Term Sheets - The VC Perspective
March 2017
The term sheet is a cornerstone of the fundraising process, outlining the essential terms and conditions of a proposed investment. It serves as a formal signal of intent from a venture capital (VC) firm to invest in a potential portfolio company. Once presented, the company has the option to accept the term sheet as is, reject it, or propose modifications to specific terms. If both parties reach an agreement, the term sheet is signed, granting the VC firm a period of exclusivity during which it can conduct detailed due diligence. This document is rarely legally binding in its entirety but acts as a foundation for good-faith negotiations and provides a framework for subsequent, legally binding agreements.
The lead investor, often the party contributing the largest share of capital in the funding round, typically drafts the term sheet. This document sets the valuation and investment terms that other investors will follow. At its core, the term sheet reflects a shared understanding between entrepreneurs and investors. Both sides recognize the opportunity for rapid growth in the market and agree to contribute complementary elements: entrepreneurial vision and operational expertise from one side, and capital, network access, and strategic guidance from the other. These combined strengths aim to accelerate value creation, with both parties committing to collaborate over the long term, often until a liquidity event such as an acquisition or IPO.
Despite this shared vision, the negotiation process can introduce points of tension. Each clause in the term sheet represents a negotiation point, with language that can favor either the VC or the entrepreneur, or in some cases, strike a neutral balance. Rarely are all terms neutral, as parties naturally advocate for provisions that align with their priorities. For example, VCs may seek protective rights to safeguard their investment, while entrepreneurs may push for terms that preserve their operational autonomy. This dynamic, often described as a "push and pull," is critical to establishing a mutually agreeable foundation for the partnership.
The term sheet fulfills several roles, analogous to a letter of intent in mergers and acquisitions. Its primary purposes are to express interest in the investment opportunity, outline the proposed transaction terms, and provide an indicative valuation. Additionally, it sets the groundwork for more detailed legal documentation, such as the shareholders' agreement, share subscription agreement, and articles of association.
A well-structured term sheet generally addresses three key areas:
Investment Terms: Defining the amount of capital to be invested, the valuation, the share structure, and the rights attached to those shares (e.g., preferred vs. common stock).
Transaction Mechanics: Outlining the steps needed to close the transaction, such as due diligence, legal documentation, and conditions precedent (e.g., securing key personnel or meeting financial performance targets).
Exclusivity and Cost Sharing: Granting the VC firm a period of exclusivity to complete the deal and specifying how transaction costs, such as legal and accounting fees, will be allocated.
Governance and control are critical aspects of a term sheet. VCs often seek mechanisms to influence key business decisions, mitigate risks, and safeguard their interests. This influence is typically exerted through board representation, veto rights over specific actions (e.g., issuing new shares, entering significant contracts, or selling the company), and protective provisions that minimize downside risks. These provisions ensure that the management team operates within a framework aligned with the investor's strategic objectives, enhancing the potential for long-term success.
Term sheets can range from concise, two-page documents to more extensive ones spanning 20 pages or more. Their complexity often reflects the stage of the investment and the level of prior agreement between the parties. Early-stage startups may encounter simpler term sheets focused on valuation, investment amount, and exclusivity. In contrast, later-stage deals or those involving significant funding rounds tend to involve more detailed term sheets that cover various contingencies and specific rights.
While drafting and negotiating a term sheet can seem laborious, it is an investment in efficiency. By resolving key issues upfront, the term sheet reduces the time and cost associated with finalizing long-form agreements. Without it, disputes over fundamental terms could prolong negotiations and inflate legal expenses.
For entrepreneurs, understanding and negotiating the term sheet effectively is critical. A term sheet not only defines the economics and governance of the investment but also sets the tone for the relationship with the VC. Entrepreneurs who approach the negotiation process with insight and fairness can earn the respect of their investors, potentially securing more favorable terms.
Brad Feld of the Foundry Group underscores that the essence of a term sheet lies in two primary areas: economics and control. Economics pertains to the financial returns investors expect during liquidity events, such as dividends, acquisitions, or IPOs. Control, on the other hand, includes the rights and mechanisms by which investors influence or oversee the company’s operations. Feld advises entrepreneurs to focus on these core elements during negotiations, as overly complex or restrictive terms in other areas may indicate excessive caution or misalignment on the part of the VC.
Term sheets also serve as tools for anticipating and mitigating risks throughout the investment’s lifecycle. For instance, provisions may address managerial transitions, operational setbacks, or financial shortfalls. Although term sheets cannot cover every eventuality, they establish guiding principles that both parties can refer back to during unforeseen challenges. These principles include capital deployment timelines, board composition, and specific conditions precedent, such as satisfactory completion of due diligence or the appointment of key executives like a CFO.
Ultimately, the term sheet is more than just a precursor to legal agreements; it is a strategic document that aligns the goals, expectations, and responsibilities of both entrepreneurs and investors. It sets the stage for a partnership built on mutual trust, respect, and shared ambition. By addressing critical terms upfront and navigating points of tension with transparency and fairness, both parties can establish a robust foundation for a successful investment relationship.