Term Sheets: What You Need To Know

A term sheet is the first formal (but non-binding) document between a startup founder and an investor, and lays out the terms for investment. We take a look at the key characteristics of a good term sheet, as well as some elements every founder should be sure to avoid.

April 27th, 2018   |    By: Emma McGowan    |    Tags: Valuation, Funding

What is a term sheet?

In the context of startups, term sheet is the first formal — but non-binding — document between a startup founder and an investor. A term sheet lays out the terms and conditions for investment. It’s used to negotiate the final terms, which are then written up in a contract.

A good term sheet aligns the interests of the investors and the founders, because that’s better for everyone involved (and the company) in the long run. A bad term sheet pits investors and founders against each other.

Term Sheets

Let’s take a look at the elements of a good term sheet — and some elements every founder should be sure to avoid.

What is included in a term sheet?

While each term sheet is going to be different, depending on the specifics of the startup and the needs of both the company and the investor, here are specific areas that should probably be covered in any startup term sheet.

a. Valuation

What’s the valuation of this startup? Before you can negotiate terms, you have to know what you’re negotiating about.

While it can be difficult to determine valuation of an early-stage startup, we’ve laid out 10 real-world valuation methods that others have used.

On a term sheet, you’re going to include both pre-money and post-money valuations. Pre-money is what your startup is worth before investment, while post-money is that amount plus the amount invested.

b. Option Pools

An option pool is a block of stock reserved for employees or future employees. On a term sheet, you’re might need to create an option pool or expand on the one you already have. You’re also setting the terms for how stock gets diluted as more stock is issued.

Unfortunately, pre-money option pools often favor the investor, as they call for all future dilution to fall on the founders. A more founder-friendly option pool would be calculated post-money and would include investors in future dilution. However, most option pools are calculated pre-money.

But remember how we said that not every term sheet is exactly the same?

Sam Altman of Y Combinator has created this founder-friendly term sheet that takes out the option pool altogether.

“Taking the option pool out of the pre-money valuation (ie, diluting only founders and not investors for future hires) is just a way to artificially manipulate valuation,” Sam writes. “New hires benefit everyone and should dilute everyone.”

c. Liquidation Preference

Liquidation preference is a safety net for investors who are getting preferred stock. In the case of your startup failing, liquidation preference gives the investors a possibility of getting at least some of their money back.

The standard term for liquidation preference is 1x the investment. Don’t agree to more than that amount. That means that holders of preferred stock get back up to the amount they invested before any holders of common stock get anything. (Of course, if all of the money is lost, no one gets anything, even preferred stock holders.)

See our guide on convertible notes in which we briefly discuss liquidation and overhangs.

d. Participation Rights

Participation rights give investors two benefits: A return on their investment before any other investors and a percentage of whatever is left. So, for example, say an investor with preferred stock has $250k liquidation preference with participation rights and owns 30% of the cap table. The company sells for $2 million, which gives preferred stock holders that initial $250k right off the top, as well as 30% of the remaining $1.75 million ($525k). That leaves $1.22 million for common shareholders and founders.

While in general it’s a good idea for investors and founders to be on the same page, this is one place where they might find themselves on opposite sides of the table. Investors like participation rights because it gives them a higher return on their investment. Founders prefer no participation rights as all.

And while investors might push for participation rights, they’re not a standard part of term sheets and you should feel empowered to push back. If your investor insists on including them in the term sheet, propose putting a cap on participation. This puts a limit on how much extra the investor gets.

A cap on participation often looks like a fixed multiple of the original investment. So, for example, you might place the cap at 2x or 3x the initial investment. That means that after that amount is reached, holders of preferred stock will have to convert to common stock before receiving any more money.

e. Dividends

Dividends are, at the most basic level, distribution of profit between a company’s shareholders. They are paid either in cash or in stock. They can also be another bonus for preferred stock holders — they’re one of the things that make this type of stock “preferred.” Dividends are usually a percentage — typically between 5% and 15% — that accrues over time.

There are three types of dividends:

  1. Cumulative: Cumulative dividends favor holders of preferred stock (i.e. the investors) and disfavor holders of common stock (i.e. founders and employees). They accrue on the original issue price. With cumulative dividends, the dividend is calculated every year and if the company can’t pay that amount, it’s carried forward (accumulated) into the next year and until its paid or the right to dividends is terminated. Cumulative dividends are not very common for early stage startup deals.
  2. Non-cumulative: With a non-cumulative dividend, the Board of Directors (see below) of a company has to declare the right to a dividend during that fiscal year. If that doesn’t happen, no one has a right to a dividend that year. This is a better deal for holders of common stock. Dividends on preferred stock only when there are also dividends on common stock. In this case, dividends are paid on preferred stock only if they’re also paid on common stock. Preferred stock is treated as if it has been converted to common stock when the dividend is declared. This option is the least favorable to holders of preferred stock and the most favorable to holders of common stock.
  3. Anti-dilution rights: Anti-dilution rights protect holders of preferred stock in the case of down round. A down round is when a company valuation goes down from one round of financing to the next. So, for example, if a company is valued at $3 million in their series A and then $2.5 million in their Series B, that Series B is a down round. Anti-dilution rights protect holders of preferred stock usually by issuing them additional shares in the case of down round or by lowering the price of converting their preferred stock to common stock.

There are two types of anti-dilution rights:

  1. Full-ratchet: This type is best for holders of preferred stock and worst for holders of common stock. It allows for the conversion of price of the preferred stock to be set base on the price of the new round of shares and does not take into account how many new shares are issued.
  2. Weighted average: Weighted average anti-dilution rights are more favorable to holders of common stock than full-ratchet. With weighted average anti-dilution rights, a formula that considers the share price of the new stocks issued as well as the number of new stocks issued. That formula is used to calculate the price at which preferred stock converts to common stock.

f. Board of Directors

While the concept of a Board of Directors may seem ludicrous to an early stage company, it’s an important part of any company as it grows. As a result, most term sheets will include a section about the Board of Directors.

Even if your startup is currently only you and a co-founder, the idea is to grow. The most equitable provision for a Board of Directors includes equal representation of founder-friendly members and investor-friendly members.

Some companies also like to have one “independent” member — someone from the business community who is respected by all parties.

Here’s a master class on managing your Board of Directors featuring veteran investor Brian Ascher .

g. Ownership Percentage of Share Classes

While a company’s board often determines big decisions, some decisions will be made by a shareholder’s vote. Your term sheet should include a section about ownership percentage of share classes — i.e. what percentage of the company each person/group holds.

Here’s a startup equity 101 refresher so you can make a better decision about who gets what slice of the ownership pie.

h. Investor Rights

Term sheets usually include a section for investor rights. The rights listed here can vary pretty widely, so this is a good area to consult with your lawyer in order to make sure you’re getting a good deal. Investor rights are usually specific actions that investors have a right to take or expect.

For example, Sam Altman’s founder-friendly term sheet includes the rights for investors to buy new shares at a favorable rate, the right to be continually updated about the company, and an agreement about proprietary rights, to name just a few.

Things to avoid in term sheets

While some of the areas that you as a founder are going to want to avoid are outlined in the relevant sections above, there are a few other common terms and areas that you should avoid having on a term sheet.

a. Redemption Rights

Redemption rights give investors the right to ask for their investment back. In the case of your company succeeding or failing this won’t be an issue, as the investor will get their return back in the former case and no one will get anything in the latter case. But redemption rights can become a problem when a startup is going through a rough patch and a skittish investor asks for their money back, tanking the startup.

b. Milestone-Based Financing / Tranched Round

With milestone-based financing, everyone agrees that an initial portion (tranche) of financing will be followed by another portion of financing, assuming the company hit certain milestones.

In some situations, if the company doesn’t hit those milestones, the investor has the right to change the terms of the deal. In other situations, founders receive portions of funding only upon meeting certain milestones.

Milestone-based financing is not very common anymore, so do feel empowered to push back if it pops up in a term sheet.

c. Unnecessary Fees

Some fees that might show up and should be contested are “board fees” or “monitoring fees.” In both cases, the investor charges you for their presence at board meetings or for the task of monitoring their investment. They’re unnecessary, unfair, and may upset future investors so don’t agree to these fees.

d. Multiple Board Seats Per Investor Per Round

It’s customary to grant one board seat per investor per round. Don’t let a greedy investor take more than that, as it dilutes your share of the company and may limit future rounds.

Binding vs. non-binding legal

While most term sheets are non-binding — the point, after all, is to lay out terms in order to hopefully enter into a legally binding agreement — there are exceptions to that rule. If the term sheet has language that explicitly states that it is non-binding, then it is non-binding.

However, if it has a clause that the parties agree to “negotiate on good faith,” neither party can back out because they’ve simply changed their minds. Other term sheets have some provisions non-binding, with others non-binding.

The takeaway here is that it’s important to closely read all of the wording on your term sheet and determine if the structure works best for you and your company.

About the Author

Emma McGowan

Emma McGowan is a full time blogger and digital nomad has been writing about startups, living with startup people, and basically breathing startups for the past five years. Emma is a regular contributor to Bustle, Startups.com, KillerStartups, and MiKandi. Her byline can also be found on Mashable, The Daily Dot's The Kernel, Mic, The Bold Italic, as well as a number of startup blogs.

Follow her on Twitter @MissEmmaMcG.

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