An investment term sheet is a non-binding document between the investor and investee that outlines all the fundamental terms and conditions of an investment transaction. It will be used to produce more detailed and legally binding documents for the transaction to happen.
Important to know that:
- A term sheet is considered a gentlemen’s agreement in which both parties agree to proceed with a transaction, but it is still conditional on a few final “checks.”
- With a term sheet signed, the transaction is still subject to a due diligence process by investors (typically on the founder, technology, and product intellectual properties, legal and commercial contracts, etc.) to ensure that the venture is as the founder claimed.
- Confidentiality and exclusivity: Term sheets typically give the investor some exclusivity period (30 to 90 days) to prevent the founder from shopping around for a new term sheet and confidentiality to disclose the details of the term sheet.
- Terms in the term sheet are important to protect the returns of risky financial investments. They clearly define the agreed ongoing dynamics between the investor and the investee until the investment is successful in returning money (liquidity event) or in case the venture cannot perform.
- Price is only one small portion of the term sheet and should not be price-optimized. Negotiation with investors should consider all the terms. For example, how exit and liquidity scenarios happen (e.g., Liquidity preference, exit provisions, and clauses), or investor controls (e.g., Board seat, Director approval rights) can be set in place to counter a price-focused request by the founder.
Common term sheet terminology and their meaning
| Classification (Their Function) |
Type of Clause / Provision |
Quick Understanding |
Specific Terms |
| Economics Matters related to the purchase and sale of shares |
Price |
Sets how much and what investors are buying |
Subsections:
- Pre-money Valuation
- Share Price
- Post-Money Valuation
- Type of Stock
|
| Incentive Plan |
Sets how valuable human capital is managed and incentivized through equity ownership. |
Subsections:
- Employee Stock Ownership Plan
- Vesting
|
| Liquidity Preference |
Determines the priority for preferred stock shareholders to get investment proceeds during liquidity ahead of others (common stockholders and debt). The amount can be set to a certain multiple, cap, or none). |
Types:
- Non-Participating Preference
- Participating Preference (Capped or uncapped)
|
| Control Matters related to the level of authority of investors on the business entity |
Board Representation And Director Approval Rights |
Representative(s) from the investor to join the board to have more decision-making authority (e.g. voting rights) in managing investment risks in the business |
Subsections:
- Board seat or observer seat
- Director approval rights
|
| Anti-dilution Protections |
Allow investors to maintain the percentage of shares when new shares are issued to new shareholders |
- Anti-dilution preference
- Methods of adjustments
- Full rachet
- Weighted average
|
| Investor Rights |
A set of provisions that provides specific privileges and options for the investor to have certain priorities in continuing purchasing new or others’ shares to maintain their stake or allow other shareholders to lose their rights if they don’t participate in the next round of investment |
Subsections:
- Participation Rights (aka “Preemptive Rights”)
- Pay-to-play
- Right of First Refusal
- Information Rights
|
| Exit Matters related to ways shareholder sells shares and leave the entity |
Drag-along |
A mandate that allows the majority shareholder to force other minority shareholders to join the sale of the venture at the same price, same rights, terms, and conditions as other sellers. |
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| Tag-along (Co-sale) |
Giving investors the right to sell their shares along with the founders and management team or other investors. |
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| Redemption |
This allows investors to sell their shares at a specific price (e.g. X% Internal Rate of Return) at a certain period (e.g., 5 years). When this is exercised, the financial investment in a venture has failed to perform to the expectation of a venture capital investment of big multiple returns. |
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