Term sheets for startups: How to avoid a bad investment deal

Learn what you need to know about term sheets so you can ensure your startup’s success

When a venture capital (VC) investor presents a startup founder with a term sheet after a pitch meeting, it can be exciting and intimidating, especially for new founders. The term sheet is a non-binding document that outlines the financial terms of startup funding offered by angel investors, VCs, and other types of investors. It forms the groundwork for the formal legal terms that are solidified later in the startup funding process.

Choosing which terms to accept and which to negotiate is important for building the best relationship with your investor and ensuring the success of your company. There are certain red flags to look out for in a term sheet that indicate an investor doesn’t have your company’s best interests in mind. Since you’re committing your company to a financial relationship with your investor, you’ll need to make sure they’re someone you can work with far into the future.    

Reaching out to an attorney is a good idea before you agree to any terms. And knowing your priorities beforehand can help make it easier to evaluate an offer. Consider what a realistic valuation for your company may be, how much control of your business you’re willing to give up, what terms you’d ideally like to see, and what some serious deal breakers may be for you. 

Here are some important tips that startup founders can follow to effectively manage the process of reviewing and evaluating a term sheet and potential investors.  

Before getting a term sheet: What are your priorities?  

Achieving a great deal for your company doesn’t start with talking to investors. It begins with understanding your company’s priorities. You may not get all that you want but knowing them will give you a framework for assessing an offer when you receive one. 

You can use these guidelines to begin considering your priorities before getting a term sheet: 

Aim for a realistic valuation of your company

Try to figure out a realistic valuation of your company before getting term sheets so you’ll know if what you’re being offered is in line with your company’s actual worth. 

Know how much control you want to maintain

When it comes to staying in control of your business, you’ll want to have an idea of how much of your equity you’re willing to hand over to investors. When financing through venture capital, the reality is that a startup founder will have to hand over some control. But if you negotiate properly, you can keep your control from being diluted so you can build your company in the way you envision.   

Determine what terms are deal breakers 

Familiarize yourself with all the terms in a typical term sheet so that you know what is being offered and the implications. It pays to know what you can compromise on and what you absolutely can’t accept. Making a list of deal breakers forces you to explore what really matters for your company. 

Get multiple term sheets if possible

Do your best to get more than one term sheet so you can compare different offers against each other. Try to strategically time the process though because term sheets typically have an expiration date. It’s a good idea to begin collecting them when you think you can get 2-3 or more term sheets within a short timeframe.

After getting a term sheet: Why a high valuation isn’t always better 

Every founder wants a high valuation for their own company but for some new startups, this can become a problem. In the course of financing, many startup founders try to maximize valuations to avoid dilution of their stake in the startup instead of aiming for realistic ones. 

In the short term, receiving a high valuation gives the founder validation for their successful business idea and its results. It also decreases the dilution effects due to the capital increase and can allow the founder to retain more shares. 

Typically, a high valuation also comes with high expectations from investors. If these are not met, it can cause your startup to get less funding in the next round of investment. For instance, if stated benchmarks are missed in the first round, investors in subsequent rounds may insist on lower company valuation. This results in down rounds, or funding rounds where your company may have to offer additional shares for sale at a lower price than the previous round. A down round can negatively affect company morale, market confidence, and reduce ownership percentages.   

Be aware of term sheet red flags

Many first-time founders can’t help but focus on the valuation and other general terms on the term sheet. If you’ve taken the time to define your priorities about accepting startup funding for your company first, you may not be as prone to overlooking any small-print terms. 

You’ll also want to stay alert to specific red flags that could indicate that an investor may not be a good fit for your company. If you find terms that limit fundraising in the future, or other harsh terms, you’ll want to negotiate those. 

A competent investor will typically be willing to address any concerns you may have and clarify their intent.    

How to protect sensitive information during fundraising 

Before getting a term sheet, you’ll need to keep your proprietary company information secure when sharing it with investors. You can securely share confidential documents such as intellectual property by using a document security solution like Digify. 

You can set copy protection, restrict access, set expiration dates, and track interactions with your documents to make sure only the right people can see them. 

Startups use Digify to send pitch decks to their investors. You can get stats on how many times your documents have been viewed and opened by your recipients. In the early stages of fundraising, these stats can help you prioritize your engagement with investors, by focusing on those most interested and trying to close them first. 

After getting a term sheet, you’ll also need to review and share the documents during the due diligence process. This is where a virtual data room (VDR) comes in handy to streamline managing partnerships, deals, and business growth. 

Using a data room portrays a professional and credible image to your investors. It has additional features that make the fundraising process easier and faster to save you time and effort. For example, Digify’s virtual data room helps to automatically number your files and folders and inform your investor of new file updates.  

Final considerations

While it can be overwhelming for startup founders, especially new ones, to make countless difficult decisions throughout the formative and funding periods of the company, these decisions are vital to a successful venture. So take the time to educate yourself and find the legal help you need to be able to effectively negotiate for your company’s best interests. 

After all, any investor you choose will have a long-term relationship with your company. You’ll want to set a strong foundation from the start to create a partnership that works well for everyone. Meanwhile, check out a free 7-day trial of Digify’s virtual data room and document security solution to make sure you’re ready to secure your startup funding. 

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