After coming up with an innovative business idea, pitching to investors, and finding capital options, the task of securing funding can seem daunting. Creating a term sheet is one tool you can use to ease the process. With the document, you can attract prospective investors and generate competition to ensure you get the best deal.
If you want to successfully fund your startup, here’s an overview of how to create a term sheet for investors.
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According to the online course Launching Tech Ventures, a term sheet is a preliminary, non-binding document between an entrepreneur and investor that outlines a financing deal. It’s the first take of the proposed agreement’s terms and conditions.
Since a term sheet is non-binding, you can use it as a blueprint of your final agreement. The document has two important aspects:
- Economics: Factors such as valuation, option pool, and liquidation preference
- Control: How much control investors have over business decisions
Whether you or your investor create the term sheet, pay close attention to both aspects to ensure you retain control of your business.
“Most venture firms have a standard term sheet,” says Harvard Business School Professor William Sahlman in the online course Entrepreneurship Essentials. “They’ll likely want to use a convertible preferred stock with a liquidation preference.”
You can also issue a term sheet with preset conditions to attract potential investors and start negotiations.
As a founder, it’s crucial to be prepared to pitch your business idea to investors with a term sheet. Here are four steps to create one.
4 Steps to Create a Term Sheet
1. Understand the Content
First and foremost, it’s essential to understand a term sheet’s content. According to Entrepreneurship Essentials, the document includes the:
- Investment amount
- Timing
- Company valuation
- Form of investment
- Stock option plans
- Parties’ rights and responsibilities
- Board representation
- Time frame for deal completion
Comprehending these requires deeply understanding your business and investment requirements. Dedicate effort to identifying the amount of funding you must ask for, the type of investment you seek, and your company’s valuation. Doing so can ensure your term sheet accurately reflects your business needs and facilitates productive discussions with potential investors.
If understanding the term sheet’s content feels overwhelming, share the responsibility with a business partner or an advisor. Alternatively, you can decide what factors are essential to your goals and focus on those first.
2. Study the Terms and Conditions
As with any business document, it’s vital to understand the terms and conditions.
The most fundamental in a term sheet are:
- Valuation: The company’s worth before and after investment.
- Preferred stock: A type of equity security investors purchase containing liquidation preferences and voting rights.
- Liquidation preference: The right for preferred shareholders to get their investments back before the distribution of sale or liquidation proceeds.
- Protective provisions: Provisions that give investors a say in business actions, such as taking on debt or issuing new shares.
- Pro rata rights: Rights that give investors a means to avoid dilution and maintain ownership by participating in future funding rounds.
These factors protect both you and your investors, but they aren’t always part of the agreement.
“If everything goes well, most control terms don’t come into play,” says HBS Senior Lecturer Jeffrey Bussgang in Launching Tech Ventures. “But when things go poorly and there are disagreements, the documents determine who’s in the driver’s seat and has the power to make major decisions.”
It’s critical to ensure you’re pleased with the term sheet’s initial draft. Once signed, it’s intended to protect your best interests.
3. Get a Lawyer
Garnering what Bussgang calls service providers—companies or individuals that offer specialized support to entrepreneurs during different stages—is another essential step in the term sheet process. Examples outlined in Launching Tech Ventures include accounting, real estate, and recruiting firms.
Among the most valuable service providers when drafting a term sheet is a lawyer. Working with one who specializes in your field can make a significant difference.
“You, as the entrepreneur, need to have enough familiarity with these terms to make good decisions that are in your company’s best interests,” Bussgang says in Launching Tech Ventures. “And you should find a good lawyer early in the process who can help you navigate these complicated waters.”
An experienced attorney can help you understand your term sheet before making any legal commitments, ensuring you protect your interests and demonstrate professionalism to potential investors.
“The term sheet is used to lay out the important terms to be agreed to between business people,” Bussgang says in Launching Tech Ventures, “so lawyers can draw up and finalize the definitive agreement that represents the legally binding shareholder purchase agreement.”
4. Prepare to Negotiate
Negotiation is crucial to creating a term sheet. You often analyze and alter the document based on negotiations to solidify its final, legally binding terms and conditions.
In addition to finding a good lawyer, Launching Tech Ventures advises taking the following steps to prepare for a negotiation with a venture capitalist firm:
- Decide which of the term sheet’s elements are most important.
- Communicate your desires before issuing the document.
- Create competitive tension by doing research, networking, and talking with investors.
- Focus on issues that help or hinder your chances of reaching your desired outcome.
Creating value for both you and your investors is critical.
“Value creation is a key part of the negotiation process,” says HBS Professor Michael Wheeler in the online course Negotiation Mastery. “If it's done well, it can turn stalemates into deals and transform good deals into great ones.”
Learn How to Create a Term Sheet
Creating a term sheet can be intimidating, but it offers immense benefits. Using the document, you can establish control over your business, create open lines of communication with potential investors, and enhance the startup fundraising process.
To reap these benefits, consider enrolling in an online course, such as Launching Tech Ventures. Whether you’re a founder, a joiner, or an investor, the course can enable you to better understand the startup ecosystem through real-world, case-based examples featuring industry-leading experts.
Ready to learn more about term sheets and the startup world? Explore Launching Tech Ventures, Entrepreneurship Essentials, and Negotiation Mastery—three of our entrepreneurship and innovation courses—to learn how to assess business opportunities and transform your idea into a viable venture. Download our free course flowchart to determine which is right for you.
