Reading Time: 3 minutes
A term sheet is an agreement given by a startup investor or venture capitalist outlining the terms and conditions of an investment. Learn how to read one.
Board fundraising takes many forms, but for startups, raising money from investors is a crucial component. This typically starts with pitching your startup to investors in hopes they’ll want to buy into your business. Once an investor decides to fund your business, all that’s left to do is sign the startup term sheet.
While the term sheet is not yet legally binding, your board of directors should still conduct due diligence and read it carefully before signing off. After all, the term sheet guides the preparation of a legally binding final agreement.
But a term sheet can be hard to understand, especially for startup boards who don’t have experience with them. Read on for a step-by-step guide to reading and understanding a term sheet.
What Is a Startup Term Sheet?
A term sheet serves as a letter of intent from a venture capital firm or investor. It outlines the basic conditions of an investment. The term sheet guides legal counsel when preparing the final legal document outlining the investment. For this reason, understanding a term sheet prior to signing it proves critical.
Inside a term sheet, investors outline valuation, equity, options, liquidation preferences, payout provisions, and board seat terms. As a startup, know that your term sheet will likely serve as a blueprint for future funding rounds.
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How to Read a Startup Term Sheet
The key to thoroughly reviewing a term sheet is understanding what to expect, knowing what you want, defining what you won’t bend to, and most importantly, relying on excellent representation to analyze the sheet with a sharp eye.
When reviewing a term sheet by an investor, specifically look out for:
- Investors with unrealistic expectations on timelines, which might signal they’re looking for a short and hot exit
- Terms and conditions that may limit future fundraising
- An investor who asks for a large controlling stake
- Harsh debt financing that could bankrupt your startup
Follow this step-by-step guide to reading a startup term sheet.
1. Review Investor Information
The funds an individual brings to the table definitely matter, but most important is who you‘re working with and giving a stake in the company to. You want an investor with high conviction and strong faith in your business. They should also be willing to offer support and guidance to help your business succeed. Ask these questions when reviewing investor information:
- What’s their funding history?
- Has the investor previously funded startups that failed or went through difficult times?
- How did the investor react when things went wrong?
2. Review Startup Valuation
Startup valuation is your company’s market worth, depending on various factors. You must be careful when reviewing startup valuation in the term sheet. The investor will use the valuation to determine the company’s percentage they’ll own after investment. Ensure a fair valuation so you and the investor are in a win-win situation.
3. Review Vesting Plan
Vesting means giving or earning the right to a future benefit, asset, or payment. Vested shares give the holder full rights to them for a specified period. Professional investors prefer vesting to protect equity from departing founders. Founders typically have vesting terms before reaching out to investors. Ensure the investor’s vesting plan in the term sheet is mutually agreeable.
4. Review Board Composition Requirements
A term sheet is primarily about funds. However, investors also use it to lay out the power dynamics between them and your company. In most cases, a term sheet specifies how many seats on your board of directors will go to the investor. Considering boards make decisions through votes, you shouldn’t give an investor seats that would outvote the founders.
5. Consult With Legal Representatives
Investors write term sheets for a living. On the other hand, this may be your first deal as an early-stage startup, and you don’t want to screw it up. Leverage a lawyer’s expertise to ensure you only agree to terms that protect the company’s best interests.
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Upon review of a startup term sheet, you can negotiate with the investor if the conditions aren’t amenable. If negotiations don’t make both sides meet in the middle, you can walk away from the deal.
Launching a startup and finding funding sources is labor-intensive. Equipping yourself with best-in-class technology helps. OnBoard’s board portal platform provides startups with the tools they need to streamline board governance.
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About The Author
- At OnBoard, we believe board meetings should be informed, effective, and uncomplicated. That’s why we give boards and leadership teams an elegant solution that simplifies governance. With customers in higher education, nonprofit, health care systems, government, and corporate enterprise business, OnBoard is the leading board management provider.
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