Surviving a successful due diligence process is a lot of work, but the winner's trophy is worth it: if you make it through, you are hopefully going come out with a term sheet from a lead investor. How exactly does that happen, and what does it mean? Let's take a look.
A Summary of Your Agreement
Most investment deals involving the purchase of stock in a startup involve so many variables that it's essential to have one place where you can document what has been agreed. These variables represent different risks needing to be allocated between investors and entrepreneurs. As you hash them out, and make tradeoffs, the term sheet becomes the place where the bargain you've struck is recorded. Not surprisingly, a term sheet is occasionally called a memorandum of understanding--because that is what it really is.
Not a Binding Contract
Unless a term sheet expressly states that some or all of its sections are legally binding, early stage investment term sheets are generally not legally binding agreements. Term sheets should instead be thought of as a set of notes outlining the principal elements of the deal as agreed to by the negotiating parties. They serve both as a basis for soliciting interest from prospective investors and as a guide for counsel who will be responsible for drafting the definitive deal documents--which are binding.
Comprehensive, but Short, and Full of Jargon
Term sheets are generally pretty short documents covering many subjects in a very concise way. They do this by relying on jargon and short-hand conventions, which can make them a bit intimidating even for experienced business people. A typical term sheet includes details about the price of the deal, the size of the round, board composition, price protections for investors, operating controls, stock and employment of the entrepreneurs, information rights, the handling of various kinds of corporate transactions and liquidations, future investors, the option pool, and a host of smaller topics. In future installments of this series, we will unpack these term sheet topics into intelligible chunks.
Usually Supplied by Investors
Term sheets are typically furnished by the investor who has agreed to lead the round. They can be supplied by the company, and sometimes are, but most investors competent to lead a round have their own form of term sheet they like to use, and will generally prefer to start with their own rather than adapt one supplied by the company.
Term Sheet Approaches
Term sheets can happen two different ways: collaboratively or unilaterally. In many rounds, particularly angel rounds, there will be a fair amount of discussion and negotiation before a term sheet is issued. In these cases the company has a pretty good sense of what to expect, making the term sheet review less fraught and more of a check off to see how faithfully it tracks what was discussed. In other rounds investors go off and think about what they have learned about the company and when they return drop a term sheet on the company with no advance discussion. Sometimes in a round like this more than one investor will drop "competing term sheets." These situations are often less about negotiation than selection. If this happens it behooves an entrepreneur to seek experienced legal help to carefully parse the language of each term sheet offered.
Your Ticket to Ride
Once a term sheet is signed it is usually intended to be open for a stated period of time and becomes the basis on which other investors in the deal syndicate are solicited. (More about the syndication process in future installments of this series.) Sometimes a later investor will insist on changes to the term sheet in exchange for becoming involved. However, later investors will generally give deference to the deal lead who authored the term sheet and it will survive the syndication process unchanged. Once enough money has been pledged to the round, counsel for investors and the company will begin working on the definitive documents. When those definitive documents are completed, the term sheet has served its purpose of memorializing the fragile initial agreement and becomes nothing more than a souvenir of that magical moment when it first looked like someone might actually believe in you and your vision.
Christopher Mirabile (@cmirabile) is the Chair of the Angel Capital Association and an early stage investor in Boston MA, USA. He is the co-Managing Director of Launchpad Venture Group and the co-Founder of angel portfolio management tool www.Seraf-Investor.com.