An investor's masterclass on term sheets

If you’re a small business or startup looking to secure funding, you’re likely to come across the concept of a term sheet. Acting as a non-legally binding document, a term sheet sets out an investment's essential details and conditions. 

When seeking either venture capital investors or angels, a business will construct a term sheet. Once everyone agrees to the terms listed and all of the information included, this sheet will then become the skeleton for a legally binding document. Considering that UK-based seed-stage valuations have been steadily rising over recent years, moving from just under £500,000 in 2011 to over £1.1 million in 2021, it’s no wonder that more companies than ever before are preparing term sheets for their funding rounds.

If you’ve never come across a term sheet before and need to write one, this guide is for you. We’ll explore what a term sheet is, break down its key components, and demonstrate when you should use one.

Table of Contents

• What is a term sheet?
• What's included in a term sheet?
• Term sheet provisions explained
• When should I use a term sheet?
• The capital-raising process in a nutshell
• Documents needed in a private capital raising transaction
• How to read a term sheet
• Term sheet FAQs – what should existing investors know?

What is a term sheet?

A term sheet is a baseline financial document that outlines comparative statistics about an investment agreement. As a document that will change and update with further edits, this is non-legally binding. Equally, they can be much more informal than a letter of intent, which is the document often produced after all parties agree to the conditions within a term sheet.

The startup looking for funding will produce the term sheet and send it out to potential investors to gain interest in the lead up to funding rounds. Once an investor enters into conversations with the startup, they can negotiate different terms within the document until both parties are happy with its standing.

From there, the term sheet will process through a legalisation phase, where it is made legally binding. 

What's included in a term sheet?

Considering the immense importance of a term sheet, it’s no wonder that there are many moving parts. As they contain every needed element that will define the investment terms and the expected return, they are relatively complicated.

While all term sheets will vary in the specific information they hold, each document will likely contain the following information: 

• Offering terms

• The initial valuation

• Type of stock investors are getting

• Voting rights

• The liquidation preference

• The option pool

• Right of first refusal and co-sale agreement

• Board structure

• Founder vesting period

• Anti-dilution protection

• Redemption rights

• Issuing dividends

• Pro-rata rights

• No shop/exclusivity

Let’s break each of these down further.

Term sheet provisions explained

Offering terms

The offering terms within a term sheet are a short description of exactly what a startup company is offering during this funding round. They will outline the core information, allowing an investor to quickly scan this description to get a general idea of what is being proposed.

Five elements typically make up the offering terms:

• Pre-money valuation – the company's total value before they’ve gone through this current financing round

• Price per share – the total cost of each share that is being offered within this agreement

• Amount raised – the total amount of money that is raised within this investment

• Closing date – the date on which this investment round will end

• Investor names – details of the names of the investors or the venture capital firm that is investing 

Across these five sections, the offering terms will outline the class of investor that this investment feeds into (Series A Preference, etc.). It is one of the most essential elements when attempting to summarise an agreement.

The initial valuation

Valuation is another critical metric to include on a term sheet, as this distinguishes how much of the business a particular investment would capture. There are two common ways of assessing initial valuation, with most term sheet negotiations using post-money valuation. The other possibility is pre-money valuation, which is how much the company is worth before the investment. 

It’s essential to list whether you are using pre-money or post-money valuations, as these will radically change the percentage of your business that an investor will receive.

Type of stock investors will get

One of the benefits of funding rounds for both venture capitalists and angel investors is that part of the negotiation will allow them to purchase what is known as preferred stock. Preferred stock, as opposed to common stock that anyone can buy, comes with a few certain advantages. 

An example of these inherent advantages is voting rights within company decisions, effectively giving investors a percentage of control of the company. One final vital distinction to make between the stock formats received is to do with what happens if the company goes bankrupt.

If a company goes bankrupt, investors with preferred stock will always get capital back before common stockholders, favouring early investors in a startup.

Voting rights

Following the inclusion of preferred stocks and their implication for voting rights, a term sheet must also set out the conditions of control in the company. A term sheet will clearly state what voting rights the company will follow.

It would help if you outlined actions like deciding to sell the company, opting to create a dividend stock or anything to do with signing contacts within your term sheet. With this in place at an early stage, investors will know exactly how much say they have in company decisions and the extent to which investors’ money impacts the business itself.

Balancing voting rights across common stocks and preferred stocks is vital in creating a well-structured company.

The liquidation preference

A method that startups use within their term sheet to minimise the risks to venture capitalist firms is including a liquidation preference. Liquidation preferences are the order in which entities with a stake in the company receive capital if the company liquidates.

When a liquidation preference is 1x, VCs will always get their investment back before other shareholders. This is the preference that most VCs are looking for, as it radically reduces the risk they must take with their capital. If this number moves towards 2x or 3x, then any money they invested will return to them in that quantity.

While a higher return favours the early investors, a 2x or 3x liquidation preference also leads to a reduced payout for any other shareholders in the picture. This can create unfavourable conditions, which can dissuade other investors down the line.

The option pool

A key part of attracting top talent to your business is offering stock options to new employees. By connecting stock options to a hire’s own finances, you’re tying the company's success to their own success. This is a wonderful method of instilling work ethic and motivation in your employees.

The option pool is the percentage of stocks you put to one side for future employees. The most common figures are between 10-15%, which will provide enough stocks for any hires you onboard. 

Depending on the stage that your company is in, the amount you should designate to your option pool will differ. If you already have a solid base of employees, then you’re less likely to need a large pool. On the contrary, if you’re only just getting started, you should create a more extensive option pool.

Right of first refusal and co-sale agreement

This clause in your term sheet is a statement that allows many investors to buy shares before you offer them to any third-party investors. If you’re offering shares at a lower price, this gives your main investors the opportunity to put more capital into the company.

Additionally, a co-sale agreement permits all investors equal opportunity when it comes to selling. If one group of shareholders sells the shares they hold, then all other parties have the chance to sell on the same conditions. This creates a sense of fairness between all investors, opening deal terms to all.

Board structure

Defining the board structure is an integral part of creating a term sheet, with this being an early stage clause that you will turn toward. Within the deal terms, you need to define how your business intends to structure its board.

Of course, if you’re bringing new investors into the company, then you need to consider exactly how they fit into the equation. Both preferred holders and common holders should be represented within your board. Typically, this calls for a member of the board to be elected by both common and preferred holders.

To bulk out the board, other directors could be appointed based on their expertise or familiarity with the company. Any alteration of the board composition, like bringing a new member into the group, must be with mutual consent from the current board.

Founder vesting period

A founder vesting period is a length of time outlined in the term sheet that pertains only to the startup’s founders. Over this period, a founder will be able to earn their shares in the company. This period is often up to 48 months, with a founder earning all of their shares each quarter over this period.

To ensure that founders and co-founders don’t walk out on the company while it is still in its early stages, the term sheet may also include a ‘Cliff’. This cliff is a period of time, up to a year, where if the founder were to leave, they would get none of their shares.

With cliffs and vesting periods in place, you ensure that founders stay at the company and work as hard as possible to see it flourish.

Anti-dilution protection

Anti-dilution protection is a clause that if you don’t add to your term sheet, the investors you’re working with certainly will. This provision ensures that investors’ equity ownership in the company will not be diluted or become less valuable over time. This protects investors if your startup releases more shares at a lower price. 

Typically, anti-dilution protection allows investors to cash out if a liquidity event occurs. With this documentation, they can either collect their liquidation preferences or convert their preferred stocks to common stocks and get a portion of the proceeds. 

Of course, investment firms will always pick whichever amount is higher. The anti-dilution protection ensures that they can keep their ownership while capturing more capital if they have to exit or more stocks are released.

Redemption rights

Redemption rights are the ability of an investor to redeem any outstanding shares they have at a specific price. The price is also part of constructing redemption rights, with this going hand in hand with post-money valuation. Of course, if they’re redeeming these rights, it’s likely that the company’s stock price has fallen. Due to this, redemption rights serve as a form of protection, helping investors retain their capital if a company goes out of business or devalues.

One thing to note is that redemption rights must be approved by a majority of shareholders to impact all parties.

Issuing dividends

Dividends are agreements with all common stockholders that pay out a total sum of money in regular payments. Typically this is around 3-5% of a stock’s total value for every stock you issue. Stock dividends are most commonly offered by established companies that want to reward stable investors. In the world of startups and fast capital, they may not come into the picture.

If dividends are a part of your future business plan, you should outline this in your term sheet for investors to see. Your dividend policy could be a make or break business plan for some investors, so always include this factor.

Pro-rata rights for invested capital

Also known as pre-emption rights, pro-rata rights are the potential of investors to buy shares in the future. As more stocks are released in the future, investors may want to maintain their percentage by contributing to future financing rounds. That said, they have no obligation to continuously buy more stocks.

This is commonly one of the most prominent points of discussion between two parties in early-stage financing. Typically, VC firms will want as many pro-rata rights as possible, giving them more security in the future. However, for a startup, giving away large quantities of pro-rata rights will lead to a lack of flexibility when it comes to financing. 

The more pro-rata rights you grant, the harder it will be to gain new investors in the future, so be careful. 

No shop/exclusivity

If you’re looking to ruin relationships with potential investors as quickly as possible, you can use your term sheet with one firm to negotiate a deal with another firm. This is frowned upon in the world of investing and will lead to you burning more bridges than you can count.

A no shop term establishes a period in which you cannot contact or discuss with other investment parties. Through this system, you’ll be in conversation with one firm for at least 30 days before you can consider other offers. Some investors may ask for even more control over the exclusivity, needing up to 60 days. 

With this, we wrap up everything that you’ll commonly find on a term sheet!

When should I use a term sheet?

A term sheet is one of the most critical elements of early-stage company growth, helping you to find and contract new investments. Whether you’re working with existing investors on future rounds or are starting from scratch, a term sheet will always be the document you turn towards.

As term sheets allow you to navigate the world of investments while also going back and forth on how much equity you’re willing to give, they are vital for early investment rounds. If you’re in the process of raising capital for your business and need to turn to external investments, then a term sheet will be one of the first documents you create.

Alongside being a centralised location where all of the most important information about your company is, it will also provide a springboard for conversation with investors. Don’t consider a term sheet as a fixed document. It should be malleable, with your conversation with an investor shaping it as you go along.

The capital-raising process in a nutshell

Raising capital is a profoundly complicated topic, expanding beyond just the construction of a term sheet. Spanning across several different stages and encompassing a complete timeline of different steps, the act of raising capital is more complicated than one would first expect.

Let’s move through a general overview of how the capital-raising process works, demonstrating every step your business needs to take to raise equity.

Funding rounds in venture capital (VC)

1. Seed stage – Angel round or “Family & Friends” round

2. Early-stage – Series A, B

3. Expansion stage – Series B, C

4. Late-stage – Series C, D, etc.

These four stages encompass the whole of the venture capital timeline. Typically, startups follow these initial investments with bridge loans and mezzanine finances steps. Finally, investing turns to Initial Public Offerings (IPOs), where a private company is offered to the public for the first time.

Each stage builds on the last, creating a system through which every single investment generates further motion and potential for the company. 

Capital raising timeline

If your startup is looking for investment opportunities through venture capital firms, you will have to follow a strict process outlined. With this in place, you’ll receive invested capital faster, ensuring that you can raise the money you need to continue to expand as quickly as possible.

There are six steps to raising funds when working with a venture capital firm:

1. Startup formation

2. Investor pitch

3. Investor decision

4. Term sheet negotiation

5. Documentation

6. Sign, close and fund

These six steps can take anywhere from three months to over nine months, demonstrating the additional complexity that back and forth arrangements can cause. Depending on the structure of your term sheet and the extent to which you have to revise your terms, the total time period of raising capital will change.

Documents needed in a private capital raising transaction

In an article entirely dedicated to constructing a term sheet, you won’t be surprised to find a term sheet on this list. However, this is far from the only document that your business will need to supply if you’re looking to raise capital. 

Typically, there are six documents that you will have to produce if you’re looking to accurately value your company and achieve a large investment. 

These are as follows:

1. Teaser / 1-Pager

2. Non-disclosure agreement (NDA)

3. Management presentation

4. Term sheet

5. Offering memorandum

6. Subscription agreement

Across these six documents, you’ll need a lawyer to double-check any contract elements you construct. While this won’t come into play with the term sheet, legal counsel will be vital going forward. Be sure to have a range of lawyers on hand to help you with much-needed legal advice.

How to read a term sheet

If you’re new to investing in a business, this may be your first time reading a term sheet, let alone constructing one. If this is the case, then there are a few metrics that you should always search for when scanning a term sheet.

When you open this document and don't want to get bogged down by different clauses and complicated segments, look for the following six things:

1. Who is investing? – Search for the names of anyone that is investing in the company.

2. Price per share – how much per share is being offered?

3. Amount raised – if there have been previous investment rounds, what value has been raised to date?

4. Capitalisation figure – the number of shares the company has multiplied by the share price.

5. Dividends – are the company planning on issuing dividends? If so, how much?

6. Price per share – saving one of the most important till last; always check how much a company is selling each share for. 

Check out our free term sheet template

Term sheet FAQs – what should existing investors know?

What to be wary of in a term sheet

Even for existing investors that have been in the game for decades, term sheets always offer a unique challenge. Considering the level of debate and negotiation that can take place within this document, term sheets are always essential to get right.

If your business is constructing a term sheet and wants to get it right, there are a few core elements that you should look out for. From documenting your dividend policy to remembering no shop clause time limits, these tips will set you on the right track:

• Learn vocab – if this article is your first introduction to a range of investor jargon, then be sure to spend time brushing up before writing or reading your first term sheet. This will save you hours of struggling in the long run.

• Valuation differences – between pre-money and post-money valuations, it’s easy to get lost in a term sheet. To avoid this, be sure to know the differences and the implication of the distinct possibilities for company valuation. If needed, there is a vast range of examples online for you to follow. 

• Not seeking legal advice – although a term sheet is a non-legal document, it forms the basis for the legally-binding paper that comprises your whole investment round. If you’re not working with a series of layers to craft your term sheet, you may be at a large disadvantage.

Always brush up on the terminology and expertise needed to effectively construct and read a term sheet. If you’re reasonably new to this industry, you can read through a term sheet template to find out exactly how they’re structured, giving you a better idea about how investment rounds work.

How long does it take to negotiate a term sheet?

While term sheets most commonly cover a range of similar materials and points, they are not all created equally. A few factors can change how long the negotiation period takes. Each of these factors will influence the process differently, leading to small changes down the road.

The main factors you will likely come across are:

• Investor interest – if an investor is incredibly interested in your business, the term sheet negotiation should be a breeze. If they’re keen to get started, you can expect this process only to take a few days. Often, the more interested a VC is in your company, the faster the negotiation process goes.

• Your Series A term sheet – if you’re going through several rounds of funding with different pools of investors, you’ll have to create various term sheets. The most important sheet that you’ll make is the first one out of all of these. As your first investors will be part of the conversation going forward, who you bring on board will impact everything down the line. If someone has a lot of micro editing to add in future rounds, then the time it takes to negotiate a term sheet will grow significantly. It’s always important to be the most careful in your first round, as this is definitely the most important.

• Stage of investment – if your company is still looking for investors, then the prospective term sheets you send out will likely need editing. However, once you’re in conversation with a VC and they decide to invest, then it should only take a few days to close the deal.

With these factors in mind, the typical negotiation period can take as long as one month. This gives both parties enough time to go through all related documents and finalise what they expect from the deal. However, this period only lasts a few days in some cases, with the closing date being settled in mere days.