A term sheet is a foundational piece in private market investing that essentially outlines an investment’s terms and conditions. The ability to accurately read and assess a term sheet is an important skill for investors to have in order to evaluate opportunities and make informed investment decisions. In this blog, learn more about understanding term sheets, some key components, and how they may be structured.

Understanding Term Sheets

Basically, a term sheet functions like a letter of intent (LOI), laying out the relationship between investors and the company raising capital. Like an LOI, a term sheet is typically non-binding but is used to summarize the key points of the investment before drafting a legally binding agreement.

Term Sheet Content

A standard term sheet generally contains the following pieces:

• Offering Terms: Details the investment mechanics, including security type, price, valuation, and investment amount
• Economic Rights: Outlines financial protections and entitlements, such as liquidation preferences and anti-dilution provisions
• Control Rights: Specifies governance structures, including board composition and protective provisions like veto rights
• Other Matters: Covers items like confidentiality and founder vesting schedules

Key Term Sheet Clauses

Investors may want to familiarize themselves with certain clauses that are typically contained within term sheets.

Valuation and Capitalization

Investors should consider the pre-money and post-money valuation of an investment. Additionally, investors may also want to take a look at the capitalization structure, like the employee option pool, how total ownership is divvied up, especially if there is a portion reserved for future employees. If that employee pool is taken out of the company’s value before the investment, it can shrink the founders’ share, not the investor’s. This means the investor ends up with relatively more control. Valuation should be analyzed in conjunction with all other terms, as a favorable valuation may be offset by investor-favorable terms elsewhere.

Liquidation Preferences

The liquidation preference outlines the order in which shareholders are paid and any multiples are applied in an exit event like an acquisition or a merger. A common structure is a 1x non-participating preference, where preferred stockholders receive their initial investment back before common stockholders receive any proceeds. More complex structures, like participating preferences, where investors get their preference and share remaining proceeds, can reduce the payout to founders and employees at certain exit valuations.

Governance and Protective Provisions

Control rights determine investor oversight. Some key elements include:

• Board Composition: Term sheets often grant investors, particularly lead investors, board seats. A balanced board is generally advisable to facilitate accountability while preventing unilateral control by any single party
• Protective Provisions: These are specific veto rights granted to preferred stockholders over major corporate actions, such as raising new debt, selling the company, or altering the charter.

Anti-Dilution Protections

Anti-dilution provisions can help protect investors from ownership dilution if the company raises future capital at a lower valuation, also known as a down round. A “broad-based weighted average” adjustment is a standard, relatively moderate protection. A “full ratchet” provision, which adjusts the investor’s price to match the lower subsequent round price, can be highly dilutive to founders and is generally viewed as aggressive.

Other Rights and Considerations

• Pro Rata Rights: Allow investors to maintain their ownership percentage in future financing rounds, protecting against dilution in up-rounds
• Drag-Along/Tag-Along Rights: Drag-along rights allow for a majority to force minority shareholders to join a sale, helping to ensure a clean exit. Tag-along rights help protect minority investors by allowing them to join a sale initiated by majority holders
• Redemption Rights: Rare but potentially impactful, these clauses may allow investors to demand the company repurchase their shares after a period, typically 5-7 years, if no exit has occurred

Assessing a Term Sheet

When evaluating an opportunity, investors should be taking a look at the term sheet within the broader context of the investment.

Analyze Holistically, Not Just Valuation

A competitive valuation does not mean the whole deal is under favorable terms for that investor’s portfolio, risk tolerance, and investment thesis. An investment with a moderately lower valuation but standard, founder-aligned terms may be more aligned with an investor’s goals than a high-valuation deal with aggressive liquidation preferences and control rights.

Model Exit Scenarios

Investors may want to model potential exit outcomes under different valuation scenarios to understand how the liquidation preference functions. This analysis may reveal the “breakpoints” at which common stockholders (including employees and founders) begin to participate meaningfully and how the proceeds are distributed.

Evaluate Long-Term Implications

Terms accepted in an early financing round often set a precedent for future rounds. Overly investor-favorable terms in a Series A may deter future investors, complicate recruitment, or misalign incentives, potentially hampering the company’s long-term growth.

Engage Professional Counsel

Term sheets are dense with legal and financial nuance. Venture capitalists and fund managers often negotiate these documents regularly. Individual investors are strongly advised to leverage experienced legal counsel to navigate the specifics, clarify ambiguities, and understand the long-term implications of each clause.

Final Thoughts

A term sheet is an important document that outlines the key points of an investment opportunity. In order to make an informed investment decision, private market investors should carefully consider how aspects of a term sheet, like liquidation preferences, anti-dilution protections, control rights, and other provisions interact in various scenarios.

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Want to learn more about investing in startups? Check out the following MicroVentures blogs to learn more:

• Evaluating Go-To-Market Strategy
• Going Public: Direct Listing vs IPO vs SPAC
• Understanding Voting vs Non-Voting Shares
• Developing Your Investment Thesis

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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.