The key to thoroughly reviewing a term sheet is understanding what to expect, knowing what you want, defining what you won’t bend to, and most importantly, relying on excellent representation to analyze the sheet with a sharp eye.
When reviewing a term sheet by an investor, specifically look out for:
- Investors with unrealistic expectations on timelines, which might signal they’re looking for a short and hot exit
- Terms and conditions that may limit future fundraising
- An investor who asks for a large controlling stake
- Harsh debt financing that could bankrupt your startup
Follow this step-by-step guide to reading a startup term sheet.
1. Review Investor Information
The funds an individual brings to the table definitely matter, but most important is who you‘re working with and giving a stake in the company to. You want an investor with high conviction and strong faith in your business. They should also be willing to offer support and guidance to help your business succeed. Ask these questions when reviewing investor information:
- What’s their funding history?
- Has the investor previously funded startups that failed or went through difficult times?
- How did the investor react when things went wrong?
2. Review Startup Valuation
Startup valuation is your company’s market worth, depending on various factors. You must be careful when reviewing startup valuation in the term sheet. The investor will use the valuation to determine the company’s percentage they’ll own after investment. Ensure a fair valuation so you and the investor are in a win-win situation.
3. Review Vesting Plan
Vesting means giving or earning the right to a future benefit, asset, or payment. Vested shares give the holder full rights to them for a specified period. Professional investors prefer vesting to protect equity from departing founders. Founders typically have vesting terms before reaching out to investors. Ensure the investor’s vesting plan in the term sheet is mutually agreeable.
4. Review Board Composition Requirements
A term sheet is primarily about funds. However, investors also use it to lay out the power dynamics between them and your company. In most cases, a term sheet specifies how many seats on your board of directors will go to the investor. Considering boards make decisions through votes, you shouldn’t give an investor seats that would outvote the founders.
5. Consult With Legal Representatives
Investors write term sheets for a living. On the other hand, this may be your first deal as an early-stage startup, and you don’t want to screw it up. Leverage a lawyer’s expertise to ensure you only agree to terms that protect the company’s best interests.