Term Sheet

How a term sheet works

A term sheet does two jobs. It records the commercial agreement, and it starts a clock.

The commercial agreement is recorded in clauses grouped by the definitive document each will end up in. The NVCA model term sheet organises itself that way explicitly, with headed blocks for the charter, the stock purchase agreement, the investors' rights agreement, the voting agreement, and the right of first refusal and co-sale agreement, so that the term sheet doubles as a drafting road map.

The clock is the exclusivity period. The NVCA model form's no-shop provision commits the company and the founders, for a stated number of days from acceptance, not to take any action to solicit, initiate, encourage or assist the submission of any proposal, negotiation or offer from anyone other than the investors relating to the sale or issuance of capital stock, and to notify the investors promptly of any third-party inquiries. The same clause restricts disclosure of the term sheet's terms.

That is why the binding-versus-non-binding distinction matters so much. Written plainly, the economics of a term sheet are proposals until the definitive agreements are signed, but the exclusivity and confidentiality are promises the moment the term sheet is.

Binding from signature: no-shop, confidentiality, and in most forms, governing law.

Non-binding until closing: valuation, security, preference, board, and every other economic or governance term.

The economic block

• Security. The NVCA model form names it Series A Preferred Stock.
• Amount raised, which the model form notes may include amounts from the conversion of SAFEs and principal and interest on bridge notes.
• Pre-money valuation, which the model form defines as setting the price per share, called the Original Purchase Price, on a fully diluted pre-money basis including an unallocated and uncommitted employee option pool expressed as a percentage of fully diluted post-money capitalization.
• Dividends, with three alternatives in the model form: as-converted when paid on common, non-cumulative when declared, or a stated cumulative annual rate.
• Liquidation preference, with three alternatives: non-participating, full participating, and capped participation.

The governance block

• Voting rights and the election of preferred directors as a separate class.
• Protective provisions, a consent list covering liquidation, charter amendments, senior securities, dividends, equity plans, debt above a threshold, and subsidiary matters.
• Anti-dilution, set out in the model form as a weighted average conversion price adjustment with customary exceptions.
• Board composition, contemplating a lead investor designee, a designee of the remaining investors, a common stockholder representative, the chief executive officer, and mutually acceptable independents.
• Pro rata participation rights for Major Investors in subsequent issuances.
• Optional provisions that are not defaults: pay-to-play, redemption rights, drag-along, and founder stock vesting.

Worked example

Suppose two term sheets arrive for the same $10,000,000 round, on a company with 15,000,000 shares outstanding fully diluted.

Term sheet one: $40,000,000 pre-money, 1x non-participating preference, 12 percent post-money option pool inside the pre-money, 30-day no-shop.

Term sheet two: $46,000,000 pre-money, 1x participating preference, 18 percent post-money option pool inside the pre-money, 60-day no-shop.

Ownership. Under one, post-money is $50,000,000 and investors take 20 percent; the pool is 12 percent; founders keep 68 percent. Under two, post-money is $56,000,000 and investors take $10,000,000 divided by $56,000,000, or 17.86 percent; the pool is 18 percent; founders keep 64.14 percent.

Paper value. Under one, 68 percent of $50,000,000 is $34,000,000. Under two, 64.14 percent of $56,000,000 is $35,918,000. Term sheet two still looks better.

Now test a $70,000,000 acquisition. Under one, the investors compare their $10,000,000 preference against 20 percent of $70,000,000, or $14,000,000. They convert, and founders receive 68 percent of $70,000,000, or $47,600,000.

Under two, the preference is participating. The investors take $10,000,000 off the top, then share the remaining $60,000,000 on an as-converted basis. Their 17.86 percent of $60,000,000 is $10,716,000, so they receive $20,716,000 in total. Founders receive 64.14 percent of $60,000,000, or $38,484,000.

The higher-valuation term sheet leaves the founders $9,116,000 worse off at this exit, and its no-shop runs twice as long. The valuation line is the least informative number on either page. All figures are hypothetical.

Where it shows up

The term sheet is its own document, usually a handful of pages, signed by the company and the lead investor. The NVCA publishes a model version that maps clause by clause to its model definitive documents, and the model itself notes that it is longer than a typical venture term sheet because it is written to serve as both a road map for drafters and a reference for the business people.

Its provisions then disperse. The charter block becomes the certificate of incorporation: the security, dividends, liquidation preference, voting rights, protective provisions, conversion, anti-dilution, pay-to-play and redemption. The stock purchase agreement block becomes representations and warranties and the expenses clause, which in the model form has the company paying the financing's legal and administrative costs including capped investor counsel fees. The investors' rights agreement block becomes registration rights, information rights and pro rata rights. The voting agreement block becomes board election mechanics and any drag-along. The right of first refusal and co-sale block governs founder share transfers.

Two clauses stay in the term sheet and nowhere else. The expiration clause, which in the model form states the term sheet expires on a stated date if not accepted by then, and the no-shop and confidentiality clause, which is binding whether or not the financing closes.

After closing, the transaction surfaces publicly through the Form D filed with the Securities and Exchange Commission for offerings made in reliance on Regulation D, which reports the issuer, the exemption, the total offering amount and the amount sold.

Common mistakes

• Signing before reading the no-shop. Once exclusivity begins, competitive leverage is gone by contract, and the NVCA model form makes that provision binding even though the investment is not.
• Negotiating valuation and conceding the rest. The preference alternative, the option pool percentage, and the anti-dilution formula routinely move more value than the pre-money number does.
• Assuming the optional clauses are unusual. Pay-to-play, redemption rights, drag-along and full participation are all drafting alternatives inside the standard model form, which means they have to be negotiated out rather than assumed absent.
• Overlooking who pays for the deal. Under the model form the company pays the financing's legal and administrative costs, including the investors' counsel fees up to a negotiated cap. The cap is the negotiation.
• Forgetting the expiration date. The model form provides that the term sheet expires if not accepted by a stated date, which shortens any real diligence window on the company's side.
• Treating the term sheet as final on economics. It is expressly not a commitment to invest, and terms are frequently renegotiated between signature and closing, which the model form's own preliminary note acknowledges when it cautions against relying on one round's term sheet in a later round.

Related terms

A term sheet fixes pre-money-valuation and post-money-valuation, names the class of preferred-stock being sold, chooses the liquidation-preference alternative, sets anti-dilution and pro-rata-rights, and sizes the option-pool. It is the document that turns a conversation into a series-a, and its effects are modelled on a cap-table.

Frequently asked questions

Is a term sheet legally binding?

Mostly not, with important exceptions. The NVCA model term sheet states that it is not a commitment to invest and that no legally binding obligations are created until definitive agreements are executed and delivered by all parties. The same model expressly makes the no-shop and confidentiality provisions binding on the company whether or not the financing is consummated.

What is a no-shop clause in a term sheet?

It is an exclusivity commitment. Under the NVCA model form, the company and its founders agree that for a stated number of days from acceptance they will not solicit, initiate, encourage or assist any proposal or offer from anyone other than the investors relating to the sale or issuance of the company's capital stock, and will promptly notify the investors of any third-party inquiries.

What terms are on a venture capital term sheet?

The NVCA model form covers the security, closing conditions, investors, amount raised, pre-money valuation, dividends, liquidation preference, voting rights, protective provisions, conversion, anti-dilution, registration rights, information rights, pro rata rights, board composition, founder non-competition and confidentiality agreements, expenses, no-shop, and expiration, plus optional pay-to-play, redemption and drag-along provisions.

How long does a term sheet last?

Two separate clocks run. The model form's expiration clause sets a date by which the company must accept or the offer lapses. Once accepted, the no-shop period runs for a negotiated number of days, which is the window in which diligence and definitive documentation are meant to be completed.

Who pays legal fees in a venture financing?

Under the NVCA model term sheet, the company pays all legal and administrative costs of the financing, including reasonable fees and expenses of investor counsel up to a stated cap, and the model contemplates company counsel drafting the documents. The cap is a negotiated number and is worth negotiating.

Can terms change between the term sheet and closing?

Yes, and the model form anticipates it. Its preliminary note observes that deal terms often are negotiated further between term sheet and closing, and for that reason cautions against relying on one round's term sheet as an accurate statement of terms in a later round.