Term sheets explained: a guide for startups

If you are considering raising Series A funding for your startup or are in talks with venture capital firms, you’ll most likely receive a term sheet.

Term sheets serve as a roadmap for the early stages of a startup’s funding process, summarising the terms and conditions of an investment. As a UK startup founder or entrepreneur, understanding the elements of a term sheet is crucial when negotiating with venture capital firms or investors.

In this comprehensive guide, we cover everything you need to know about term sheets. This includes what a term sheet is, its key components, and a walkthrough of each step of the term sheet process.

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What is a term sheet?

A term sheet is a non-binding document that clearly outlines the key terms and conditions of an investment.

This document sets the groundwork for negotiations and legal agreements between investors and a startup in mergers and acquisitions, capital investments, and private equity deals. It’s designed for negotiation, ensuring that all parties in an investment deal are on the same page.

After a successful pitch meeting, Venture Capitalists (VCs) and other investors would typically present their term sheets to you, the founder. This preliminary document typically outlines details such as voting rights, equity stake, investment amount, and other essential information.

Once you review the term sheets, you either accept or propose a counteroffer. If both sides agree, the signed term sheet becomes the foundation your legal team uses to create the final, legally binding agreements.

Even though terms sheets are not legally binding, they set the tone for negotiations and outline the key terms and conditions that will shape the final investment agreements.

Key components of a term sheet

Now that you understand what a term sheet is, let’s look at some of its key components. Knowing these elements will help you, as the founder, navigate negotiations with more confidence and clarity.

Valuation (pre-money and post-money)

Valuation in this context simply means how much of your company’s equity you’re giving away in exchange for investment amounts. It’s also used to determine your startup's worth, especially in the early stages.

When estimating your company’s value, investors focus on two aspects:

• Pre-money valuation: This is the amount investors believe your company is worth before any funding is added. This assessment is done based on your company’s current assets, revenue, team, and market potential. If a term sheet says your startup has a £10 million pre-money valuation, it means investors believe your company is worth £10 million before investing.
• Post-money valuation: This is what your company is worth after an investment has been made. This is calculated by adding the investment amount to the pre-money valuation. Post-money valuation is also used to determine the percentage of ownership an investor owns in your business.

Here is how you can calculate your post-money valuation:

Post-money valuation = [Pre-money valuation ] + [New investment]

So if an investor contributes £3 million and your pre-money valuation is £10 million, your post-money valuation will be £10 million + £3 million = £13 million

Note: Valuations are not precise calculations of your company's current assets, debts, or financial statements like a traditional appraisal would be. Instead, they represent how much investors believe your company will grow and how much they are willing to pay based on that belief.

Investment amount and percentage stake (equity stake)

Another key component in a term sheet is the investment amount and percentage stake. In this context, the investment amount is the total new capital investors commit to putting into your company during a funding round.

This amount is usually agreed upon and often aligns with your startup's funding needs. In return, the investor owns an equity stake in your company, which is represented by shares.

Their shares give them a claim to a portion of your company’s value and future profits. The more equity they hold, the more influence they have over major decisions and the overall direction of your startup.

To understand how much of your company an investor will own after a funding round, you can use this simple formula:

Equity Stake = [Investors Share or Investment Amount ] / [Total Shares or Total Value Post-Round] X 100

For example, if an investor owns 150 shares in your company with 1,000 shares outstanding, here’s how their equity stake would be calculated:

ES = (150/ 1,000) x 100 = 15%

This means the investor would own 15% of your company upon closing the round.

Voting rights and board rights

Investors often want protection when making big decisions that can change the company’s direction.

In a term sheet, investors add a voting rights clause, which gives preferred shareholders the right to vote on matters related to your company’s policies. This clause outlines how voting power is divided across different classes of shares.

Investors, especially lead investors, may also ask to be official board directors to gain control of your company's management, establish corporate policy, and make significant decisions. This clause would specify how many board seats investors would hold.

A good way to think of voting rights and board rights clauses in a term sheet is as control mechanisms that allow investors to participate in your startup's governance. With these clauses, investors can protect their interests and make strategic decisions in your company.

Investor protections and anti-dilution provisions

Investor protections are a set of rights and clauses in a term sheet that are designed to safeguard venture capital investors' interests. This gives investors the right to prevent a decision that could harm their investment.

An anti-dilution provision is designed to protect investors when your company issues new shares at lower prices. It prevents you from diluting investors by selling stock to others at a price lower than the price the initial investor paid.

There are two varieties of the anti-dilution provision:

• Full-ratchet anti-dilution: Full-ratchet anti-dilution protects investors if you raise money later at a lower valuation (a “down round”). For example, if an investor buys 10,000 Series A shares at $10 per share and you later raise another round at $9 per share, the full-ratchet clause resets their share price to $9. This means they are treated as if they originally invested at the lower price; you have to give them extra shares, which reduces your ownership.
• Weighted-average anti-dilution: Weighted-average anti-dilution protects investors during a down round, but instead of resetting their entire share price to the new lower price, it only adjusts their price partially based on how many new shares you issue at the discounted price. If an investor buys 10,000 shares at $10 per share before a down round, their share price would be slightly adjusted.

Other clauses (e.g., drag along, confidentiality)

Below are some essential clauses you should look out for when reviewing a term sheet:

• Drag-along rights: These rights allow the majority shareholders to force minority shareholders to sell their shares in sales initiated by the majority. With this right, majority shareholders can sell their entire company by ensuring that they (both majority and minority shareholders) sell their shares under the same conditions.
• Confidentiality: This clause helps safeguard sensitive information exchanged between your startup and investors during due diligence. It ensures that all parties involved do not disclose sensitive, non-public information between the startup seeking funds and the potential investors.
• Information right: This clause in startup funding ensures that investors are given access to your company’s information. This information includes access to regular updates on your company’s financial performance, operations, and strategic directions.
• No-shop clause: The no-shop clause prevents you from seeking investment proposals from other investors once you’ve agreed to a term sheet. This clause protects the investor so they can invest time and money in doing due diligence without worrying that you’ll leave for another deal.

💡 Learn more about navigating from pre-seed to exit

The term sheet process

Here’s a quick walk-through of the term sheet process:

Pitching investors

This process typically begins with the founder meeting with potential investors.

In this stage, you walk investors through:

• What your startup does
• Product demos
• Revenue model
• Customer acquisition strategy
• Market size
• Competition

If the investor likes your startup and wants to move forward, they will start preparing a term sheet.

💡 You may also like our guide to elevator pitches

Receiving the term sheet

If everything checks out with the investor, they will send you a term sheet. A typical term sheet should include:

• Your company’s pre-money valuation
• How much they are investing
• Anti-dilution clause
• No-shop clause
• Broad structure
• Voting rights

Negotiation and review

This is where you carefully review each aspect of the term sheet. Make sure you have a clear understanding of the economic and control terms and their implications on your company.

You can involve a lawyer who specialises in venture deals. You should also prioritise your non-negotiables and ensure that they align with your long-term goals. Some founders care more about control, while others are more focused on exit flexibility.

Reach an agreement and sign

When both sides agree and align on the terms. You can then proceed to sign the term sheet. After signing, you enter a no-shop period during which the VC conducts detailed due diligence.

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FAQ

Here are some frequently asked questions about terms sheets:

What is the main purpose of a term sheet?

The main objective of a term sheet is to outline the key economic and control terms of a startup investment before the full legal documents are drafted. It serves as a blueprint for founders and investors to ensure everyone is on the same page regarding the terms of the investment before moving forward.

What are the six essential components of a term sheet?

A term sheet includes the following components:

• Valuation - pre-money valuation and post-money valuation
• Investment amount
• Board structure
• Investor protection
• Exit and closing conditions
• No-shop clause

Are term sheets legally binding agreements?

Most of the terms in a term sheet are non-binding, meaning either side can walk away before the final contracts are signed. But it serves as the groundwork for drafting legal agreements.
However, specific situations, such as confidentiality, no-shop clauses, are legally binding and enforceable.