A term sheet is a non-binding agreement that outlines the fundamental aspects of a business transaction, typically an investment in a startup. The term sheet conditions specify the terms both parties have agreed to in principle, such as the company’s valuation, investment amount, investor rights, and control provisions. These conditions act as a framework for the final, legally binding agreements.
Think of the term sheet as a detailed handshake — it clarifies expectations before legal resources are spent drafting official contracts.
Key Term Sheet Conditions
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Valuation: This indicates the pre-money valuation of the company, determining how much ownership equity an investor receives. For example, with a $4 million pre-money valuation and a $1 million investment, the investor owns 20% post-investment.
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Liquidation Preference: This clause sets the order and amount investors are paid if the company is sold or liquidates. A standard 1x liquidation preference ensures investors recoup their initial investment before others receive proceeds. Watch for “participating preferred stock” or high multiples which can heavily favor investors at founders’ expense.
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Pro-Rata Rights: These allow investors to maintain their ownership percentage by participating in future funding rounds, preventing dilution.
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Anti-Dilution Provisions: Protect investors if the company raises funds at a lower valuation in subsequent rounds by adjusting share prices or ownership percentage.
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Board Seats and Voting Rights: Defines investor control in corporate governance, including board membership and voting power.
Binding vs. Non-Binding Provisions
Most economic and control terms in a term sheet are non-binding, meaning they serve as negotiation guides rather than enforceable obligations. However, clauses like confidentiality and exclusivity (“No-Shop”) are usually binding, legally restricting parties from negotiating with others during due diligence.
Common Pitfalls
- Overvaluing the company without considering control terms or liquidation preferences.
- Skipping legal review from a qualified attorney.
- Underestimating seemingly routine clauses like voting rights or liquidation preferences.
- Agreeing to a lengthy exclusivity period, which can limit fundraising options.
What Happens Next?
Upon signing a term sheet, investors typically start due diligence, verifying company details before final legal agreements are drafted, such as the Stock Purchase Agreement.
For more on startup investment documents, see our Business Loan Term Sheet article.
References
- IRS.gov on startup investment basics
- Investopedia: Term Sheet Definition and Analysis
- Forbes: Understanding Term Sheets
- Y Combinator: A Guide to Seed Fundraising
This article aims to help startup founders and investors understand key term sheet conditions to negotiate more effectively and avoid costly mistakes.