Startup Financing and Term Sheets

In the earlier stages of their venture, all entrepreneurs try to collectively impress their investors. They do so with the hope that they will be able to raise funds in the near future. However, when investors invest their funds, these funds are given on certain terms and conditions.

The terms and conditions of one startup financing can be very different from the terms and conditions of another. For every deal, these terms and conditions are enumerated in a document called the “Term Sheet”. Entrepreneurs often find it remarkably difficult to understand complicated terms.

In this article, we will have a closer look at what a term sheet is and why is it considered to be important.

What is a Term Sheet?

The term sheet is a preliminary document that lists all the important terms and conditions agreed upon between the investors as well as the entrepreneurs. It is important to note that the term sheet is not a legally binding document in itself. Instead, the term sheet is used to draw upon an agreement which can then be considered to be legally binding. The term sheet serves as the basis upon which lawyers draft all legal paperwork.

A term sheet is not considered to be binding. It can be negotiated several times before the final agreement is drawn up. However, it needs to be understood that once the final agreement is created and registered, then the changes are not reversible.

The term sheet is considered to be a document that outlines the various scenarios which can occur if the funding is provided. It details the rights and duties of both parties. It is quite uncommon for investors to add one-sided and exploitative terms in their funding agreement. However, entrepreneurs cannot completely rely on the goodwill of the investors. They must themselves be aware of the importance of the term sheet and what the future implications of signing a wrong one could be.

Why is a Term Sheet Important?

The term sheet contains several key elements of the final contract between the investors and the entrepreneurs which is why it is considered to be very important. For instance, the term sheet places restrictions on the quantum of funds that a startup can raise in the future as well as the mechanism that can be used to raise these funds.

A term sheet is a blueprint of the proposed relationship between the two parties. It is essential for the two parties to be comfortable with the rights and duties which are being given by the agreement. If both parties do not understand the nature of these rights and duties, it is likely that a conflict will arise at a later stage.

Investors are long-term partners in any venture. Their involvement in the business doesn’t stop when the check is cashed. Also, they do not passively invest in any company. It is very likely that an angel fund or a venture capital investor would want to get involved in the operations of the firm. The term sheet is important because it outlines the scope of information that will be shared with them and also the rights and regulations to which they must adhere to.

Negotiating the Term Sheet

The first point to understand is that a good valuation does not necessarily mean that an investor should accept the funding. It is quite possible for the investors to use a good valuation as bait and then introduce certain restrictive covenants in the term sheet. In a large number of such cases, investors often end up losing control of the organization which they have built. This is a predatory practice and well-renowned angel funds, as well as venture capital firms, do not behave in this manner. However, it is important for the entrepreneur to be aware of the possibility and also to be prepared for it.

As mentioned above, the process of negotiating the term sheet can be quite tedious and repetitive. It is also important to know that some investors and entrepreneurs view this as a zero-sum game. They often adopt an adversarial approach. This means that the investors try to gain as much control as possible while entrepreneurs try to give out as little information and control as possible. Many startups have been destroyed over the years because of such conflicts. It is very important for entrepreneurs as well as investors to realize that an adversarial relationship creates a lose-lose situation for both parties.

Entrepreneurs, as well as investors, can avoid this conundrum by adopting the best practices related to term sheets within their industry. Term sheets used by successful startup companies can be adopted. Of course, there can be minor changes in the agreement to reflect the specific situation of each startup. However, it would benefit both the entrepreneur as well as the investor to follow the process diligently.

The fact of the matter is that being on the same page as the investors are critical for the founder of every startup. The term sheet helps in formalizing the agreement between both parties. It is the foundation based on which a stable, as well as scalable business model, can be built.

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Startup Finance