Who Prepares a Financing Term Sheet - the Startup or the Investor?

Frequently, a startup that is starting the fundraising process feels that it should prepare a term sheet to take to prospective investors. Whether this is necessary and serves it well depends on two key factors (a) the type of investor that it is targeting, and (b) the stage/type of financing.

Type of Investor: Angels vs. VCs

Generally speaking, if a company is targeting angel investors, and especially if the idea is to get a group of angel investors to participate on substantially the same terms, it is fairly typical to approach these investors with a company-prepared term sheet.

Note, however, that in a bridge (convertible note) financing, and if the amount requested from each angel investor is small, it may be prudent to skip the term sheet step altogether, and to present investors with a draft convertible promissory note instead of a term sheet. This can save time and costs. In an equity financing, the simplest of which are still more complex than an average bridge financing, a term sheet may be unavoidable.

Approaching venture capital firms with a term sheet, unless it's for a follow-on financing on terms from the previous round, is unlikely to be beneficial. In fact, if anything, it might hurt the startup: the venture capital firm that will lead the round will prepare its own term sheet, but if the startups presented its own term sheet with concessions (investor-favorable terms), those investor favorable terms are very likely to be incorporated into the term sheet ultimately presented by the venture capital firm, even though it may not be a standard term for that stage of financing for the fund.

Stage of Financing: First Financing vs. Successive Financing

In the context of a rolling bridge financing, once the first investor has invested, the terms of that investment can be used as a benchmark with other investors that the startup targets. If there is a shift in leverage, making it easier to the startup to raise money (as it gains traction, for instance), the terms might stay substantially, but not exactly the same, with the valuation cap increasing or falling away entirely, as an example.

The first time that a company raises funding through the sale of equity (stock financing), negotiating the right terms is of utmost importance. The bulk of the terms will stay the same, or get worse, through successive rounds. The only term that will, hopefully, improve is valuation. But the control terms will, at best, stay the same, and very commonly will get more complicated and cumbersome as more investors are involved.

When a startup is doing well, and has supportive existing venture capital investors, who are going to invest in the new round, it is quite typical for the startup to mark-up the term sheet from the last round of financing and to use that as the starting point for negotiations with the new investor. The support of the existing investor cannot be understated in this situation. When Accel, Kleiner Perkins, Sequoia or Andreessen Horowitz (it certainly helps to have a first tier VC as an investor) tell the new investor that they like the terms from the prior round and expect them to stay substantially the same in this round, that's what happens.

Where Does a Startup Get a Term Sheet?

Of course, your attorney will be happy to provide you with a term sheet, drafted for your specific needs. No amount of reading insightful blog posts, such as this one, will fully replace consulting with a knowledgeable startup attorney. But if you are not going to be using your attorney for this, or if you would just like to educate yourself about term sheets before talking to an attorney or to investors, here are some resources:

The Series Seed term sheet is a good template for a very simple first equity financing. If your investors agree to it, you can save yourself time and money by using the other Series Seed forms as well, which are much simpler than, for instance, the NVCA form documents and better tailored to a financing involving angel investors and a small amount of capital.

Wilson Sonsini has done a good deed and created online term sheet generators for convertible note financings and equity financings. In order to generate a term sheet using one of these generators, you have to answer a number of questions, some of which may be difficult if you are not at ease with the vocabulary and the nuances of financings. However, at the very least, it's a good way to see what questions you should be asking yourself and your investors about the terms of your transaction.

Not to be outdone by Wilson Sonsini, Orrick also has put out its term sheet creators for convertible note financings and preferred stock financings. If you try both Orrick's and Wilson Sonsini's, let me know in comments which one you like better and why.

Happy company making!

Inna

Inna Efimchik, a Partner at White Summers Caffee & James LLP, specializes in assisting emerging technology companies in Silicon Valley and beyond, providing incorporation, financing, and licensing services as well as general corporate counseling.

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