The term sheet: what it is and why it's important for your startup

In the context of startup funding, the term sheet is a preliminary document that sets out the key terms and conditions of an investment proposal.

Although the term sheet is not legally mandatory and in most cases it is not a binding agreement in itself, it is used as a starting point for negotiations between the startup and investors, outlining aspects such as valuation, rights of potential investors and main conditions, streamlining the funding process by providing an overview before drafting final contracts.

In today's article, we analyze what types of term sheets exist, what are the key clauses that should be included, what errors should be avoided, and so on.

The importance of the term sheet 

It is important to mention that the importance of the term sheet lies in its ability to clarify and structure the main terms before a significant investment of time and legal resources is made.

Through this document, the investor communicates his intention to get involved in the investment round of the project proposed by entrepreneurs. Usually, this type of agreement comes into play when talks between both parties have reached an advanced level, thus marking a crucial moment of potential collaboration.

By its very nature, the term sheet saves time and costs by precisely defining the main terms from the start, reducing the possibility of protracted negotiations that do not reach a definitive agreement. By addressing the most critical issues such as what the total investment will be, what the startup's pre-money and post-money valuation will be, what the voting rights and investor protection clauses will be, etc., it allows the parties involved to focus on what is truly significant without getting caught up in minor details.

La suppleness It is also a valuable attribute of the term sheet, since it is, in most cases, non-binding, it gives the freedom to adjust and modify the terms before reaching legal and definitive commitments. This makes it easier to adapt the agreement as the process progresses, promoting a more fluid and adaptive negotiation.

It should be noted that, although it is not legally binding in and of itself, may include legal commitments such as confidentiality agreements and exclusivity clauses, through which investors are not allowed to disclose business information or entrepreneurs to negotiate with other investors until the investment agreement has been closed, respectively.

Types of Term Sheets

Although, in the context of startups, the most common term sheet is the one used in funding rounds, there are several types of term sheets that are adapted to the specific needs and objectives of transactions of various kinds, such as: acquisitions and business mergers, strategic collaborations, convertible debt agreements, licensing or technology transfer agreements, etc.

In the same way, although in most cases the term sheet is a non-binding agreement, in some cases the parties may choose to sign a binding term sheet. What are the most significant differences?

  • Non-Binding Term Sheet: Also known as a “letter of intent” or “memorandum of understanding”. It means that the parties involved in the negotiation are not legally required to comply with established terms and conditions in the document. It therefore serves as a guide for negotiations and as a framework for the proposed transaction, but the parties still have the flexibility to modify or abandon the terms before reaching a definitive agreement.
  • Binding Term Sheet: In this approach, the terms and conditions set out in the term sheet are legally binding, and both parties are required to comply with them as they move towards formalizing the agreement. A binding term sheet is often used when parties want to ensure the seriousness of the transaction and want to avoid significant changes in terms during subsequent stages of negotiation and execution.

Ultimately, the decision of whether a term sheet is binding or not depends solely and exclusively on the preferences and objectives of the parties involved in the negotiation.

Contents of the term sheet

The clauses included in a term sheet depend to a large extent on the details and the specific circumstances of the investment being considered: at what stage of development are the startups in? , what is the business model? , what is the company's growth potential? , etc. It is important that all parties involved understand and agree on the terms reflected in the term sheet, as it acts as a framework for subsequent negotiations and the drafting of final contracts. Some of the most common clauses that can be found in a term sheet for startups are:

  • Involved parties: It details the parties involved in drafting and signing the term sheet, such as investors, entrepreneurs and legal advisors.
  • Business Description: Mention the nature of the business, products/services offered, target market and other relevant details.
  • Type of funding: Discuss whether it is a capital increase, a convertible loan, debt, etc. Explain how each type of financing can influence the terms of the term sheet.
  • Total investment: Addresses the amount of money that will be invested in the business and how it is determined.
  • Company valuation: It explains how the company's valuation is calculated and how it affects the terms of the agreement.
  • Shareholding: It details what percentage of ownership investors will receive in exchange for their investment.
  • Investor protection clauses: Talk about the clauses that investors can look for to protect their investment, such as preferential liquidity clauses and veto rights.
  • Rights and obligations of the parties: It describes the rights that investors obtain (for example, the right to vote) and the obligations of the founders.
  • Terms of departure: It addresses how the exit of investors will be handled, whether through an acquisition, an initial public offering (IPO), or other scenarios.
  • Schedule and conditions: It explains the deadlines and conditions for the investment, as well as the milestones that must be met.
  • Confidentiality Clauses: Mention any confidentiality requirements associated with the term sheet.
  • Legal provisions: Highlights important legal aspects, such as jurisdiction, applicable laws, and dispute resolution.
  • Closing and execution: It describes how the final execution of the agreement is reached and what happens after the term sheet has been accepted.

How do you negotiate the terms of a term sheet? What are the best practices for reaching a mutually beneficial agreement?

Negotiating the terms of a term sheet involves a collaborative process between the parties involved in the transaction.

First, establish a transparent and frank communication right from the start it's essential. Making all parties involved understand expectations and feel comfortable discussing terms openly can prevent unnecessary misunderstandings and conflicts.

Before entering into negotiations, it is essential conduct a thorough investigation. Knowing market standards, comparative valuations, and typical terms in similar transactions provides a solid basis for supporting proposals. This information provides an advantage in having a clear understanding of what is reasonable and realistic.

In addition, it is important identify key objectives and determine the areas where you are willing to reach an intermediate point and those where you will not give way. This prioritization allows negotiate strategically, focusing on what is truly essential to achieve a mutually beneficial agreement.

Ultimately, flexibility and creativity are essential components. Being willing to compromise in smaller areas can lead to a more equitable and satisfying agreement. Beyond the financial aspects, it is important to consider how the proposed terms can add value to both parties in the future. A perspective focused on the long-term value can strengthen the relationship and encourage continued collaboration.

La inclusion of legal and financial advisors with experience can provide objective guidance and ensure that the terms are legally sound and financially feasible.

You should be aware that negotiation can take time, so it's important Stay patient and work toward a solid agreement that reflects the needs and objectives of all parties involved.

What common mistakes should be avoided when drafting or negotiating a term sheet?

Avoiding common mistakes when drafting or negotiating a term sheet is crucial to ensure that the transaction proceeds efficiently and effectively. Here are some mistakes to avoid:

  • Lack of clarity: The term sheet must be clear and precise in terms and conditions. It is important to avoid using ambiguous language or vague terms that could lead to misinterpretations.
  • Omission of key terms: Leaving out important details can lead to confusion and disputes later on. It's important to make sure that you include all the essential terms and conditions in the term sheet.
  • Incompatible terms: All terms must be consistent and co-exist in a harmonious way. It's important not to include contradictory or incompatible terms in the term sheet.
  • Premature Negotiation: Negotiating before you're ready can lead to unfavorable terms. It's important not to enter into the term sheet negotiation without a solid understanding of your own objectives and limits.
  • Lack of flexibility: While it's important to have clear boundaries, being too rigid can make it difficult to negotiate. A lack of flexibility can hinder the search for mutually beneficial solutions.
  • Lack of agreement on key concepts: Clarifying and discussing terms such as valuation, shareholding and voting rights helps to avoid future misunderstandings. It's important not to assume that the parties agree on key concepts.
  • Excessive optimism: It is important to evaluate terms realistically and based on data, without being carried away by emotion and excessive optimism when drafting or negotiating the term sheet.
  • Forgetting the long-term relationship: The transaction isn't just a one-off agreement; it also sets the foundation for a long-term relationship. It's important to consider how the terms will impact future collaboration.
  • Excessive Pressure: Forcing a transaction can lead to unfavorable terms or the breakup of the relationship. It's important to avoid excessive pressure to close the deal quickly.

How does the term sheet affect the future valuation of the company and subsequent funding rounds?

The term sheet can have a significant impact on the future valuation of the company and on subsequent funding rounds. The terms set out in the term sheet not only affect current investment, but they can also send signals to future investors and have repercussions on the company's long-term financial strategy.

Initially, the term sheet Define the current valuation of the company, determined by the price per share multiplied by the total number of shares outstanding. A conservative valuation could protect current investors from significant dilution, but it could also negatively affect the attraction of future investors.

In addition, the valuation stipulated in the term sheet sets a tangible precedent for future funding rounds, influencing how potential future investors will value the company.

In addition, the previous investment structure, including terms such as preferred liquidity and veto rights, also impacts the interest of subsequent investors and the valuation they would be willing to assign to the startup.

A term sheet that provides a fair valuation and equitable terms for both parties can stimulate a balance between funding and dilution, facilitating progressive growth and sustainable development of the company over time.

In short, it is important to carefully consider how the proposed terms may affect the financial position and the attraction of investors in the future. Making balanced and strategic decisions in the term sheet can contribute to sustainable and attractive growth for investors over time.