Whether you are a startup seeking investments or an investor looking for a viable venture to channel your funds in, it is always essential to follow a full disclosure policy concerning the terms and conditions of the investment before any commitment is made. Besides the other significant details, all these terms and conditions are all part of a term sheet. Before we lay out the steps on closing the funding, let’s first grab a quick revision of what a term sheet constitutes and what significance it holds in the enterprise-investor camaraderie.
Investopedia defines a term sheet as ‘a nonbinding agreement that shows the basic terms and conditions of an investment (outlined by an investor seeking to invest in your company).’ The term non-binding implies that none of the parties- here, the entrepreneur and the VC - is legally obligated to abide by the sheet’s contents. Term sheets are a crucial document for startups looking to find potential investors. The contents of a term usually include:
i. Valuation of the company or startup
ii. Investment amount
iii. Percentage stake
iv. Liquidation preference
v. Voting rights
vi. Anti-dilutive provisions, and
vii. Investor commitment
Essentially, the term sheet lays the groundwork for the contract that would most likely happen between the two parties if there’s consensus on the major aspects mentioned in the term sheet. This ensures that the occurrence of any legal dispute is minimized, and hefty legal charges involved in drawing up the legal agreement are not incurred ahead of time.
As for the question - what does a term sheet contain - a Forbes article aptly says it “details what you as the start-up are giving, and what you are getting in return. Then it lays out the guidelines of how both parties will act to protect the investment.”
Here, we’ll discuss the latter part - that of ‘how both parties will act to protect the investment,’ i.e., the next steps to close the funding after you are done with the task of drawing out a term sheet:
#1 Prepare Yourself for Term Negotiations
Once you have decided to initiate a fundraise, discuss with your lawyer the status of your business concerning its traction, opportunity, and liquidity. In this way, you will become aware of your business’s leverage for the upcoming financing event. Time to set up your negotiating position now!
Together with your lawyer, note down your position and supporting arguments concerning every term in the term sheet - whether about liquidation preferences, voting rights, or pre-money valuation.
#2 Follow-up after Receiving the Term Sheet
Once the term sheet arrives in your mailbox or email, quickly write back to the VC a positive response with gratitude. If there are multiple VCs interested in backing your venture, buy time and respond to each one of them before you schedule your first call with the investor.
All investors genuinely interested in your project would follow up, and you would have a clear way ahead on how to take the next step.
#3 Consider the Investor’s Profile
If there are multiple term sheets received, you must acknowledge the same response to the respective VCs. Time to call your lawyer again! Go through all the term sheets together and try to identify the possible pros and cons while developing your negotiating position further. Next, consider the investor’s profile about what domain knowledge and connections they might bring.
What would be the nature of your relationship with the VC lead and whether the VC will capacitate any further investments in the future. Ask for references of the particular VC’s past dealings to get a better idea.
#4 Holding Term Sheet Negotiations
Investors often keep the most contentious topics for the latter part of the discussion, but companies should first discuss the terms they are uncomfortable with, terms they want to change, or add to the sheet. The organic sequence of a term sheet negotiation involves talks about:
i. Pre-money valuation
ii. The scope of the economic terms mentioned in the document, including liquidation preference, anti-dilution provisions, etc.
iii. Significant control terms, including the degree of freedom to raise debt financing or make management compensation decisions, etc.
iv. Conditions required to be fulfilled before financing
Once the above list is check-boxed, you can safely sign the term sheet. If you have multiple term sheets lined up, it is time to repeat the above steps to negotiate and close more funding until you reach your desired funding target.
#5 The Imperative of Due Diligence
Under due diligence, the company or startup seeking funds should allow the investors to verify its claims or the facts it has disclosed. The main areas of due diligence cover the technical, team, financial, and legal aspects of a company.
#6 Schedule Corporate Dinner Dates
There is ample time between the term sheet negotiations roundup and the completion of the definitive agreement. Companies should use this opportunity to arrange a dinner or two with the investor to strengthen the relationship further. Engaging a future board member to find common ground at the level of principles helps deepen the investor’s understanding of the top priorities of the company.
#7 Signing of the Final Definitive Agreement
More than the company and the investor, each lawyer will be involved in debating and negotiating every word of the financing agreement. You should hold a direct discussion with the CEO or leader of the VC at this time to approach the issues pragmatically. Thus, the entire agreement will fall into place, and the funds will be credited to your bank account for you to begin your operations.
Once you have received the term sheet, the actual struggle begins as even though you have found investors interested in funding your company, you need to ensure that you can successfully close the funding. Often, the emerging brands, however attractive they are, in their early fundraising stages, have to wait typically for 8-12 months before they can close the funding. This can be a dangerous position for startups and new brands in the crucial initial years of their business. Companies should avoid broken term sheets. It becomes extremely difficult to strike conversations with the same investor for want of trust or go to other investors who already suspect a broken term sheet. To avoid being trapped in such a situation, companies must close quickly on interested investors.
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