What is a Term Sheet?

When a startup receives confirmation from investors on its intention to invest, the confirmation is communicated using a document detailing the terms of the investment along with quantum and valuation; this is called a term sheet. Technically speaking, the term sheet is a non-binding document (meaning legally non-enforceable) used to solidify the terms of the investment. Think of this as a step just before finalizing the deal documentation to iron out all the finer details and requests from investors concerning rights and control in the company/startup.

Here is a template term sheet from the StartupIndia website for your reference.

While I could go through each of the various parts of the term sheet, we will look at some of the important critical terms from it, and we will list out a few points that make up an ideal term sheet from a founder’s perspective. Other aspects are mostly self-explanatory. But if you have specific questions apart from the points we discuss, do let us know in the comments section.

Firstly, pre-emptive rights are the rights of the investor to maintain the holding in the company by participating in any further investment rounds the company is undergoing. An investor will want to do this to ensure their stake in the company is not diluted. In almost all the VC investment rounds, the pre-emptive rights are a given. But as a founder, to ensure that their dilution is minimal across several rounds of funding, a fallaway threshold should be set up – say 5% – to ensure that any investor below 5% may not be able to have the pre-emptive rights.

Secondly, the anti-dilution clause. This clause is quite technical and will not go into the details. But put simply, most VCs will want to maintain their holding in the best of the startups so that they can get the maximum returns when they exit the investment. And VCs bake in the right to have this option not to dilute holdings in the agreements while the investment is being completed. This is called Anti-dilution. There are two types of anti-dilution – the weighted average method and the full-ratchet method. The less aggressive and founder-friendly option is the weighted average method. So watch out for this clause.

Thirdly, affirmative voting matters. This section details the various finer points of company operations that the investors will want visibility on and want to have the final say. In most cases, to enable companies to run smoothly, investors keep this list to critical points like taking on liability or changes in business operations or aspects of the business like those. Founders need to go through these matters in detail and ensure they speak to investors about any reservations and the reasons for that. In all likelihood, investors will understand and allow for relaxation from standard terms.

The other term to watch out for is the liquidation preference. The common request from investors here would be to have a 1x liquidation preference. This means that if the company liquidates, the investors will first get the entire investment amount before any other promoters and common shareholders see any capital being returned. Watch out for participating liquidation preference rights asked by investors – which works like this – say a company is liquidating and the investors have 1x participating liquidation preference, then the investors will get the investment amount back. And then, from the capital that is left over, the investors will again get pro-rata allocation. This is quite an aggressive right. So always ensure you have non-participating 1x liquidation preference – which is fair for the investors and the founders. Will try to have a separate blog on liquidation preference. But here is a short blog by Nithin on liquidation preference.

For any first-time founder, I can only imagine their feeling about receiving their first term sheet. All the hard work, blood, and sweat finally make sense, and a euphoric feeling sets in, I suppose. But while it is time to celebrate, the critical thing to do is to go through the term sheet in detail and watch out for terms that might not be favorable.

Will cover what an Investment Committee is in the next blog. Until then!

This is the sixth post by Dinesh Pai in the Venture Capital category. Dinesh heads investments for Rainmatter and is an avid blogger.