Venture capital term sheets: A guide

A venture capital term sheet is the blueprint for an investment. Although term sheets have a set of formalized components, terms are generally undefined. The parties involved may have different understandings of what the terms mean. Nonetheless, the term sheet does require everyone to forecast the likelihood of various outcomes for your business, including its value as well as the timing and terms of future financing.

The term sheet is also not a legal promise to invest. Typically, the term sheet is simply a contract that requires you to keep negotiations confidential and, in some cases, may prevent you from soliciting any other investors for a period of time.

These are five documents that more definitively spell out the obligations of the relationship with your investor and are negotiated later. They are based on the initial term sheet:

1. The stock purchase agreement

2. Investor rights agreement

3. Certificate of incorporation

4. Right of First Refusal (ROFR) & co-sale agreement

5. Voting agreement 

Key elements of a VC term sheet

A venture capital term sheet is essentially the same from one VC firm to another. So, it may be surprising to see that often the terms can fit on a single page, making the document relatively user friendly, though the terms can be confusing.

You should confirm that your potential investor is trustworthy.

Before you sign a term sheet, however, you need to do due diligence. Although it is exciting to have someone interested in your company, you should confirm that your potential investor is trustworthy. You should also try to limit the number of conditions outlined in the term sheet and define terms as precisely as possible to avoid misunderstandings and confusion.

Certain terminology in a term sheet is common. Here are ten terms you’ll likely encounter and should be familiar with.

VC term sheet examples

There is a trend toward making VC term sheets shorter, more transparent with clearer definitions and easier for founders to understand. Whereas VC firms work with term sheets every day, for first-time founders a full understanding of what’s at stake facilitates better discussion and negotiation. While one-page term sheets exist, some can extend to dozens of pages.

Y-combinator, one of the world’s most respected accelerators, has shared what they believe to be a good term sheet template. And here is SVB's VC term sheet template to reference if you were to build your own term sheet.

How to get a fair VC term sheet

Although a VC term sheet is non-binding in many respects, it may be filled with unfamiliar terms that require definition because this plan will serve as a guide for your investor agreements going forward. Therefore, you need to protect your interests and the interests of your business. Although it is imperative to have legal representation, you also need a working knowledge of terms to ensure you can negotiate effectively. 

Work with your partners and advisors to identify the most important terms to you and your team and focus on those. Not only are you negotiating for favorable terms, but you are also building credibility with the VC. If you take the term sheet “as is” or inversely argue every point without strong rationales, you’re creating a negative image for yourself and your team going forward. 

 

Identify terms that are most important to you and your team and focus on those.

Be willing to stand up for the important issues — and show that you know what the most critical issues are. Then, the VC will understand what is important to you and will respect you for trying to strike a good and fair deal. 

If you are uncertain about which terms to prioritize, work with a trusted advisor or an experienced startup lawyer to identify those that will help you the most. Typically, however, the most salient points are:

• Valuation/Dilution — First, determine your startup’s value and recognize that a lower valuation from a respected investor may be a better deal than a high valuation from one with a less than stellar reputation. Second, understand the importance of negotiating for a minimal option plan reserve in the fully diluted pre-money valuation. It could enable you to get a higher price per share for your company at the exit. 

• Liquidation preference — This defines the return an investor receives when you sell your company and can significantly impact your return. Take the time to model various anticipated exit values to understand the actual dollar differences between liquidation preference options.

• Protective provisions — These are veto rights that investors have over specific corporate actions. Some make sense, particularly for early-stage startups, but others that limit where you can raise funds or how you can amend your certificate of incorporation may cause problems in the future.

• Founder vesting — The important things to consider include:

  1. What date does vesting commence?
  2. Does vesting accelerate upon termination without cause?
  3. Does vesting accelerate (in whole or in part) upon a change of control?

• Anti-dilution protection — Nearly all deals have some provisions to protect the VC from dilution and most are reasonable. However, if it is a “broad-based anti-dilution protection” or “full ratchet,” you may want to get advice from an expert and even reconsider the deal.

• Exclusivity — This is a standard condition that requires that you don’t talk to other investors for a specific period after you sign the term sheet and while the investor is doing their due diligence. But be sure the time period isn’t too long — 30-45 days is about right.

How to negotiate a better VC term sheet

When you get your first term sheet, remember that it is only a starting point. So, before signing, be sure you have done your best to negotiate advantageous terms:

• Talk to more than one VC — This will put you in the best negotiating position and make it possible to push for favorable terms and the best possible valuation. Try to avoid entering into an exclusivity period with one VC until you gauge the interest of others. 

• Confirm VC’s interest — If you receive a term sheet the VC is interested in, be wary of “no shop” clauses. If you need to agree to give the VC exclusivity, be confident they have the commitment, resources, and money you need before the negotiations go too far.

• Work with an attorney with VC financing expertise — An expert will provide the support and advice you need. It will also show the VC that although you’re inexperienced, you still have the good sense to enlist an expert to achieve success.

• Take control — You’re the face and voice of the company; you’re leading the negotiations for your team. It’s not your lawyer’s responsibility to negotiate terms. They are there for backup, but you’re there to strike a deal. 

• Prioritize your terms — You and the VC will not agree on everything. So before you begin negotiating, identify issues that are deal killers and issues where you can afford to be more flexible.

A fair term sheet is good for everyone

When negotiating a term sheet, it’s easy to think that the investor has all the power. But if you are confident in your vision and team — this is the opportunity to demonstrate your value. With a solid knowledge of the issues, a reasonable approach, and a desire to negotiate fairly, you’ll be able to get favorable terms and respect from your new VC partner.

Running a startup is hard. Visit our Startup Insights for more on what you need to know at different stages of your startup’s early life. And, for the latest trends in the innovation economy, check out our State of the Markets report.