Term sheet refers to a non-legally binding document that outlines all the terms of a VC investment deal. Prior to any money changing hands, venture capitalists want to make sure that they are adequately protected in the unfortunate event that your startup becomes a victim of unfavorable market forces (which is a really polite way of saying that VC investors don’t want to be completely wiped out if your startup is forced to liquidate or dissolve).
Many startup founders assume that much of the language included in term sheets is just legal boilerplate that they have no power to change or alter. But keep in mind – venture capitalists are incredibly seasoned investors, and if they sense an opportunity to make a deal more favorable, they will do so in an instant. Term sheets, after all, are generated by the lead investor in the deal, and not by the startup team. Thus, the term sheet is not some “take it or leave it” ultimatum presented to interested investors. Instead, it is an important document that walks through all material terms and conditions of a potential VC investment deal.
There are several basic terms that a term sheet might include, such as “price per share” and “amount of shares issued.” There will also be terms describing the type of security or equity involved. And, of course, there will likely be a term describing the valuation of a company. In this case, there are two essential types of valuation to consider – the pre-money valuation and the post-money valuation. For the first-time entrepreneur, these terms might appear to be the same, but they are entirely different, depending on how the venture capital round is financed.
There are also other terms that usually get glossed over by first-time startup founders. One of these concerns “conversion rights.” If VC investors are receiving preferred stock in your startup company, then the conversion rights will describe how to convert this preferred stock into common stock. Usually, this is done at a very favorable rate, such that if your company goes on to raise another round of capital from investors, it will be possible for investors to own a greater percentage of your company. Another term that might get glossed over is “liquidation preference.” This describes what happens in the event of an exit strategy (i.e., your company is bought, IPOs or dissolves). You can be assured that, if bad things happen, that venture capitalists will be made whole first before anyone else can get cash out of the company.
Keep in mind – every term in a term sheet describes a shift in the balance of power between investors and startup founders. Venture capital investors will naturally be looking to shift risk away from them and towards the startup founders. And, they will be looking to gain as many economic benefits as possible in the event of any future scenario, whether good or bad. So it’s incumbent upon startup founders to familiarize themselves with the full details of the term sheet, and not just focus on the amount of money they are receiving.