The owners of startups, VCs, and other businesses often make frequent use of term sheets, which are nonbinding agreements that provide an overview of the general terms and conditions for an agreed-upon investment. These documents are often agreements between entrepreneurs and investors like venture capitalists who have agreed to inject capital into the funding of a startup. A term sheet can be a vital document for an emerging startup, with potential long-term implications for the financial future of the business.
Even though this document is not legally binding, it is still a critical document during the negotiating process between entrepreneurs and investors. While startup founders have the option to negotiate the conditions of a term sheet on their own, many entrepreneurs enlist the assistance of experienced business attorneys for guidance.
Is Any Part of an Investment Term Sheet Binding?
While most are always non-binding, there is one binding section called the "no shop" agreement. This section is designed to protect the prospective investor and requires the startup to avoid searching for other investors for a designated period of time. Some term sheets may include conditions that require the startup to pay a fee if the business breaches a no-shop agreement. In exchange for this term, the venture capitalist will usually agree to work towards securing an official agreement within a reasonable amount of time.
What Should Be Included in an Investor Term Sheet?
The specific provisions will vary depending on the nature of the business, the investor, financial considerations, and many other factors. While the specific terms included may vary, there are some key details that should be included in the majority of term sheets:
- How much money will the investor dedicate to the startup?
- What will the investor have control over?
- The company's starting value
- Investors should be named
- Common shares, B-class shares, and preferred shares
- Financial data such as capitalization tables, percentage of ownership designations, and stock options
- A confidentiality agreement
- Preferences for liquidation
- The company's post-money value
A term sheet should be as comprehensive as possible and address all investment-related terms and conditions. Startup founders should be aware of what needs to be included for their specific situation and understand the process of constructing these documents.
Financing and Valuation Considerations
Concerns related to financing and the valuation of the startup will be a central tenetVenture capitalists assign an estimated value for startups they invest in. Term sheets will often reference a "pre-money" valuation, which is an estimate of the company's value before the current investment round. Additionally, a post-money valuation will usually be included, which is an estimate of the company's value after the current round of investments. A company's valuation will determine the percentage of the company that will be owned by investors after the investment has been made. This figure can also influence how much control the investors have in the operations of the company, including voting power.
A pre-money valuation is calculated by multiplying the following figures:
- Price per share in the startup's current preferred stock financing
- Fully diluted capital - This figure is the number of shares of the business' common stocks that are outstanding, issuable according to outstanding convertible securities and exercisable securities, and reserved to be issued based on the option plans of the company.
A high valuation may not always be the best option for a startup, as some companies may end up ceding more control than they would have liked to investors. Startup owners can learn more about valuation and other startup financing matters by contacting the experienced business attorneys at Amini and Conant.
Common Unfavorable Terms for Entrepreneurs
Venture capitalists, angel investors, and other types of investors are integral to the process of building and expanding startups. However, startup owners should be aware that these investors will seek a deal that benefits them as much as possible. In some cases, investors may include certain provisions in a term sheet that are not in the best interest of the startup. Some key examples of these types of provisions include:
- Unfavorable financing - Some investors may include financing terms that are lopsided in the investor's favor. In some term sheets, the investor may include harsh repayment terms that could jeopardize the company's financial future.
- Unreasonably large controlling stakes - A controlling stake is one of the main incentives for many investors, but startup owners should be wary of an unreasonable request. A stake that gives them the largest share would also grant them the majority of control of the company.
- Disadvantageous liquidation preferences - Most term sheets include liquidation preferences, which determine how payouts will be distributed if the company is liquidated. The terms of a liquidation preference will designate how much initial magnitude the investors are entitled to as a payout following liquidation. Unfavorable provisions in this section of a term sheet may give the investor an unfair share of relative value and security.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.