Understanding Term Sheets: 6 Tips for Writing a Term Sheet

A term sheet is a non-binding agreement and legal document that lays out the basic terms and conditions for investment. A term sheet serves as a template for a future binding agreement. Founders of start-up companies frequently use term sheets to attract investors, especially venture capitalists, or “angel investors,” who invest their own money in a startup in exchange for a percentage of ownership. Companies can also use a term sheet for mergers or attempted acquisitions.

Since this agreement contains a great deal of information, first-time start-ups may use an online term sheet template for guidance or hire a professional to help with composition. Once completed, and after both parties have negotiated all the terms, entrepreneurs and other investors will enter the “due diligence” phase. Both parties agree to a time frame for this phase in which potential investors work out details surrounding the company’s early stages, including organization and financial projects.

The purpose of a term sheet is to profile an understandable and detailed document that investors and company founders can use to negotiate and agree upon the important terms of their agreement without the fine detail or permanency of a binding document. A term sheet must spell out all deal terms and conditions for both parties to avoid future disputes over the terms and expenses required.

There are several essential components that a typical term sheet may include:

• Board of directors: While it might seem like establishing a board of directors is a necessary decision, it’s essential to include it on the term sheet. Appointing board members ensures that the business is structured like a business, and the right board members can make board votes. Establishing board seats also allows for the company to grow in a manner that continues to distribute funds to all appropriate parties.
• Company information: Term sheets should always include the company’s name, its starting value, and the investors involved in the potential agreement.
• Detailed investment overview: To provide as much detail as possible in your term sheet, include the following: the amount of the initial investment; the percentage stake it will earn; the terms for investor commitment, which is how long they are required to remain vested in the company; and the time frame for the response to the term sheet.
• Information about voting rights: Some companies choose to include the terms for voting rights in their term sheets to explain how much of the company’s direction is overseen by the investor.
• Liquidation preferences: Companies may also include the liquidation preference, which details how the proceeds from the sale of a company would be distributed to the investors, and a confidentiality agreement.
  
• Participation rights and pro-rata rights: Participation rights protect investors if they decide to take back their investment share by receiving a return before other investors; they can then fully participate in funding without worrying about losing money later. Pro-rata rights allow investors to continue to participate in future financing rounds to maintain their ownership percentage.
• Purchase price: If the company uses a term sheet for a merger, include the initial purchase price and assets, preferred payment method, and any company elements that are not part of the deal.

Writing a term sheet requires attention to various requirements and details. Here are some important elements to understand and include:

1. 1. List the terms. Explain who is issuing the term sheet, the amount of the investment (including price per share) and the investors’ names, and the money they offer per share. Include the pre-money valuation (the company’s value before funding) and the nature of the securities or stocks involved (Class A, Class B, preferred or common stocks, etc.) Additionally, the company should be transparent on the items the term sheet addresses, whether it be a sale or acquisition or stock financing for a start-up, to eliminate potential confusion, which can impact investors’ confidence in the deal.
2. 2. Summarize the terms. Detail the target company involved in the term sheet and the potential investors. It should also be made clear that the items listed on the sheet are not a commitment to invest and that their commitment is only required after all parties agree and address all of the featured terms. Identify key terms that take top priority in the negotiation and note a target date for the completion of all negotiations.
3. 3. Explain the dividends. A term sheet should be explicit about profit distribution for shareholders and whether these dividends are non-cumulative (determined by the board of directors) or cumulative (in which the dividends go directly to the investors). Companies may also provide anti-dilution provisions, which are the rights to which stockholders are protected if the company’s value decreases by converting their stock into common stock. (This is typically either weighted average (based on a formula) or full-ratchet by adjustable rate.)
4. 4. Include liquidation preference. You also want to determine and include liquidation preference in your term sheet. This information will detail how investors will receive at least a portion of their funding should the company suffer a hardship.
5. 5. Include voting agreement and closing items. Close with the establishment of a voting agreement, which will determine how important votes will be made and counted regarding the company’s future. Companies may also consider mentioning an option pool, which sets aside an amount of stock for current and future employees.
6. 6. Read, edit and prepare for signatures. Ensure all of the terms on the sheet are necessary and understandable to avoid confusion and disagreements. Prepare the term sheet for signatures by the agreed-upon date.

The terms “term sheet” and “letter of intent” are often used interchangeably, but they share a key distinction: a letter of intent is a formal document, whereas the term sheet is simply a list of requirements that can be detailed in bullet points.

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