What is a term sheet?

In startup fundraising, a term sheet is a mostly non-binding document outlining the terms and conditions under which venture capitalist investors will invest in a startup. 

The economic terms outlined in terms sheets include company valuation, investment amount, percentage stake, and liquidation preference. We will cover these and more terms in this blog. 

In short, terms sheets outline the math behind a deal and what happens if a liquidation event occurs (e.g., IPO or M&A). 

The control terms often established in a term sheet include voting rights on important decisions, pro-rata rights, and other specific provisions, such as whether a venture capital investor will be granted a board seat for funding the startup. 

While term sheets are mostly non-binding, certain provisions related to exclusivity, sharing of confirmatory diligence costs, and confidentiality may be binding upon signing.

Example terms in a term sheet

Let’s say a VC agrees to invest $3M in your early-stage startup at a $10M post-money valuation with a 2X liquidation preference. 

If you are unfamiliar with any of these terms, you will be able to decipher this statement by the end of this guide. These conditions are likely outlined in a term sheet; we will review them below.

How are term sheets used?

Term sheets are mostly non-binding, but that doesn’t mean they aren’t important. They help simplify the fundraising process by outlining the terms investors and startup officers agree to that will ultimately serve as the skeleton for a binding, contractual agreement. 

They are typically only delivered once an investor sincerely desires to execute an investment subject to confirmatory diligence work.

Here is how term sheets help founders, investors, and parties involved in an M&A private equity transaction.

For founders

Term sheets provide crucial information for founders as they determine if the investment is right for them before they begin business and legal negotiations. 

Term sheets:

• Provide clarity on the proposed investment terms.
• Reveal the investor's priorities and negotiation style, as well as the investor's goals and approach.
• Help founders prioritize the key elements in the negotiations with investors.
• Serve as a guide in drafting the final, legally binding investment agreement, saving time and legal costs.
• It can generate interest and competition from multiple investors.

Terms sheets are a resource for founders, helping them gain clarity and control during the fundraising process and ultimately secure the best possible investment deal for their company.

For investors

Term sheets are a key tool for investors to clearly define the investment parameters, protect their interests, assess the startup's potential, and establish a productive long-term partnership.

The term sheet contains important details and disclaimers, such as the valuation, investment amount, equity allocation, investor rights, and more. It also provides a framework that can be used to draft the definitive investment documents efficiently. 

This document allows investors to negotiate favorable terms around liquidation preferences, board representation, anti-dilution protection, and other clauses that give investors more control and downside protection.

Reviewing the term sheet helps investors evaluate the startup's business model, team, proposed valuation, and the founder's ability to negotiate effectively. Investors can also use the term sheet to generate interest among multiple startups, potentially leading to better deal terms. 

Importantly, the term sheet lays the groundwork for an ongoing relationship between the investor and the startup, setting the tone for future collaboration.

As part of a merger

The term sheet is a crucial early step in the M&A process. It helps both the buyer and the target company agree on the key transaction terms before investing significant time and resources into negotiating the final, binding agreement.

It is typically the first step in an M&A transaction and outlines the major terms of the proposed acquisition. 

It describes key deal terms such as the purchase price, structure (asset vs stock purchase), holdback/escrow provisions, indemnification caps, right of first refusal, survival periods, and exclusivity periods. 

These deal terms are crucial because they affect the transaction's timing, certainty, and risk exposure. 

As mentioned earlier, a term sheet is a mostly non-binding document signed by the target company and the prospective buyer. However, it often also contains a few binding provisions, such as exclusivity, non-solicitation, and confidentiality clauses.

Negotiating at the term sheet stage is important because it can be difficult to renegotiate at a later M&A stage.

The term sheet stage allows the parties to focus on the core deal structure and economics without getting bogged down in the detailed legal language of the final agreement. Furthermore, the term sheet serves as a framework that instructs the lawyers and advisors on how to draft the definitive agreement and other transaction legal documents. An outline of the key terms ensures the parties are aligned before proceeding.

For the target company, it clarifies the investor's intent and the potential impact on founders, entrepreneurs, and shareholders. For the buyer, the term sheet helps ensure their interests are protected, as well as the necessary control and information rights. 

Equity vs. debt term sheet

Terms sheets may deal with debt or equity financings and generally have different structures, focuses, and terms, depending on the type. 

Equity term sheets and debt term sheets both serve as a framework for the final, legally binding investment agreement. They help founders and investors or lenders and borrowers align on the major terms before proceeding to lengthy legal negotiations.

As the name states, the major difference is that an equity term sheet outlines the terms and conditions for an equity investment, while a debt agreement term sheet outlines these for debt financing, such as a loan or venture debt.

Another major difference is in key terms included: An equity term sheet covers details that include valuation, amount of investment, type of shares (common vs. preferred), investor rights, control, and other key provisions. 

On the other hand, a debt agreement term sheet outlines the loan amount, interest rate, repayment structure, collateral, events of default, and other key provisions.

What is a term sheet vs. a contract?

The primary difference between a term sheet and a contract is that a term sheet is much less detailed and largely non-binding. 

The term sheet serves as a precursor and framework for the final documentation. A contract is the final, legally binding agreement that formalizes the deal, often accompanied by various addendums and related agreements.

A term sheet provides an overview of the essential terms, while a contract includes thorough legal language and provisions. 

Drafting a term sheet generally requires less time and fewer resources than a full contract, and it allows the parties to focus on the key business terms before investing in the detailed legal work.

Another key difference is that the term sheet is typically used in the early negotiation stage to align the parties on the core deal terms before proceeding to a binding agreement.

The contract is the final, legally enforceable document incorporating the terms agreed upon from the term sheet.

Note: There are some portions of the term sheet that are legally enforceable, like the confidentiality provision.

What is a term sheet vs. a letter of intent? 

While these terms are often used interchangeably, they have some key differences. 

As the name suggests, a letter of intent (LOI) is often written in narrative form for an investor to express their interest in purchasing or investing in a business. They are common in real estate transactions.

A term sheet serves as a skeleton for an eventual contractual agreement, outlining key terms and conditions of a deal. 

The goals are different. Term sheets help align parties on deal conditions and reduce legal administration costs. Letters of intent express interest and provide a level of assurance to a seller.  

Generally, term sheets contain the key terms of the contemplated transaction in a more abbreviated format, such as bullet points. 

Can you negotiate a term sheet?

Yes, absolutely. Term sheet negotiation is a crucial part of the startup fundraising process, allowing founders to shape the key terms of the investment and protect their interests before finalizing the binding agreement.

Founders should negotiate the following key items:

• Valuation and investment amount
• Type of shares (common vs preferred) and liquidation preference
• Board seats and voting rights for investors
• Founder control and ability to make key decisions
• Restrictions on future fundraising and dilution of ownership

While most term sheet provisions are negotiable, founders should be careful not to have excessive demands and risk losing the investment deal altogether. 

Founders should use the term sheet negotiation process strategically and create a sense of competition among investors to drive better terms.

What's typically included in a term sheet?

We’ll break down the key terms typically included in different types of term sheets. 

Investment term sheets

An investment term sheet covers the financial, operational, and control-related terms governing the startup and investor investment deal. In a term sheet, you will usually find the following components:

• Deal structure: This section outlines the structure of the proposed investment, such as whether it's a merger, acquisition, equity investment, or some other type of transaction. 
• Description of the investment: This includes details, such as the investment amount, the company's valuation (pre-money and post-money), the percentage of equity the investor will receive, and the payment terms. 
• Key terms and conditions: The term sheet highlights the critical terms, such as the timeline for due diligence, any conditions that must be met, and contingencies that could affect the deal.
• Ownership and equity: This section defines the ownership stakes and allocation between the founders, investors, and other parties involved.
• Governance and management: The term sheet outlines how the company will be governed and managed, including the composition of the board of directors and key decision-making processes. 
• Liquidation preferences: This provision specifies how the proceeds from a sale or liquidation event will be distributed between the investors and founders. 
• Investor commitment: The term sheet may include details on the investor's commitment, such as the time required to remain invested. 
• Anti-dilution provisions: These terms (sometimes called down round protection) protect the investor's equity stake from lowering its value in future rounds. 
• Option pools: The structure of management incentives - like executive option pools - or employee option carveouts (as an motivational tool) may be included.
• Voting rights: The term sheet defines the investor's voting rights and control over the company's decisions.

Debt agreement term sheets

A debt agreement term sheet covers the essential financial, legal, and operational terms governing the loan between the lender and the borrower. It includes the following components:

• General information: This includes the borrower and lender's names, the date, the closing date, and the currency of the transaction. 
• Loan amount: This specifies the total amount of the loan or debt financing. It can be a fixed amount or a range. 
• Loan structure: This confirms the debt structure, whether a senior note, subordinated debt, or other debt instrument.
• Interest rate: This section outlines the interest rate on the loan, including the frequency of interest payments (e.g., monthly, quarterly).
• Commitment fees: Defines any upfront or ongoing costs associated with the debt, such as an arrangement fee or commitment fee on unused portions of the loan. 
• Repayment terms: Specifies the repayment schedule, including any required prepayments or distributions. 
• Security/Collateral: This section details the security or collateral that will be used to secure the debt, such as accounts receivable, inventory, property, and, in some cases, intellectual property.
• Risk mitigation preferences: Outlines the lender’s preferences for mitigating risk and can include collateral, security interests, guarantees, or other credit enhancements.
• Extension rights: Specifies whether the lender has an option to extend the loan term or maturity date so the borrower can have more time to pay the loan back.
• Representations and warranties: This section defines the key representations and warranties the borrower must make, such as the accuracy of financial statements and compliance with laws.
• Covenants: Details the affirmative and negative covenants the borrower must adhere to, such as limits on additional debt, capital expenditures, distributions, etc.
• Events of default: This section outlines the events that would trigger a default on the loan, such as non-payment, covenant breaches, bankruptcy, etc.‍
• Due diligence at closing: This specifies the lender's due diligence requirements. It can include reviewing the borrower's financial statements, contracts, licenses, collateral, and other documentation to ensure the loan is sound.

Glossary of terms found in a term sheet

Investment term sheets and loan agreement term sheets differ in their purpose, the type of financing involved, the key terms covered, the binding nature of the documents, and the negotiation dynamics between the parties. 

These distinctions are important to understand when navigating the fundraising process.

Investment term sheet glossary

Valuation: pre-money & post-money

The pre-money valuation represents the company's value before the new investment. It is an important metric to determine the price per share and ownership percentages in the financing round. 

The post-money valuation is the company's value after adding the new investment. 

Valuation cap

The valuation cap determines the price at which the investor's convertible securities, such as convertible notes or preferred stock, will convert into equity in the company during future funding rounds. 

The purpose of the valuation cap is to protect the early investors from excessive dilution of their ownership stake if the company's valuation increases significantly in later financing rounds. 

By capping the valuation, investors ensure they can convert their investment at a lower price, effectively giving them a larger ownership percentage in the company. 

The founders want to set the cap high enough to leave room for future growth, while the investors want it low enough to protect their investment. Negotiating this provision is a key part of the term sheet process for startups seeking investment.

Drag-along clause

Drag-along rights are designed to protect the majority shareholders in an exit event, such as a sale or merger, by ensuring they can negotiate the sale of the company without minority shareholders blocking the deal. 

These rights give the majority shareholders the power to "drag along" the minority into a transaction they may not have otherwise agreed to, allowing the majority to negotiate the sale more effectively. 

While the minority is forced to sell, the drag-along clause typically requires they receive the same price and terms as the majority shareholders, providing some protection. Drag-along rights normally expire once the company goes public through an IPO.

Dividends

Dividends are the distribution of a company's profits or excess earnings to its shareholders, typically cash or stock. 

The company's board of directors can declare them, but most states don’t allow companies to pay dividends unless they meet certain financial requirements.

Liquidation preference

The liquidation preference is a key provision in a term sheet that outlines how proceeds will be distributed in a liquidity event, with important implications for investors and founders that must be carefully negotiated.

Voting rights

The term sheet will outline the voting rights granted to preferred stockholders, a key provision that impacts the balance of control between founders and investors. Careful negotiation of these terms is essential.

Pro-rata rights

Pro-rata rights are a common and important term in term sheets. These rights allow investors to maintain their ownership percentage in a startup as it raises more capital over time and welcomes new investors.

No-shop agreement

A no-shop agreement grants the investor a period of exclusivity. This agreement prohibits the startup from soliciting or negotiating with other potential investors during a specified exclusivity period. 

This assures the investor that the startup is committed to the current investment deal and will not use the term sheet to gain leverage with other investors.

The no-shop period typically lasts 1-3 months, with a shorter duration being more favorable for the startup as it provides more flexibility. 

It may allow limited exceptions or carve-outs to the no-shop clause, such as permitting the startup to notify the investor of unsolicited third-party offers.

Loan agreement term sheet glossary

Loan amount

The term sheet will specify the total amount of the loan or debt financing, either as a fixed amount or a range. This represents the maximum amount the lender will provide to the borrower. 

Guaranty

Guarantees provide additional assurance and recourse for the lender. Sometimes, the term sheet may require personal guarantees from the company's founders or key individuals to secure the loan.

Interest rate

The term sheet will outline the annual interest rate or "coupon" that will be charged on the outstanding loan balance. This can be a fixed or variable rate tied to a benchmark bond, such as the U.S. Treasuries.

The term sheet will also specify the frequency of interest payments, typically monthly or quarterly.

Term

The term sheet will indicate the length or maturity date of the loan. This can be structured as an amortizing loan with regular principal payments or a "bullet" loan with a single lump sum repayment at maturity.

Collateral

The term sheet will describe the collateral or security the lender will require, such as accounts receivable, inventory, property, or other assets. An advance rate against the collateral's value may also be specified.

Financial covenants

The term sheet will outline any financial performance covenants the borrower must maintain, such as minimum liquidity, debt service coverage ratios, or leverage limits. Violation of these covenants can trigger an event of default.

Loan costs

The term sheet may include details on any upfront fees, closing costs, or ongoing expenses associated with the loan. This can include arrangement fees, commitment fees, or legal/diligence costs.

How to structure a term sheet

1. Identify your needs

Gain clarity about what you are asking for, including the amount and type of investment. 

What would be a best-case scenario? 

Then, identify your company’s valuation.

This way, you can clearly communicate your business needs and have meaningful conversations with potential investors that will move the needle forward.

2. Include the key elements.

By structuring the term sheet to address these key elements clearly, you can create a comprehensive framework for the investment that aligns the interests of both the company and the investor.

Investment amount

Specify the total amount of investment the investor will provide. This is a key term that determines the company's post-money valuation.

Valuation

The valuation will determine the percentage of equity the investor receives and how much employee stock options are worth. Include the company's pre-money valuation the value before the investment. Also, specify the post-money valuation, which is the value after the investment. 

Security type

Outline the type of security the investor receives, such as common stock, preferred stock, or convertible notes. Clearly define the rights and preferences associated with the security. 

Liquidation preference

Specify the liquidation preference, which determines the order and amount the investor gets paid in a liquidity event. This is a key protective provision for the investor.

Board composition

Outline the structure of the board of directors, including the number of seats allocated to the investor. Remember, board composition impacts the investor's level of control and influence. 

Protective provisions

Identify any special rights or "veto powers" the investor will have over certain company decisions. These protective provisions safeguard the investor's interests.

Vesting and cliff

Specify the vesting schedule for any founder or employee equity, including any initial "cliff" period. This aligns with incentives and helps retain key talent.

Dividends

Outline any dividend rights or preferences the investor will have. This impacts the distribution of the company's profits. 

Anti-dilution

Describe any anti-dilution provisions that protect the investor's equity stake from being diluted in future funding rounds.

Exclusivity/no-shop

Include a provision that gives the investor a period of exclusivity to finalize the investment. This prevents the company from shopping the deal to other investors during negotiations.

3. Consult a lawyer

Consulting an attorney when creating a term sheet is highly recommended. Lawyers can leverage their legal expertise to protect your interests, avoid potential issues, and establish a strong foundation for the investment agreement. Also, having a lawyer review and negotiate the term sheet helps to set the stage for a smoother, more successful fundraising process. 

Tips for navigating the term sheet process

By following these tips, you can effectively navigate the term sheet process, secure the best possible deal for your company, and lay the foundation for a successful long-term partnership with your investors.

1. Prioritize your key terms

Identify your company's 3-4 most critical terms, such as valuation, liquidation preference, and board composition. Focus your negotiation efforts on the terms that will significantly impact your company's future. De-prioritize the rest.

2. Create healthy competitive tension

Engage with multiple investors to generate interest and competition for your deal. Leverage other offers or the ability to "walk away" to strengthen your negotiating position. Research the investors and understand their typical deal terms and pressure points.

3. Act, don’t react

Proactively share your ideal terms and priorities with the investor before they provide a term sheet. This allows you to anchor the negotiation and set the tone rather than reacting to their initial offer. Demonstrate that you understand the key terms and are prepared to negotiate assertively. 

4. Negotiate in writing, not live

Avoid negotiating term sheets live. Instead, do it in writing. This allows you to consider your responses and carefully control the process. Live negotiations can make it difficult to conceal your negotiating position and leverage.

5. Focus on the long-term partnership

Remember that you'll work with the investor for the long term, so establish a productive relationship. If the negotiation process is overly difficult, it may indicate future challenges. Aim to create a "win-win" situation that aligns the interests of the founders and the investors.

How to negotiate a term sheet with your investors

1. Decide which of the term sheet’s elements are most important.

Identify the 3-4 key terms that are critical to you, such as valuation, liquidation preference, and voting rights. De-prioritize less important provisions, such as dividends, information, and registration rights. Understand which terms matter most to both you and the investor.

2. Communicate your desires before issuing the document.

Proactively share your ideal terms and priorities with the investor before they provide a term sheet. Anchor the negotiation and set the tone rather than just reacting to their initial offer. Demonstrate that you understand the key terms and are prepared to negotiate assertively.

3. Create competitive tension by researching, networking, and talking with investors.

Talk to multiple investors to generate interest and competition for your deal. Leverage other offers or the ability to "walk away" to strengthen your negotiating position. Research the investors and their typical deal terms to understand their priorities and pressure points.

4. Focus on issues that help or hinder your chances of reaching your desired outcome.

Concentrate your negotiation efforts on the terms that will most significantly affect your company's future, such as valuation, ownership, and control. 

Be willing to compromise on less critical provisions to maintain goodwill and reach an agreement. Understand the investors' structural limits and red lines, and avoid pushing too hard on those points.

Download: Term sheet template 

Even basic terms found on a term sheet may be complex to a founder who has never used one, but luckily, we have a term sheet example here you can download. 

Editor’s note: This content is for informational purposes only. It doesn't necessarily reflect the views of Rho and should not be construed as legal, tax, benefits, financial, accounting, or other advice. If you need specific business advice, please consult an expert, as rules and regulations change regularly.

FAQs: Term Sheets

What happens after a term sheet is signed?

Once a term sheet is signed, the founder must move quickly to close the deal, stick to the term sheet, manage the process efficiently, and ensure alignment with the investor before finalizing the investment.

Why are term sheets non-binding?

The term sheet is intended to serve as a framework and starting point for negotiations, not a final, legally binding agreement. 

The non-binding nature of term sheets is a deliberate design choice that provides flexibility, encourages good faith negotiations, and avoids prematurely locking the parties into a final agreement before all the details have been agreed.

While some specific provisions, such as confidentiality and exclusivity, may be binding, most term sheet terms are non-binding and open for further negotiation. 

With a non-binding term sheet, either party can leave the deal if the talks break without being legally obligated to complete the transaction. 

What are liquidation preferences?

Liquidation preference is a VC term determining the order and amount of payouts to shareholders in a liquidity event, such as a company sale or acquisition. 

Liquidation preferences have significant implications for both investors and founders. These preferences set investment agreements that outline how a startup will distribute its sale or liquidation proceeds among its investors. 

What is the difference between a term sheet and a stock purchase agreement?

The term sheet is a largely non-binding document that provides an initial framework for the key terms, while the stock purchase agreement is the final, legally binding contract that governs the actual stock sale transaction between the parties. 

The term sheet precedes and informs the drafting of the stock purchase agreement.

What is the difference between a term sheet and a shareholder agreement?

Similar to the stock purchase agreement, the term sheet is a mostly non-binding document that outlines the proposed investment terms. 

In contrast, the shareholder agreement is the final, legally binding contract that governs the ongoing relationship between the shareholders and the company. The term sheet is created first and informs the drafting of the shareholder agreement.

What is the difference between a term sheet and a Memorandum of Understanding (MOU)?

While both term sheets and MOUs are generally non-binding preliminary agreements, the term sheet is focused on the financial and transactional details. 

Conversely, the MOU establishes a general framework of cooperation and collaboration between the parties and is not likely to include specifics on economics and governance. 

Conclusion: Manage your cash responsibly with Rho

Whether you are a first-time founder raising your pre-seed funding or a seasoned, multi-time founder raising your Series A, a term sheet will likely be involved. 

Terms sheets are a cost-effective way for investors and founders to quickly align on the important details around a potential investment in a startup and shorten the timeframe so founders can focus on building their business, not drafting legal documents. 

However, successfully pitching investors and raising cash is only half the battle; you want to ensure your cash is effectively allocated to earn yield that can potentially extend your cash runway. 

Rho makes this easy, offering a business banking platform with cash management services that help you put your cash to work. Learn more about our treasury products today. 

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Isabel is a guest contributor. The views expressed are hers and do not necessarily reflect the views of Rho.