Demystifying term sheets: what every founder should know

In the world of startup funding, term sheets play a crucial role in negotiation strategies, valuation, due diligence and ultimately securing the best investment

For founders seeking funding, the term sheet is a critical document that can make or break a deal. Yet, it remains shrouded in mystery and can be intimidating for first-time entrepreneurs. Investment rounds are pivotal stages in the growth journey of any startup. They are the juncture where dreams are fuelled with capital, and visions start to take tangible shape. Yet, this exhilarating phase is often marred by one intimidating document—the term sheet. In this article, with the help of advice from UNSW Founders Program Manager and investor Beste Onay, we’ll embark on a journey to demystify term sheets, unravelling their significance, key components, and the critical art of negotiation. More than just a financial contract, understanding term sheets is about preserving your startup’s vision, protecting its interests, and ensuring a fair partnership with investors.

What is a term sheet?

A term sheet is a non-binding document outlining the basic terms and conditions of a potential investment. It serves as a preliminary agreement between the startup and the investor, setting the stage for the more detailed and legally binding documents that will follow, such as the definitive investment agreement.

“Whilst not legally binding, founders should seek advice from experienced legal and financial advisors who specialise in startup investments,” says Ms Onay. “These professionals can provide valuable insights and help founders navigate the complexities of term sheets.”

Understanding the fragility of term sheets

One of the first things every founder should know is that a term sheet, despite its seemingly binding nature, is not set in stone. It’s more like a “maybe” than a “definitely.” Both parties – founders and investors – retain the option to walk away. This non-binding aspect is why term sheets are often referred to as the opening chapter of negotiations. They provide a framework for discussion, but the final deal is shaped through negotiation and due diligence.

Ms Onay adds: “Founders should remember that they can propose changes or counteroffers to terms that they find unfavourable. They can also receive multiple term sheets from different investors, which they can use to create competition and get them the best deal. It’s important to engage in open and transparent communication with potential investors during this process.”

The importance of taking ego out of It

Before we delve into the intricacies of term sheets, let’s address an essential piece of advice: take ego out of it. In the world of venture capital, humility and pragmatism often pay off more than bravado. Term sheets are not battles; they’re blueprints for collaboration. Resist the temptation to view negotiations as a zero-sum game; instead, focus on building a partnership that benefits both parties. Don’t be a vulture hunting for every last advantage; aim for equitable terms that promote a thriving business.

Read more: The art of valuation: how to price your startup for investment

“Term sheets often include provisions related to board seats, decision-making, and veto rights,” says Ms Onay. “Founders want to strike a balance between maintaining control of their company and accommodating the interests of investors. They should also focus on the key terms that will have the biggest effect on their company. Not all terms are equally important.”

The pre-money vs post-money conundrum

A term sheet is essentially a nonbinding agreement that outlines the fundamental terms and conditions of an investment. Among these terms, the valuation holds a paramount position. Valuation determines how much equity the investor will acquire in exchange for their capital. It can be expressed in two ways: pre-money and post-money valuation. Pre-money valuation refers to the estimated worth of your company before the investment, while post-money valuation includes the infusion of capital. Understanding this distinction is crucial, as it has a direct impact on the equity stake investors will hold post-investment.

“Founders need to carefully assess the valuation offered in the term sheet,” Ms Onay warns. “They want a valuation that accurately reflects the company’s current and potential value while ensuring they don’t give away too much equity too early. A company will typically give away 10-20 per cent each funding round.”

When due diligence comes into play

Once both parties have agreed upon the term sheet’s framework, the due diligence phase commences. This is where investors dig deep into your company’s financials, operations, and legal standing. It’s a rigorous examination to ensure that what was presented in the term sheet aligns with the reality of your startup. Due diligence can be extensive, involving financial audits, legal reviews, and market assessments. It’s the bridge between the initial agreement and the final investment.

Ms Onay asserts: “Founders should also do due diligence into the investors. For example, they could speak with the investor’s portfolio companies to learn how they behave when times get tough.”

Understanding term sheets is not just a matter of deciphering complex legalese; it’s about navigating a crucial phase in your startup’s journey. Take heed of the advice to keep ego out of negotiations, be wary of predatory term sheets, and always remember that term sheets are the beginning, not the end, of the fundraising journey. They are the canvas on which you paint the future of your startup, and with the right knowledge and negotiation skills, you can ensure that the partnership benefits both you and your investors.

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Term sheet glossary

• Valuation: This is where the negotiation begins. It defines the value of your company and determines how much equity the investor will receive in exchange for their investment. Example: A startup raises $1 million at a pre-money valuation of $4 million, giving the investors 20 per cent equity ownership post-investment.
• Investment amount: Specifies how much capital the investor is willing to invest in your startup. Be clear on the amount and its disbursement terms. Example: The investor commits to invest $750,000 in three tranches over 12 months, contingent on specific milestones.
• Liquidation preference: This clause dictates who gets paid first in the event of a liquidation event, such as a sale or merger. It can have a significant impact on how much money founders receive. Example: The term sheet includes a 1x non-participating liquidation preference, meaning investors get their money back before common shareholders receive any proceeds.
• Board seats: Specifies how many seats on the board of directors the investor will occupy and whether they have voting rights. Example: The investor will have one board seat with observer rights in the startup’s board meetings.
• Anti-dilution protection: Protects investors in case the startup raises capital at a lower valuation in the future. There are various formulas, such as full ratchet and weighted average, which determine how much additional equity investors receive to compensate for the drop in valuation. Example: The term sheet includes weighted average anti-dilution protection, which adjusts the investor’s ownership proportionately to the new valuation.
• Vesting period: Establishes a timeframe over which founders and key team members must remain with the company to fully vest their equity. Example: Founders have a four-year vesting period with a one-year cliff, meaning they must stay for at least one year before any equity vests, and the rest vests monthly over the next three years.

Templates for term sheets as well as subscription agreements, shareholder agreements, IP assignment deeds and other documents are available from the Australian Investment Council website.

This article is republished with permission from UNSW Founders. UNSW Founders sparks innovation within students, scientists, and alumni by centring on nurturing ideas, enhancing skills, and fostering networks. This dynamic environment gives rise to 50+ fresh startups annually. Explore further details, upcoming events, and opportunities at UNSW Founders here.