Entrepreneurs looking to rapidly grow their startups, oftentimes turn to external financing. From the very first pitch deck, through negotiations, and until receiving the investment, there is a document known as a term sheet. This document reflects the fundamental terms and conditions under which an investor can fund a startup and will apply for the duration of the relationship with the founders.
Term sheets are important and can be quite complex, but they don’t necessarily have to be. The key is to know what to expect, what should be included, and, of course, know what should be negotiated.
What is a term sheet?
A term sheet is the first formal document –however, non-binding– between the founder and investor. It’s a document similar to a letter of intent, that establishes the terms and conditions of the investment, but is not a required document for both parties. It’s essential to know what this document contains, since once the negotiations are made, the rights and obligations that have been agreed on will have to be written in the investment contract. In a few words: It’s the roadmap that leads to an investment.
The objective of the term sheet is to describe what the startup is offering, and what it is receiving in return. It establishes the guidelines for how each party should act to protect the investment. This document is generally written by the investor, who proposes the investment according to the terms reflected in the term sheet. Yet, while there isn’t a universal format to unravel what is to be expected in each term sheet, they tend to follow similar schemes. There are many templates available online that can help understand what they are and what they contain.
In his book The Art of Startup Fundraising, Alejandro Cremades gives some examples of how term sheets can be really scary for start-up founders, as it can be a very lengthy document loaded with technical terms. This panic contrasts with the excitement of finally closing an investment, which results in entrepreneurs usually giving in to terms without truly knowing what they are getting. A company might regret making this decision when it grows or in its next investment rounds.
Term sheets are not something that entrepreneurs should overlook. However, keeping in mind that not all of us are financial analysts, lawyers, or experts on the matter, my next article will explain key concepts in a simple way so that any entrepreneur can understand the basics of a term sheet.
This article is not meant to provide legal advice. It should be understood as a simplified overview for readers to consult with their legal advisors as every situation is unique.