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Term Sheet Breakdown: Your Comprehensive Guide to What You Need to Know

Are you a founder dealing with investments for the first time? Or perhaps an investor looking to deepen their understanding of term sheets? Either way, navigating your way through the finer details of financing can be overwhelming. That’s why it’s essential to understand each element of a term sheet and how they affect decisions around investing in both the short-term and long run.

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Get ready to get up close and personal with this all-inclusive guide on what exactly goes into a term sheet – no question left unanswered.

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To learn more about other terms commonly used in venture capital,ย check out our complete VC Glossary.

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What is a term sheet?

A term sheet is a document commonly used in venture capital and private equity investing to outline the terms of an investment agreement between a company, investor, or syndicate of investors. It typically includes various financial and legal considerations that govern the relationship between the parties and serves as a blueprint for the more detailed investment documents that eventually need to be drafted.

What is a term sheet used for?

A term sheet is used to set the parameters for an investment agreement between a company or investor and to help document key deal points that are essential for protecting both parties. It helps ensure that all parties understand the terms of the agreement and can provide a basis for negotiating a more detailed final agreement.

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Having a term sheet in place provides a framework for discussing and negotiating the details of an investment agreement between all parties involved. It can help streamline the process of establishing an agreement, allowing all participants to have a better understanding of the investment terms.

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Understanding term sheets is an important part of making informed decisions when investing in startups, venture capital, and private equity. An effective document should address all the components needed to effectively structure the deal and protect both the company and investor interests. Entrepreneurs and investors need to review these documents carefully to ensure they understand the details of the agreement and can make an informed decision.

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By having a term sheet in place, all parties involved can have confidence that their respective interests are protected and that the investment agreement is legally sound. So if you’re looking for a guide to term sheets, this term sheet breakdown should help.

What is included in a term sheet?

The term sheet details important elements of the investment agreement, including:

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    • The investment amount and type of security

    • Valuation information

    • Voting rights and control

    • Dividend or other returns to investors

    • Board composition and rights

    • Lockup periods for investor shares

    • Liquidation preference

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The document also includes any conditions that must be met before the investor is legally obligated to make their investment, as well as other legal and financial provisions that are specific to the particular deal.



Term sheet terms

Term sheets have standard language that is recycled and reused. Here are terms that are commonly used that you should know and understand when you are presented with a new term sheet.

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Valuation (Pre-Money & Post-Money)

Valuation is the term used to determine the value of a company or asset. When referring to term sheet terminology, the term valuation typically references pre-money valuation and post-money valuations.

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Pre-money valuation refers to the value of a company before an investment is made, while post-money valuation takes into account any new investments and is considered the company’s true value. A term sheet should clearly define these two values so that all parties have a clear understanding of what they are investing in.

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Voting Rights & Control

This term outlines who has control over important decisions within the company. It defines things such as who gets voting rights, who will sit on the board of directors, and which shareholders have control over what decisions are made.

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Having this clearly outlined in the term sheet helps ensure that all parties understand each other’s roles in decision-making and helps eliminate disagreements down the line.

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Percentage Stake

The percentage stake is the percentageย of equity ownership the investor will own of the company if the deal goes through.

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Dividends

Dividends describe how profits from the business will be distributed among shareholders. Generally, dividends are only used with convertible debt.

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Dividend agreements may also specify if investors can choose to receive cash payments instead of stock options when receiving dividend payments.

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Lockup Periods

A lockup period is essentially an agreement between investors and founders regarding how long certain shares will remain locked up before they can be sold or transferred by either party.

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This helps protect both sides by ensuring that one cannot take advantage of their position by selling off shares too soon or holding onto them for too long without sharing profits with investors accordingly.

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Valuation Cap

The valuation cap is the value when convertible notes become eligible to convert into equity.

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Valuation caps on convertible notes serve as a safeguard for noteholders, providing them with both investment security and potential upside.

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Established at the start of the loan period, these โ€œceilingโ€ prices give investors peace of mind knowing that their money will convert to equity up until a predetermined maximum value per share price โ€“ giving everyone involved an assuring sense of financial stability.

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Drag Alone Clause

When one shareholder owns more of a company than the others, they can use their majority status to forcibly ‘drag along’ any other investors who are minorities that don’t want to sell.

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This means all shareholders must agree – or at least accept – the same pricing and payment terms for when it comes time to part ways with their piece of the business pie.

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Drag-along rights provide a unique opportunity for minority shareholders to benefit from terms, prices, and conditions that are normally unavailable. This provision in a term sheet guarantees equity holders the same advantageous sale agreement regardless of their amount of ownership – allowing everyone to share in success on equal footing.

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Liquidation Preference

This term states that in a liquidation event where creditors must be paid first, investors have priority access over proceeds generated from liquidation sales ahead of common stockholders or other equity holders to mitigate their losses in case of insolvency or bankruptcy filings within the company they invested into. This term helps protect investors against potential losses due to bankruptcies within a company they’ve invested in.

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Pro-Rata Rights

If a company is seeking additional investments, pro rata rights can provide investors with the opportunity to participate in future rounds of financing without any commitment or obligation.

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This agreement between an investor and business gives investors preferential treatment for their past support by allowing them to maintain their proportionate share of ownership.

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No-Shop Agreement

A no-shop agreement in a term sheet is an added layer of confidentiality that expresses the investors’ trust in your intentions and commitment to their deal โ€“ it invests faith that you won’t use the terms outlined to shop around for other offers from potential investors.

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Bottom line

Term sheets are an important element in many negotiations, especially those of a business nature. It is essentially a document outlining the terms and conditions of the proposed agreement between two parties.

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Both sides involved โ€“ whether individuals or corporations โ€“ must carefully consider all of the terms provided to ensure that the interests of both parties are adequately represented.

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With a comprehensive term sheet, both parties can be assured that they are entering into a fair and equitable agreement that provides long-term solutions and solutions beneficial to their mutual interests.

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Term sheets will undoubtedly continue to play an integral part in business and legal negotiations; they should be crafted with care and given due consideration every step of the way.

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Ultimately, having a clear understanding of how these documents operate is critical for successful negotiations about any type of transaction.

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FAQs

Who prepares a venture capital term sheet?

The term sheet for a venture capital investment is typically prepared by the company that is seeking funding.

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This document helps ensure that both parties have a clear understanding of the financial agreement and all its components, safeguarding their respective interests in the investment process.

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By clarifying expectations upfront and defining all the key points of agreement, term sheets are critical to setting up successful venture capital investments.

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Is a term sheet legally binding?

A term sheet is not a nonbinding agreement, and it does not necessarily imply an obligation to enter into any binding agreement or transaction. It is just an expression of a possible business transaction between the business and investors.

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Generally speaking, this document outlines the fundamental terms of a potential agreement between two parties and serve as the basis for further negotiation and legal documentation. It forms the basis of more enduring and legally binding documents, such as the stock purchase agreement and voting agreement.

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Is a term sheet the same as a contract?

No, a term sheet is not the same as a contract. A term sheet is a summary of the important terms and conditions that two parties have agreed upon at the outset of their commercial relationship. It is not legally binding but serves as the foundation for negotiations and helps pave the way for a definitive agreement or contract.

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What is the main purpose of a term sheet?

The main purpose of a term sheet is to outline the fundamental terms of a potential agreement between two parties and serve as the basis for further negotiation and legal documentation.

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It acts as an initial written agreement that can help protect both sides from any misunderstandings or disputes that may arise in the future.

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Additionally, a term sheet can also provide additional safety measures such as drag-along clauses, liquidation preference rights, pro-rata rights, and no-shop agreements. This helps ensure that all parties involved have clarity regarding financial arrangements and understand their respective roles in the investment process.

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Can you negotiate a term sheet?

Yes, term sheet negotiation often involve discussions around the amount of equity and voting rights the investors will receive in exchange for their investment.

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Other topics that can be negotiated include liquidation preferences, pro-rata rights, and no-shop agreements. These terms can be adjusted to ensure that both parties have clarity on their respective roles and obligations in the investment process.

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Are term sheets different between venture capital, growth equity, and private equity?

Yes, term sheets can differ between venture capital, growth equity, and private equity depending on the type of business or industry.

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For example, venture capitalists tend to be more focused on early-stage companies and investments that are more speculative. As a result, term sheets for these types of investments may include additional clauses to help protect the investor from potential losses or failure of the venture.

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Pre money valuation and post money valuation is important to venture capitalists while private equity firms are typically more interested in more established companies with a financial track record.

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On the other hand, term sheets for private equity investments may contain fewer provisions as these deals are usually less speculative and have a lower risk profile. Growth equity term sheets can also differ from those used in venture or private equity.

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It is important to understand the terms of each term sheet to effectively negotiate the best deal for your company or venture. In addition, an experienced legal adviser may be able to assist in ensuring that you receive fair terms and protect your interests.

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While a term sheet must be created and negotiated by legal counsel, a free term sheet template to view is available through the National Venture Capital Association.

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How long does it take to get a term sheet?

The time it takes to get a term sheet can vary depending on the complexity of the term sheet and the amount of negotiation involved.

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Generally speaking, this document take around 1 to 4 weeks to draft and negotiate, but this timeline could be shorter or longer depending on the specifics of each deal.

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Additionally, term sheets that involve venture capital investments might take longer to negotiate than ones for private equity investments. It is important to keep in mind that term sheet negotiations should be conducted in an efficient and timely manner to ensure that both parties are satisfied with the terms of the agreement.

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