I’ve heard some wacky stuff recently from entrepreneurs about term sheets. Some people seem inclined to throw the term around in contexts where it doesn’t belong. It’s a pretty simple concept, so I figured I’d draw up a quick primer to summarize the basics.
What is a term sheet?
A term sheet is a document that formalizes the preliminary understanding of two parties in an investment transaction. It’s not a contract, but rather a good-faith agreement to work together to draw up a contract later.
Why do you need a term sheet?
Big-money investment transactions require a lot of heavy lifting. Investors don’t want to waste their money in due diligence and legal fees if they don’t have an agreement on the basics. By signing a term sheet, investors and entrepreneurs establish reasonable parameters for what to expect in upcoming negotiations.
As an entrepreneur, what should I look out for in a term sheet?
The same things you would seek to avoid in a seed round or a Series A. But, since term sheets come early in the process, you should be particularly wary of investors who seek to prevent other VCs or angels from joining in on a round. If you come across an investor who discourages you from speaking with other potential investors at the term sheet stage, make sure you do your diligence on them. There’s no reason to foreclose the possibility of additional mentorship and investment early in the process unless there is a compelling reason to do so.
Most entrepreneurs understand the importance of valuation and capitalization, but make sure you also have someone who knows what they’re doing scrutinize the proposed liquidation preferences. Otherwise, you’re likely to get nothing if the company closes down before a successful exit.
Of course, there are many other issues that could be objectionable in a term sheet, so it’s important to have good advisors helping you if you’re looking at one for the first time.