How to Navigate A Term Sheet

At the most basic level, a term sheet is a non-binding contract. It’s a short document, anywhere from 1-10 pages, that has a handful of terms outlining what will happen in an investment. If a deal goes through, lawyers will take the term sheet and turn it into hundreds of pages of legal documentation.

Let’s take a quick step back and think about why term sheets exist. Venture capital investors get money from people called limited partners, who trust the VCs to deploy and steward their capital, hoping that there will be a return on their investment. When they hand over their money, the VC agrees to a certain number of restrictions, rights, and protections that will be in force throughout the lifecycle of that investment. It’s a forum for the investor and the founder to make sure they’re aligned, that they have incentives to row the boat in the same direction, which is to build a very powerful and successful and profitable company.

Concretely, what does this look like? One term would be the composition of a board. Another would lay out the investors’ rights to information. There are terms that define equity for employees, voting rights for investors, limits on decisions a founder can make. Probably the most important and striking elements of a term sheet are the dollars and cents: how much are you raising? How much equity are you giving up? What’s the valuation of the company? How much of their investment do the investors get back before the founders and employees get a cut of the profits?

How Should You Evaluate A Term Sheet?

If this is your first time receiving a term sheet from a potential investor, chances are you’re excited. Someone believes in your vision enough to hand over some cold, hard cash. But remember: in signing this document, you’ll be entering into a long professional relationship with the investor. You should bring the document to a seasoned venture attorney, who’s seen countless term sheets, and can tell you how this one compares. She might see red flags that you would miss.

If the term sheet has been suitably scoured for red flags, it’s time to take  careful, holistic look at it. Each one is different. Valuation might be more favorable on one term sheet, but board control might be more favorable another. You’ll need to sit down and look at all of the terms and weigh their relative importance to you. At the end of the day, for instance, you might take a lower valuation because you get to hold on to the control of the company longer. That might be more valuable to you than a higher valuation.

The point is, don’t be hasty. Maybe you’ve been bootstrapping, putting company expenses on your personal credit card, and you’re just desperate to get an infusion of cash. Take a deep breath. If a VC has taken the time to send you a term sheet, they’re also going to take the time to walk through it, negotiate, discuss what you want your working relationship to be like. Again, this is a serious, long-term relationship you’re entering. Be sure you know what you’re walking into.

What Comes Next?

At this point, you’re well along the road to making your dream a reality. You’ve got a vision, a concrete plan, some fellow travelers and a pile of resources to deploy. Now you just need to hit your milestones, keep the ship heading where it should, and navigate the inevitable storms and changes of course that every startup deals with. Good luck!