Term Sheets: Definition, What's Included, Examples, and Key Terms

A term sheet is a nonbinding agreement that shows the basic terms and conditions of an investment. It is a template and basis for more detailed, legally binding documents. Once the parties involved reach an agreement on the details laid out in the term sheet, a contract that conforms to the term sheet details is drawn up.

Uses of a Term Sheet

The term sheet should cover the significant aspects of a deal without detailing every minor contingency covered by a binding contract. This helps ensure the parties in a business transaction agree on most major aspects while reducing the likelihood of a misunderstanding. This, in turn, could avoid costly legal challenges later on.

All term sheets contain information on the assets, the initial purchase price, any contingencies that may affect the cost, a time frame for a response, and other important information.

Term sheets are most often associated with startups. Entrepreneurs find this document crucial for investors, often VCs, who may offer capital to fund startups.

A term sheet used as part of a merger or attempted acquisition typically contains information about the initial purchase price, the preferred payment method, and the assets included. It might also have information about what, if anything, is excluded from or must be part of the deal for one or both parties.

What's Included in a Term Sheet?

The details in a term sheet depend on what's being agreed to. For an angel investment, the early funding investment term sheet will be substantially different from what's included in one for a commercial real estate development.

Generally, though, there are standard details included:

• Nonbinding terms: Neither party is legally obligated to abide by whatever is outlined on the term sheet.
• Valuations: Company valuations, investment amounts, the percentage of stakes, and anti-dilutive provisions should be detailed clearly.
• Voting rights: Startups seeking funding are usually at the mercy of VCs who want to maximize their investment return. This can result in the investor asking for and obtaining a disproportionate influence on the company's direction.
• Liquidation preference: The term sheet should state how the sale proceeds will be distributed between the entrepreneur and the investors.
• Investor commitment: The term sheet should state how long the investor is required to remain vested.

For debt agreements, here is what's commonly included:

1. Financial details: This consists of the term, loan size, interest rate, and other financial matters common to debt.
2. Risk mitigation preferences: The lender will often require specific conditions to be met or particular information to be provided in a recurring manner.
3. Extension rights: The borrower is often allowed to extend a loan, but the term sheet identifies the conditions and cost of the extension.
4. Due diligence at closing: As part of the term sheet, the lender may stipulate what they require when the loan agreement is drafted.

Terms Found in a Term Sheet

Term sheets often have standardized language. Here are some specific terms discussed in two different types of term sheets.

Investment term sheets

Dividends: Investors may want clarity on what net income distributions they will be entitled to. In addition to clarifying the dollar amounts, investors may want to know the timing (i.e., monthly, quarterly, or annually).

Drag-along clause: Investors may want guarantees that minority stakeholders will follow the guidance of majority stakeholders.

Liquidation Preference: Investors may want to know the order in which owners are paid if the company gets sold. This reduces the risk to investors.

No-shop agreement: This outlines the terms that restrict the company from taking investment money from other people for a specific period.

Pro-rata rights: Investors may want to better understand their rights for future investing rounds. For example, depending on their present investment, they may be entitled to the right of first offer for an investment offering in the future. Meanwhile, there may be penalties for investors who decide not to participate in future investment rounds.

Valuation (pre-money and post-money): Investors might want the pre-money and post-money valuations done before an official investment agreement is drafted.

Valuation cap: This is the value at which convertible notes can be converted into equity. Often a crucial point in negotiations, this figure should be discussed early between the parties to ensure a fair starting point for the startup's valuation and to protect the investor.

Voting rights: Investors may be interested in what they say they have over the company's operations. This may be an agreement on the number of votes the investor receives or any restrictions on matters about which they aren't eligible to vote.

Loan term sheet

Collateral: Borrowers may have to post collateral to substantiate value in case of default. This is often the underlying asset the debt supports, and the lender may require the first deed of trust.

Financial covenants: Borrowers may need to prove financial health to the lender. This includes providing certified financial statements, guarantee statements, or other records following the agreed-upon covenants with the lender.

Guarantee: Borrowers may need to identify a legal entity with established credit to vouch for the debt and be liable if the company defaults.

Interest rate: Depending on the loan, terms may vary widely. The interest rate may include a fixed spread rate plus a variable rate for long-term loans. For example, it might be a one-month term with a secured overnight financing rate (SOFR). The latter is a benchmark interest rate for dollar-denominated derivatives and loans, which reflects the cost of borrowing cash overnight collateralized by Treasury securities.

Loan amount: Borrowers need a specific amount of funds to borrow. This term may be a fixed dollar amount, subject to loan-to-value metrics, a debt service coverage ratio, and net operating income calculations.

Loan costs: Besides interest, a lender may require an annual administration fee or a one-time closing fee. These expenses can be significant for bigger loans, and borrowers should review upfront costs before loan proceeds are distributed.

Term: Borrowers must know when the loan is fully payable. For open lines of credit or development loans, this is the period during which interest is assessed, but principal payments may not be due.

Tips for Writing a Term Sheet

Every term sheet will vary, as the parties, conditions, and agreement will rarely be repeated. Still, here are broad tips for drafting a term sheet that applies to almost every situation:

Summarize the conditions: At the beginning of the term sheet, draft a summary identifying the agreement's overall purpose and the intended outcome. This includes explicitly addressing the project (e.g., Seed A funding of Company XYZ or residential development of 254 units in Los Angeles, CA). Identify each legal party involved.

State binding/non-binding terms: A term sheet should explicitly state whether the agreement is binding or nonbinding. This is often noted early in the term sheet.

List the terms: Understand that a term sheet is the first formal information the opposing party may receive. While the term sheet should not include the complete list of details in the agreement, it should provide enough information to entice the other party without overwhelming them. Cover the most important aspects of the deal, with the understanding that minor details can be sorted out later.

State the time frames: Even if the term sheet is nonbinding, it should include an expiration date that requires the opposing party to take action by a specific time. This encourages participation and action on the term letter and ensures the terms are not stale or unfavorable if held open too long.

Encourage feedback: Consider distributing a digital version of the term sheet that tracks changes. Ideally, the first draft would be a complete meeting of the minds with no further changes needed. Realistically, this is rare. Ensure the other party tracks any changes, allowing each side to quickly identify areas not yet in agreement.

Documents Similar to Term Sheets

Term sheets are like many other documents, so it's important to understand the differences.

Letters of intent

A letter of intent (LOI) is a document that declares a preliminary commitment by one party to work with another. These are common in business transactions, where one company announces its intention to do business with a second company.

A term sheet is often like an LOI when the action is one-sided, as in acquisitions or a working document, to serve as a jumping-off point for more intensive negotiations. The main difference between an LOI and a term sheet is stylistic; the former is written as a formal letter, while the latter comprises bullet points outlining the terms.

Memorandums of understanding

Memorandums of understanding (MOUs) outline agreements between two or more people or organizations in a formal document. MOUs are not necessarily legally binding but show that all parties are willing to move forward with a contract. They often serve as the starting point for contract negotiations or mergers.

Although term sheets are distinct from LOIs and MOUs, the three documents are often referred to interchangeably because they accomplish similar goals and contain similar information.

Example of a Term Sheet

In 2024, the New York City Department of Housing Preservation & Development released a term sheet for its HomeFirst Down Payment Assistance Program. The program is intended to help low-income people buy owner-occupied homes by offering forgivable loans to use toward a down payment.

The term sheet outlines which entities are eligible for the program, what home types qualify, the loan amount, loan terms, as well as construction requirements. At the end of the term sheet, the department's contact information is shown, so interested parties who agree to these terms can communicate with the NYC Office of Development.

The Bottom Line

A term sheet is a document that evidences serious intent between two parties that often signals the beginning of a transaction. It's the first step for the two parties working on structuring a deal. Though term sheets are usually not binding, they may require a good faith deposit in escrow, indicating serious effort toward a future deal.