What is a Term Sheet?
A term sheet is a document that explains the terms for a potential investor to make a financial investment in a business. Although a term sheet typically contains legal language, it is not usually a document with legal effect. The exception to this is if the parties use the term sheet to negotiate a deal. Their negotiations should demonstrate that the points of the term sheet bind them.
More commonly, a term sheet is seen as an offering. If the parties agree to the term sheet, their attorneys draft a contract. A term sheet typically covers funding, corporate governance and liquidation. Here is an example of a standard term sheet written in plain English.
A term sheet can be written in a “smart style” that allows for easy conversion into a contract. It is not recommended that parties use a software program akin to a term sheet generator to create an initial draft of the term sheet. A term sheet contains many technicalities, starting with the laws of the state in which the term sheet is signed. States have different understandings of what constitutes a contract and what entities are defined as corporations.
Parties also have to be careful of hiring an inexperienced attorney who could bill too many hours for reviewing the term sheet. It is recommended that businesses retain a lawyer experienced in writing and reviewing term sheets. They should also retain that same lawyer to write the contract.
Typically, both parties sign a term sheet if they agree on the terms. The parties are then bound to keep the contents of the term sheet confidential. The business is also bound to not negotiate with other investors within 30 to 45 days after signing. These two points are called “confidentiality” and “exclusivity.”
Common Courtesies Regarding a Term Sheet
Term sheets sometimes contain language that is vague or ambiguous, such as “in a short while.” It is expected that both parties will meet following the introduction and signing of the term sheet to clear up concerns. The parties should avoid attaching a term sheet to a final contract. Doing so could lead to the term sheet being understood to contradict the contract.
When Should Investors Use a Term Sheet?
Investors should use a term sheet to clarify three main points:
1. How much stock the startup will have and what classes of stock will exist.
2. How much say investors have in the way the startup is run. It is particularly useful when a business shares how it will select the Board of Directors. Although investors often want to play a substantial part in their startup investment, companies want to limit the control that the investors can exert over the company. It is a good idea to discuss with a startup’s founders how the relationship between the founders, the investors and management is expected to develop.
3. The schedule on which investors will provide funding, the amounts that they will give and the compensation that investors will receive in return.
An investor should not use a term sheet in place of a contract.
Today, a startup is not limited to raising capital through in-person meetings or video conferences. A startup can use an equity-based crowdfunding platform, like Merging Traffic, to raise funding online.
It is beneficial for investors to determine how the company founders and managers see the investor’s contribution. Having open, honest discussions about funding and expectations is the first step toward the parties transforming the points of a term sheet into reality.