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Daniel Faierman ➡️ [email protected] 

Chuck Cotter ➡️ [email protected]

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If you’re a founder, a newer/aspiring early-stage investor/angel, or even an experienced early-stage investor, we think you’ll enjoy reading.

At the bottom of each newsletter, you’ll find a link to our ongoing term glossary. And, just to state the obvious, as our disclaimer mentions, this isn’t official legal advice. We are generalizing and glossing over certain term sheet and fundraising details to make this (hopefully) more understandable.

Before we get into it, we had to share a cynical, yet unfortunately true quote that we came across in a blog a few months ago:

This is exactly why we started Term Sheet Pitfalls - to democratize access to simple term sheet education resources for anyone who could benefit! Hopefully this quote becomes less true over time after reading our content each week.

You’ll notice that each topic opens up with the option to listen to audio if that’s your preference 🎧️ 

About the Authors

What’s a term sheet anyways?

Our honest opinion (coming from a full time VC lawyer and VC investor): founders and VCs need to have their own understanding of term sheets even if outsourced legal support exists. As a founder, it’s YOUR company and you’re responsible for your existing shareholders and employees when you sign a term sheet. The same goes for VCs and their LPs. While a good lawyer can help materially, the best founders and VCs can negotiate on their own behalf and trade strategic thoughts with their counsel, getting the best out of each other. In Daniel’s opinion, the best part of counsel is that they’ve seen numerous examples of complex fundraises and can thus pull from experiences that founders likely haven’t had.

Before we get too deep on the fun stuff like liquidation preferences, SAFE conversion mechanics, and types of anti-dilution rights, we want to take a BIG step back and dedicate our first post to answering some basic questions about term sheets.

1. What’s a term sheet?

2. Is a term sheet binding?

3. How should a founder behave and communicate with investors after receiving a term sheet(s)?

4. What does the closing process look like after a term sheet is signed by both parties?

5. What are definitive agreements vs. term sheets?

6. Can deals fall apart after definitive agreements are signed?

What’s a term sheet?

A term sheet is a short form document that outlines the main terms and conditions of a potential business deal. As Chuck says, “term sheets are generally legally nonbinding but reputationally binding.”

What does he mean exactly?

Technically, if a term sheet gets signed by both parties (company and VC), it doesn’t mean the deal is legally completed – either party can technically still back out. This is what is meant by “nonbinding.” However, if you sign a term sheet as a fund, unless you discover something materially negative in your post term sheet due diligence, you should be willing to close the deal. We’ll talk more about this in the section below on exclusivity.

There are two main exceptions to the “legally nonbinding” nature of term sheets:

1/ Confidentiality 🤫: prevents the startup from disclosing the terms of a term sheet to third parties (i.e., other lead investors, startups, etc.). This enables both parties to negotiate in good faith.

2/ Exclusivity 🤝: often referred to as a “no shop,” this provision locks parties into negotiating only with each other for a defined period (i.e., 30-60 days).

Why would a VC fund want to include an exclusivity provision in a term sheet? The deal process is expensive. Once the term sheet is signed, the fund will start spending thousands of dollars in legal fees (not to mention time and energy) to close out diligence, review the legal agreements, etc., and they don’t want anyone else swooping in to steal the deal and leave them holding the bag on these costs without any investment to show for it.  

Back to Chuck’s quote of “reputationally binding.” In a few rare cases, Chuck has witnessed funds enter “exclusivity” with a startup, find nothing materially negative about the startup in due diligence, and still decide to back out.

This is a TERRIBLE reputational move for a firm. Why?

1. The VC firm is burning the founders’ precious time and resources and preventing the founder from engaging with other prospective lead investors.

2. At this point, the founders have probably told other prospective investors that they’ve signed a term sheet with another firm as their lead investor. Now, if the founders go back to those prosepctive investors, these investos may wonder why the VC firm that the founders signed the original term sheet with backed out after due diligence (and get cold feet).

3. The VC firm just forced the startup to burn another 30-45 days’ worth of cash for nothing. 

Chuck has gone as far as to proactively warn startups not to agree to exclusivity clauses with firms that engage in this behavior without good reason. Nonetheless, ~90%+ of deals that Chuck has worked on have closed after term sheets were signed by both parties. Further, for the vast majority of those that didn’t close, the VC firm uncovered something surprising in legal due diligence that truly warranted not moving forward with the deal.

PS: not good for a startup to back out after signing a term sheet with exclusivity either… but less reputationally risky for founders – they aren’t the ones focused on trying to build a generational VC fund known for treating founders with honesty and respect.

PSS: founders can still solicit other incremental co-investors during an exclusivity period – founders should not be soliciting competing lead investors, but one can certainly keep conversations going with potential co-investors that will likely be excited by the prospect of investing behind a strong lead for the round.

How should a founder behave after receiving term sheet(s)?

Chuck and Daniel might have a different answer than others.

First, don’t share the term sheet with employees (it’s none of their business, you want them to stay focused, and you could spook them if the deal falls through) or other potential lead investors (especially under confidentiality).

Second, take time to consider the terms with legal counsel, which funds should respect. Again, while term sheets are not legally binding, it’s going to be difficult to “re-trade” any terms once the term sheet has been signed since you’ve signified you are largely aligned to the offer by signing. 

Finally, act with sincerity, honesty, and minimal emotion. There’s a temptation to be manipulative to get the best deal you can, but be careful. In most cases when we’ve seen valuation get pushed up by competing lead investors, the founder is consistently level-headed and professional – as opposed to deliberately trying to push parties against each other. In the past, Daniel has deliberately bowed out of some exciting deals if a founder felt overly manipulative… even if the company appeared flawless in diligence. Life’s to short to not work with great people as often as possible.

Consider something like this:

Dear Investor X, we received a term sheet with good terms and are considering signing it. We’d like to give you the chance to also submit a term sheet if you’re interested by date XX/XX. We’ve enjoyed connecting with you over the last few weeks and look forward to hearing back.

This sounds honest, respectful, straight forward, and relatively unemotional/neutral.

Important: don’t name any fund as being super interested in your round unless it’s definitely true. This can easily backfire - most VCs have some degree of connection to each other and love to talk (as well as co-invest with their friends).

What does the closing process look like after a term sheet is signed by both parties?

In early-stage VC, nearly all business due diligence (operational, financial, human) takes place before signing the term sheet. Nothing surprising should emerge after a term sheet is signed - so as a founder, if there is anything that could threaten the deal in the post-term sheet legal diligence phase, it should be disclosed prior to the signing of the term sheet.

Once a term sheet is signed, most of the focus shifts to legal due diligence, which will involve legal counsel. This often includes (but is not limited to) a review of trademarks/IP/patents, an audit of contracts with key vendors (i.e., in CPG: co-manufacturers), an audit of the company’s cap table, a deep dive into prior financing rounds, and more. Simultaneously, the company and VC will be negotiating the definitive financing agreements, which will give the investors a variety of rights over the company’s corporate governance after their investment.

Definitive agreements are binding – once signed, an investor has a legal obligation to fund the investment. Definitive agreements are a detailed extension of the short form term sheet. Some of the most common documents include: the stock purchase agreement (SPA), the investor rights agreement (IRA), the voting agreement (VA), the company’s certificate of incorporation (charter), and the ROFR/Co-Sale agreement. Both parties are usually motivated to get to the finish line as quickly as possible and kick off the relationship officially and collaboratively… also don’t worry, we’ll break down many of the terms below in future newsletters!

• Stock Purchase Agreement (SPA): outlines basic terms of a VC deal in greater detail and includes price per share, number of shares sold, valuation, closing date/conditions (single close vs. rolling), reps and warranties, and indemnification provisions.

• Investor Rights Agreement (IRA): outlines rights and obligations of both parties. We will talk through several of these terms in greater detail in future newsletters but IRA incorporates:

  • Right of first refusal: Allows investors to accept or decline to purchase company shares before other investors (comes into play commonly during secondary transactions)

  • Preemptive rights: give the investors the right to participate in future equity financings

  • Redemption rights: requires a company to cash out an investor's shares if certain conditions are met

  • Information rights: give investors the right to receive financial and corporate information

  • Registration rights: allow investors to sell their shares in a public offering

  • Board representation: Allows major investors to appoint directors to the company's board

  • Amount of investment

• The Voting Agreement (VA): outlines how the shareholders of your company will vote on matters such as the composition of the board of directors and certain sales of the company (drag-along).

• Certificate of Incorporation (Charter): a document that establishes the legal existence of a corporation; serves as proof of formation

Another topic we will cover in the future is what it means to be a “major investor.” Many of the clauses within the definitive agreements may only apply if an investor meets the major investor threshold.

Do deals fall apart after definitive agreements are signed?

RARELY; in only two cases ever, Chuck has witnessed a lead investor bail after signing the definitive agreements.  

Until next time ➡️ we have some great content preprared on startup valuation

Ongoing Term Glossary

Confidentiality: prevents the startup from disclosing the terms of a term sheet to outside parties (i.e., other investors, startups). This enables both parties to negotiate in good faith.

Definitive documents:  the legal contracts between the investors and the company that detail the terms of the transaction and are drafted by a lawyer.

Exclusivity: often referred to as a “no shop,” this provision locks parties into negotiating only with each other for a defined period (i.e., 30-60 days). 

Lead Investor: primary investor(s) (co-leads can exist) in a funding round that set terms and typically are writing the largest check(s); often take a board seat.

Legally nonbinding: refers to the nature of term sheets. A signed term sheet does not legally mandate a deal be completed.

Major Investor: refers to a participating investor in a financing that surpasses a certain check size threshold, unlocking certain rights. I.e., “all those who invest over $500k will be deemed major investors and shall receive information and pro rata rights.”

Helpful Resources on today’s topics:

1) Term Sheets and Definitive Agreements

2) Nixon Peabody: SPA, IRA, VA

Is there a topic you’d like us to cover? Don’t be a stranger! Ever want to dive deeper on a topic in VC Investing or Law?

We can be reached here:

Daniel Faierman ➡️ [email protected] 

Chuck Cotter ➡️ [email protected]

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✍️ Written by Daniel Faierman and Chuck Cotter 

Disclaimer: The information provided in this entry does not, and is not intended to, constitute legal or investment advice; instead, all information, content, and materials available in this entry are for general informational purposes only.