What is a Term Sheet?

The term sheet outlines the specifics, the key terms of the collaboration with a venture capital or private equity investor. First of all, it is a good sign if you got one. It may happen you received an indication of interest or LOI (letter of intent) that summarized the main terms of the offer, then you got a much more detailed term sheet.  

Each term sheet is unique to the project stage, company, investor, and investment size.  However, it is important to note that a term sheet is not a bank loan agreement or a "take it or leave it" set of conditions! While some terms are standard, many are negotiable—and should be negotiated.

Hundreds of businesses in the region seeking investment face the question of how to strike a good deal with an investor, protect their interests, and lay the groundwork for a successful partnership in the years to come. The process is complex, requiring both parties to reach consensus not only on critical issues like equity ownership or profit distribution but also on many other conditions.

A poorly negotiated agreement can lead to a disadvantageous and demotivating “relationship” for years instead of fruitful collaboration.

Many entrepreneurs lacking the experience in transactions tend to judge whether the term sheet is favourable based on one or two parameters — usually equity ownership and company valuation (the two is connected naturally). If the investor demands a higher equity stake or sets a lower valuation than previously expected, they consider it a bad deal. While this may seem reasonable, the term sheet contains numerous other terms that significantly influence the overall picture and can even tip the scales in a different direction. It’s worth to consider carefully which conditions genuinely provide advantages and are negotiable while avoiding unnecessary delays with terms that cannot be negotiated or won’t provide significant benefits.

In addition to determining equity ownership, there are many other factors companies should focus on—but unfortunately, they often neglect these. Let’s take a closer look at these!

Equity and Valuation – What’s the Right Balance?

It is common for companies seeking venture capital to evaluate potential investors primarily based on the equity stake they expect in return. However, both entrepreneurs and investors sometimes misguided about equity stakes. Investors often demand more equity than what would be “fair,” or even a controlling majority in the company, even though they could achieve their goals using other tools.

This issue is particularly a problem for early-stage companies, where risks are exceptionally high because there may not even be a product-market fit or sufficient market validation. Excessive equity demands can kill the founders' motivation.

What does this mean in practice?

Let’s assume the VC investor requests 40% in the first round, justifying it with reasons like high risk or uncertainty about the numbers. Depending how they forecasted the runway and which phase the company is, a new round of funding may be required. The new investor will look at the current cap table and situation and propose they need 35-40% for their significant contribution (even worse if it’s a down round). This would reduce the founders to owning just 35-40%. Should a new round come, there is not much space for the new investor left. The cap table is broken.

In many cases, an experienced VC will not invest in these cases. Even the product and team is great, if the cap table is broken, they have to pass it.

Imagine if at the end of the day the founders dilute to 10-20%... Will they be as motivated to push hard, working day and night fully committed? A subtle comment: if the first investor has anti-dilution protection, the situation becomes even more dramatic. The second investor will immediately realize that continuing discussions is pointless as the deal won’t work.  

The situation is even worse if a not-so experienced investor doesn’t recognize the problem, engages in months-long negotiations, and then makes an offer that leaves the founders with only 10-20%. After months of talks and significant effort, the founders may simply reject the deal.

Good news, that experienced, “top-tier” VC investors know they can’t request more than ~10-25% in a certain round, and nowadays the terms are gravitating towards “standard” deal terms. Still, one has to be cautious.

Private equity deals are bit different as there may be buyouts in the structure or mixed (growth capital and buyout), also the company shall be in a more matured phase, making the equity stake & valuation discussions somewhat easier and more straightforward.

From the perspective of the founders or the company, it’s clearly a mistake to focus solely on  valuation while failing to view the term sheet as a comprehensive package.

Even with low equity ownership, an investor may get strong control over the company's operations, significantly limit the autonomy and decision-making rights of the founders or management. Moreover, an excessively high initial valuation might complicate or even block subsequent funding rounds.

So, all in all, you should not let an investor get too many shares in the company as it can block your future rounds. On the other hand, targeting an unrealistic valuation can also backfire when things don’t go as planned and you need additional financing, but in the new environment with the actual metrics, your fair valuation is not as high as it was, so you will face a down round, that will be painful for everyone.