If you’re a founder or a business owner, tracking down finance for your company can be challenging, not least because the world of funding comes with its own set of terminology and standard documents. One such document is the ‘term sheet’.
A term sheet will come into play if you’ve pitched for finance and have investors lined up. The next step will likely be that you are presented with a ‘term sheet’. A term sheet is simply a list of the terms on which an investor (or a lender) is prepared to offer funding.
As a term sheet lays the groundwork for formal legal documents, you should be sure to understand what it says so you can push back against any conditions you don’t agree with.
Let’s take a look at term sheets, and how they evolve over different stages of funding rounds.
What is a term sheet?
A term sheet is a list of terms and conditions on which an investor is prepared to fund your business.
At a basic level, term sheets describe the amount of the proposed investment and the share of your business the investor would like in return. It may also include finer detail like voting rights and the role the investor would like to play in company affairs.
While term sheets themselves aren’t legally binding, they lay the foundations for the formal legal documents that follow. The first draft is normally issued by your proposed investor, and from there the terms will be negotiated between you. Once these have been agreed in principle, formal legal documents will be drawn up.
Term sheets are useful as they ensure that the parties in an investment transaction agree the major points of the deal up front, thus avoiding major misunderstandings or disagreements (or at least flushing these out at an early stage).
Here are the most important aspects to remember about term sheets:
- They aren’t legally binding contracts, they’re just agreement in principle on key issues
- If you already have a successful business, there may be considerable scope for negotiation of terms. If you’re just starting out, you may have to accept the terms as presented in the term sheet
- They should be clearly worded
- They will likely contain provisions about the following issues:
- How the company will be valued
- How much the investment will be
- What percentage of your business the investor is looking for
- What steps the investor (and business owner) wish to take to protect their percentage investment (anti-dilution provisions)
- Whether the investor wants a say in the way the business is run (voting rights)
- If the company is sold or liquidated, how the proceeds of this liquidation will be shared between the business owner and the investor (liquidation preference)
- The exit strategy for the investor
Common terminology found in a term sheet
Here’s an explanation of some of the common words and phrases used in a term sheet:
- Employee share option plans. These are incentive schemes that some companies set up to reward their staff with shares or options for shares. Investors are interested in them as they can affect the share structure of the business in which they’re investing
- Dilution. This describes what happens when a company issues new shares such that the percentage of the shares owned by existing shareholders goes down or is ‘diluted’ as a consequence of the new share issue
- Pre-money value. This refers to the value of the business before the injection of fresh capital by the investors
- Preference shares. These are a class of shares issued to investors that are ‘preferred’ to other shares in certain circumstances, such as when dividends are issued, or when a company goes into liquidation
- Voting rights. These are the rights that attach to shares and that give the holders a right to vote in company meetings (as distinct from directors’ meetings at which business decisions are taken)
- Reserved matters. These are certain types of decisions in which shareholders may have increased rights to vote because the decision might negatively affect them in some way
- Rights of pre-emption. This means the right that a shareholder may have to bid for shares if the company decides to issue new shares (to avoid dilution, for example)
- Drag-along rights and tag-along rights. Drag-along rights are the rights shareholders may have to force others to sell shares in the event of an acquisition. Tag-along rights are the rights a shareholder may have to sell their shares to a buyer at the price offered to the other shareholders
How a term sheet should look at different stages of investment
The more established and successful a business is, the less risky it is to invest. In these cases, a founder may have significant leverage to negotiate favourable terms. Early-stage businesses with less trading history on the other hand are riskier, so investors will expect to negotiate harder terms including a higher percentage of equity.
As a business progresses through different funding rounds, the term sheets get longer and more complex. A successful term sheet negotiation aims to balance the rights of both founder and investors, so the parties can move quickly to funding and final execution of legal documents.
Seed and early-stage term sheets
Seed capital is funding provided to start-up or early-stage businesses. Because these businesses are usually not yet trading, and may even still be at the concept stage, funding amounts are generally small and also high risk. Seed capital may be ‘bootstrap’ funding provided by founders, friends or family, but it may also be provided by angel investors or venture capitalist firms (VCs) who specialise in early-stage finance. Angel investors and VCs will generally expect to receive an equity stake in the business in return for their investment.
Seed capital investors may fund an early-stage business in a number of ways:
- Convertible loans or convertible loan notes where the investor loans the business money with a view to converting that loan to equity at a later date
- Equity investments where the investor takes an immediate stake in the business, usually preferred shares
- Advance subscription agreements where an investor provides funding but shares will be issued in a later funding round at a discount or SAFEs (simple agreements for future equity)
Here are some of the most common issues that will be covered in a seed capital or early-stage capital term sheets:
- Whether the funding will be in the form of debt (a convertible loan note) or equity (immediate share issue, SAFE or advanced subscription agreement for example)
- Valuation and the capitalisation table. The ‘cap table’ describes the shares issued and potentially to be issued (under employee option schemes for example) at a point in time. The cap table is used to calculate the price per share and percentage ownership, once the company has been valued. The percentage of shares that investors will receive will depend on whether this is calculated prior to the investment being received (pre-money) or after the funding has taken place (post-money)
- Whether any shares issued will be ordinary or preferred shares, and the terms of any preferences such as liquidation preferences
- What role, if any, the investor expects to play in management of the company and what rights to information they will have
- What discounts will be available to investors if shares are to be issued at a later date, and what, if any, valuation caps will apply when the company is valued in order to mitigate the risk to investors
- What anti-dilution provisions will apply to prevent early-stage investor’s percentage interest in the company being diluted by shares being issued in future funding rounds and investors’ rights to participate in future funding rounds
- What conditions, if any, will there be prior to funding being made, for example, that advance assurance has been received from HMRC that the investment will qualify for preferential tax relief under the EIS or SEIS
- How investor rights will be protected
- What the structure of the company will be and whether investors will have a seat on the board
- How the investor expects to exit the company, and the terms of that exit
VC and later stage funding rounds
The main difference between seed and early-stage term sheets and VC and later funding rounds (Series A and beyond) is that these term sheets tend to be much more complicated and detailed, and also contemplate what happens in the event of an IPO (floatation). While the terms that apply to seed and early-stage businesses will equally be included in VC/later stage term sheets, in addition, the following issues are more likely to be covered and in more detail:
- Drag and tag-along rights. These rights are intended to protect the rights of minority investors in the business
- Veto rights. As funding rounds progress, and the percentage ownership of the company by external investors increases, investors are more likely to want a say in the way the company is run in order to protect the value of their investment
- Board appointments and board approval. Later stage investors are likely to want a seat on the board of directors in return for their investment for oversight and control purposes
- VCs are likely to want business owners to provide detailed warranties about the business and statements made in the course of funding and due diligence
What needs to be included in a term sheet
There are no hard-and-fast rules about what should be included in a term sheet. However, at a minimum the term sheet will describe the type of investment (convertible loan, equity investment, deferred equity investment for example), and what the investor expects in return.
These are the most basic items a term sheet will contain:
- The names of both parties
- The legal identity of the investor
- The type of investment being offered
- How and when the valuation of the company will take place
- The amount of the funding
- How the price per share will be calculated
- Exit provisions (liquidation, sale or IPO)
- Board seats, voting rights, veto
- Anti-dilution provisions
- Pre-emption rights
Common pitfalls to look out for when reviewing your term sheet
If you’re a founder or small business owner looking for investment, here are some red flags you should avoid when reviewing your term sheet:
- If the investment is in the form of a loan (a convertible note), watch out for any interest rate changes or repayment terms that might cause you financial problems
- Make sure the company valuation is realistic
- Avoid giving investors too much equity. Investors looking for a larger share of your business might end up with too much control over your business. Up to 20% per funding round is a reasonable limit to set
- Don’t agree to tight restrictions on your ability to look for further funding
- Avoid allowing too many investors on your board or giving them too many voting rights
- Look for investors who are genuinely interested in your business, and want to help you grow
It’s very important to seek legal and financial advice if you are negotiating a term sheet. Consider working with a firm that has experience in providing legal advice for start-ups and small businesses specifically, as they will have the knowledge that could protect your business financially.
It’s also prudent to get the right legal advice in place because calculations about company value and share price are very complex, and the percentage of the business you will be giving away will differ depending on whether the share price is calculated prior to the investment being made (pre-money) or after (post-money).
Don’t be afraid to ask for advice, particularly if you’re not confident making these calculations yourself. Ask your corporate lawyer to prepare a capitalisation table and explain to you how this works.
Avoid ‘no-shop’ clauses in a term sheet that try to tie you in to particular investors, or that would restrict your ability to seek other investors for too long a period of time.