How to Draft an Investor Term Sheet
Once you have formulated a business concept, presented it to potential investors, and explored various sources of funding, the challenge of securing capital may still seem daunting. However, you can simplify this process by creating a term sheet, a valuable tool that can assist you in attracting interested investors and promoting healthy competition to obtain the most favorable terms. If you are seeking to finance your startup successfully, below is a comprehensive guide on crafting a term sheet specifically tailored for potential investors.
What Does The Term Sheet Entail?
A term sheet serves as the fundamental, non-binding agreement that establishes the foundation for a financial arrangement between an investor and an entrepreneur. This initial draft establishes the framework for the terms & conditions anticipated in the potential agreement. Since a term sheet lacks binding obligations, it can serve as a guide for the ultimate agreement. This document comprises two critical aspects:
- Economics: Some of the key considerations include option pool size, liquidation preference, and valuation.
- Control: The degree of investor influence in shaping business decisions.
To ensure that you maintain control of your business, it is important to closely scrutinize both elements of the term sheet, regardless of whether you or your investor are creating it. Within the ‘Entrepreneurship Essentials’ online course, Professor William Sahlman from Harvard Business School highlights that many venture firms typically utilize a standard term sheet, often expressing a preference for including preferred stock with conversion rights and liquidation preference.
Furthermore, you can opt to offer predetermined conditions in a term sheet as a way to attract potential investors as well as initiate the negotiation phase. Being a founder, it is vital to prepare yourself for pitching your business concept to investors while having the term sheet in hand. Below are the 4 steps to craft your term sheet:
Step 1: Comprehend the Information Presented
To begin with, it is of utmost importance to have a deep understanding of the contents of a term sheet. It generally covers the following key components:
- Investment amount
- Company valuation
- Stock option programs
- Type of investment
- Rights and obligations of the parties
- Board representation
- Deal completion timeline
To fully understand and effectively address these factors, it is important to have a deep understanding of your company’s business operations as well as investment goals. It is recommended that you put in the effort to determine the appropriate funding level required, the specific investment type you are pursuing, and comprehensively assess your company’s valuation. Following through with these steps will ensure that the term sheet you prepare accurately mirrors your business requirements and serves as a valuable tool for constructive engagements involving potential investors.
When the content of the term sheet becomes overwhelming, it can be helpful to enlist the assistance of a partner or advisor in your business to share the responsibility of understanding it. Another option is to prioritize the factors aligned with your objectives and concentrate on grasping those initially.
Step 2: Review Terms & Conditions
Just like any other business document, it is essential to fully grasp and comprehend terms & conditions of the term sheet.
Key components of the term sheet are:
- Valuation: The evaluation of the company’s value both preceding and after receiving the investment.
- Liquidation preference:Preferred shareholders are entitled to reclaim their investments before the proceeds from a sale or the winding up of the company are distributed to other shareholders.
- Preferred stock:An equity security that investors acquire, offering liquidation preferences as well as voting rights.
- Protective provisions:Empowering investors to impact crucial business actions like debt acquisition or share issuance through specific provisions.
- Pro rata rights:Investors are granted rights to prevent dilution and preserve their ownership stakes through active participation in upcoming funding rounds.
Terms & conditions may not be significant when everything is going well. However, in challenging situations and amidst disagreements, these terms become pivotal in determining who has the authority to enact important decisions and take control of the situation. It’s crucial to be satisfied with the initial draft of the term sheet as it is designed to safeguard your primary concerns once it is executed.
Step 3: Consult a Lawyer
Another crucial step in the term sheet process is enlisting service providers I.e organizations or individuals who provide specialized assistance to entrepreneurs at various stages like lawyers and accountants. Having a lawyer involved during the creation of the term sheet can prove to be extremely advantageous. The expertise of a lawyer specialized in your industry can be a game-changer. Engaging the services of a skilled attorney can provide you with a clear understanding of your term sheet prior to entering into any legal obligations. They will add points that support you and try their best to remove or amend the terms that do not support you and your business. This not only safeguards your interests but also demonstrates a high level of competence for potential investors.
Step 4: Ready Yourself for Negotiation
Negotiation is an essential aspect of developing the term sheet. It involves analyzing and revising the document through discussions, with the ultimate goal of finalizing its legally binding terms & conditions. We recommend to consider and prepare the following for the negotiation phase:
- Determine the key elements within the term sheet that hold the utmost significance.
- Express your requirements and preferences before presenting the document.
- Generate competitive pressure through networking, research, and engaging with investors.
- Direct your attention towards issues that either facilitate or impede your ability to achieve the desired outcome.