We’ve written before about equity financings and how to decide between a priced equity financing versus convertible debt, as well as how to think about the difference between Seed, A, and B fundraises, but we sometimes hear founders pondering another question: whether their financing should include a term sheet. Usually, they’ve decided on a Series Seed or Series A, it’s their first round, and they’re not sure what the point of a term sheet is or if they have the power to suggest one to their investor.
Why Create a Term Sheet?
As described in this blog post, a term sheet is a document where the investor and entrepreneur decide on the terms of the investment (it’s usually 10 pages or so). The alternative, if you forgo the term sheet, is that you skip straight to the next step of drawing up a full set of equity financing documents (which is often many different documents spanning 100 pages).
The advantage of a term sheet is that it focuses on the material business terms, so the investor and the company can agree on the parts they actually care about. This saves time, in that if the deal falls through the term sheet is only 10 pages, and not too much time has been wasted on it. The legal costs of creating a 10-page term sheet are also relatively limited, so the money spent is manageable if the deal doesn’t ultimately come through.
This is why most companies will (1) agree on a term sheet that both the investor and the company will sign, and then (2) the term sheet will be handed off to the lawyer to create the whole bundle of financing documents, many of which will be signed by both the company and investor.
How do you create a term sheet?
You now know what a term sheet is, and why it’s helpful, but if it’s your first financing (Series Seed or A) and your investor seems to be running the show, how do you create a term sheet? The good news is, you most likely won’t need to. A term sheet for a Series Seed or a stock purchase agreement is a best practice, and your investor will probably give you a term sheet unprompted.
If you’re the hot new startup in town, you may even have interest from multiple VCs and have multiple VCs give you term sheets. You’ll then compare the term sheets and decide which offer to accept. Once you decide on which VC’s term sheet to accept, the VC will give the term sheet to the lawyer, and the lawyer will use it to draft the full set of financing documents (hopefully using a system like Fidelity!).
What if I don’t have a term sheet, because we skipped that stage?
While term sheets are the norm, it is possible to complete a financing without one. This is an unlikely scenario for most founders, but if you have an investor with whom you have a good pre-existing relationship and there are no other investors, for example, you might skip the formal term sheet. However, you should note that the purpose of the term sheet must still be fulfilled: you still have to agree on the core business terms, even if you don’t have a formal term sheet. This agreement could be reached orally or over email, which effectively serves as a term sheet.
A Word on Keeping Perspective
While term sheets are an important way for both parties to make sure that they’re on the same page regarding what business terms the deal will encompass, they are not the final set of documents. Think of them almost as an outline or a starting framework for the real documents to come. There are very few terms that survive term sheet creation that are legally enforceable.
The term sheet is just the beginning of a fundraise and although the terms matter, they only matter if they make their way into the equity financing documents that come after. This is a marathon, not a sprint, and after the term sheet is complete, you’ll still have a number of equity financing documents to get through.
Did you know that Fidelity can generate term sheets for equity financings?
Fidelity does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation.