rounds, founders often become more adept at their own negotiating skills. However, the risk of making a mistake in a binding contract grows significantly larger with each round.
A knowledgeable startup attorney should review each and every term sheet to ensure terms are clear and founders understand every detail of the relationship they are about to enter. Lawyers can help vet potential investors or partners, set protective precedents, and establish a positive foundation for long-term partnerships aligned with founders’ business mission and vision.
HJF Law Offers Term Sheet Support for Startup Success
In the startup ecosystem, it’s never too early to hire a lawyer! At HJF Law, we know startups, and we know term sheets. Getting term sheets right at the earliest stage is critical, as these do set the precedent for investor and partnership agreements throughout the life of the company. An early mistake can not only risk capital or shares, it could potentially risk control of the company.
Founders need attorneys who not only have their back, but are available at every critical stage. Our unique operations model allows you to reach out to us any time you have a question, without worrying about exorbitant fees. We want you to feel comfortable and confident throughout your startup journey.
Whether you have a simple legal question or seek to retain representation for your startup, we’re here to help. Reach out to us here or call (917) 726-8184.