How to Create a Term Sheet for Investors

After coming up with an innovative business idea, pitching to investors, and finding capital options, the task of securing funding can seem daunting. Creating a term sheet is one tool you can use to ease the process. With the document, you can attract prospective investors and generate competition to ensure you get the best deal.

If you want to successfully fund your startup, here’s an overview of how to create a term sheet for investors.

What Is a Term Sheet?
According to the online course Launching Tech Ventures, a term sheet is a preliminary, non-binding document between an entrepreneur and investor that outlines a financing deal. It’s the first take of the proposed agreement’s terms and conditions.

Since a term sheet is non-binding, you can use it as a blueprint of your final agreement. The document has two important aspects:

Economics: Factors such as valuation, option pool, and liquidation preference
Control: How much control investors have over business decisions
Whether you or your investor create the term sheet, pay close attention to both aspects to ensure you retain control of your business.

“Most venture firms have a standard term sheet,” says Harvard Business School Professor William Sahlman in the online course Entrepreneurship Essentials. “They’ll likely want to use a convertible preferred stock with a liquidation preference.”

You can also issue a term sheet with preset conditions to attract potential investors and start negotiations.

As a founder, it’s crucial to be prepared to pitch your business idea to investors with a term sheet. Here are four steps to create one.

4 Steps to Create a Term Sheet
1. Understand the Content
First and foremost, it’s essential to understand a term sheet’s content. According to Entrepreneurship Essentials, the document includes the:

Investment amount
Timing
Company valuation
Form of investment
Stock option plans
Parties’ rights and responsibilities
Board representation
Time frame for deal completion
Comprehending these requires deeply understanding your business and investment requirements. Dedicate effort to identifying the amount of funding you must ask for, the type of investment you seek, and your company’s valuation. Doing so can ensure your term sheet accurately reflects your business needs and facilitates productive discussions with potential investors.

If understanding the term sheet’s content feels overwhelming, share the responsibility with a business partner or an advisor. Alternatively, you can decide what factors are essential to your goals and focus on those first.

2. Study the Terms and Conditions
As with any business document, it’s vital to understand the terms and conditions.

The most fundamental in a term sheet are:

Valuation: The company’s worth before and after investment.
Preferred stock: A type of equity security investors purchase containing liquidation preferences and voting rights.
Liquidation preference: The right for preferred shareholders to get their investments back before the distribution of sale or liquidation proceeds.
Protective provisions: Provisions that give investors a say in business actions, such as taking on debt or issuing new shares.
Pro rata rights: Rights that give investors a means to avoid dilution and maintain ownership by participating in future funding rounds.
These factors protect both you and your investors, but they aren’t always part of the agreement.

“If everything goes well, most control terms don’t come into play,” says HBS Senior Lecturer Jeffrey Bussgang in Launching Tech Ventures. “But when things go poorly and there are disagreements, the documents determine who’s in the driver’s seat and has the power to make major decisions.”

It’s critical to ensure you’re pleased with the term sheet’s initial draft. Once signed, it’s intended to protect your best interests.

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