Business Financing: Term Sheets, What They Are, and Why You Need One

This last week was the Angel Capital Summit.  On the first day, several sessions provided attendees with insightful and important information about business start-up financing and issues. On the second day of the event, 26 start-up companies got a chance to pitch their companies on the attendees.  @RockiesVenture live tweeted the event, and in addition to @HWkwong @innov_news @disruptcolorado @RexasaurusRex, I (@douglasgriess) helped out as well. For the Venture Bucks portion, the 1st place winner was Trek Pak, @TrekPak, 2nd place was Vokl, @VoklBusiness, and 3rd place was Swift Tram, Inc., @SwiftTram.

One of the most helpful sessions at the Summit was the session on Term Sheets.  Below, I will highlight what a Term Sheet is, and why it is important for start-up business finance.

What are Term Sheets?

A term sheet is a mostly non-binding document created by a start-up company which sets forth the most important details of how the investment the company is looking for will be structured.  A term sheet is a summary of the starting point for negotiations between the start-up and the investor(s).

A term sheet generally includes items such as the following:

  • the amount of investment sought;
  • the price per share sought;
  • an outline of the equity interest offered such as conversion rights or obligations, dividend rights, dilution protection, preemptive rights and other issues
  • restrictions on the management of the company such as rights to approve certain actions of the company or participate on the board of directors;
  • rights to redeem the investment;
  • registration rights; and,
  • conditions to closing the deal such as employment, noncompetition, or non-solicitation agreements.

Naturally, this is only scratching the surface of what a term sheet could contain, or how the different terms could be customized.  Each term sheet is going to be different depending on the business and situation.  

Why You Need a Term Sheet

First, a term sheet establishes that a start-up is actually serious about getting equity financing.  In addition, it forces the start-up to examine, evaluate, and commit to a framework for investment that includes not only stating what it is actually seeking, but also what it is prepared to give in exchange for financing. The start-up has to start thinking about the investment from a different perspective, specifically, the viewpoint of an investor looking for a return. 

Second, one of the most important things a term sheet does is streamline the courtship process by weeding out potential suitors who are not in agreement about the fundamental terms of the relationship being contemplated. Specifically, it gives investors a chance to determine if they should spend any time pursing investment with the company.

Third, a term sheet often requires a company to make basic binding commitments which facilitate the investment negotiations and process.  For example, the term sheet often allows an investor to get access, for a period of time, to the companies key documents in order to conduct due diligence.  Another example is that the term sheet may require the company stop soliciting or working on other investment opportunities during the negotiations.

Conclusion

At the Angel Capital Summit, many companies pitched the idea of their company and identified the kind of investment for which they are looking, the basic exit strategy, who the management team is, and what they plan to do with the investment.  The idea is this gives investors a glimpse of the company that potentially starts a conversation.  If those conversations bear fruit, terms sheets are often the next step to moving toward an actual investment and transfer of funds for rights.  Failing to have a term sheet can actually derail the process.

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