Summary
- A term sheet outlines the main terms of an investment deal and is mostly non-binding, except for key clauses like confidentiality, exclusivity, cost allocation, and governing law provisions.
- Founders should carefully review valuation terms, pre-emption rights, and anti-dilution provisions, as these affect ownership percentages and future dilution in subsequent funding rounds.
- Investors typically secure protections through due diligence conditions, liquidation preferences, board representation, and tag-along or drag-along rights to safeguard their investment and ensure fair treatment.
- This article is a guide to term sheets for startup founders and SME owners in England and Wales raising capital through equity financing.
- LegalVision is a commercial law firm that specialises in advising clients on corporate and investment matters.
Tips for Businesses
Never sign a term sheet without legal advice, even if most clauses are non-binding. Pay close attention to valuation, anti-dilution provisions, and liquidation preferences, as these significantly impact founder ownership. Negotiate exclusivity periods carefully to maintain flexibility whilst demonstrating good faith to investors.
Raising capital is one of the most important and potentially stressful stages for a business. Whether you are a startup founder or a growing SME, securing investment means bringing new people into your company and giving away a slice of ownership. To make sure everyone is on the same page, investors and founders usually start with a term sheet.
In this article, we will look at what a term sheet is, which parts are legally binding, and how it protects both sides – with clear explanations of the legal terms you will see along the way.
This guide will help you to understand your corporate governance responsibilities as a director, including the decision-making processes
What is a Term Sheet?
A term sheet is a short, usually non-binding document that sets out the main terms of an investment deal. It is like a handshake in writing – a way for founders and investors to agree on key points before spending time and money on detailed legal contracts.
Term sheets are common in equity financing, where investors receive shares for their money. They are widely used in UK venture capital and angel investing.
Which Parts are Legally Binding?
Most of a term sheet is not legally binding – it is just an agreement in principle. However, there are usually a few important clauses that are often made legally binding:
- Confidentiality: both sides agree to keep the terms and discussions private.
- Exclusivity/No-Shop: the company agrees not to seek investment from anyone else for a set time while negotiations are ongoing.
- Costs: sets out who will pay legal or administrative fees, whether or not the deal goes ahead.
- Governing Law: typically states that the laws of England and Wales apply if any disputes arise.
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Legal Safeguards for Companies (Founders)
1. Valuation and Offering
The term sheet will set a valuation for your company and define how many shares the investors will get. For example, if your company is valued at £2 million before investment (known as the pre-money valuation) and the investor puts in £500,000, they would own 20% after the investment.
2. Pre-emption Rights (Protecting Founder Ownership)
Pre-emption rights give existing shareholders the first right of refusal on the new shares before they are offered to others. This helps founders and early investors keep their percentage ownership and avoid being diluted when new shares are issued.
3. Anti-dilution Protection (Guarding Against Lower Valuations Later)
Anti-dilution provisions contain mechanisms that prevent certain shareholders, usually investors, from being diluted if your company raises money later at a lower valuation (a “down round”). It issues additional shares to the investors in a down round to account for the difference in shares they would have received had the investor also invested at the lower price.
From the founder’s side, anti-dilution clauses can lead to more dilution for you – so negotiate them carefully.
Legal Safeguards for Investors
1. Due Diligence Conditions
In most capital raises, the investors will undertake due diligence checks on a company before they commit their money to that company. Investors often include a condition that the deal only goes ahead if due diligence checks (legal, financial, commercial) are satisfactory. It protects them from investing in a company with hidden problems.
2. Liquidation Preference (Getting Paid First)
This gives investors the right to get their money back – and sometimes more – before founders or other shareholders if the company is sold or closed down. This will often come in the form of a preferential share class that is issued to investors.
For example, if an investor has £500,000 worth of preference shares with a liquidation preference, they will get that £500,000 back before the other shareholders receive a portion of the available capital.
3. Board Representation
It is common for investors to ask for a seat on the company’s board of directors, giving them oversight of big decisions. This helps protect their investment, but founders should be cautious about giving up too much control. Founders should be aware that votes in a board meeting are done by a show of hands and are not related to any shareholding that directors may or may not separately hold.
4. Tag-Along and Drag-Along Rights
Tag-along rights allow minority shareholders to join in a sale if a major shareholder sells their stake, ensuring fair treatment.
Common Mistakes to Avoid
Founders often rush to sign term sheets, assuming tough terms can be renegotiated later, but this rarely happens. Another pitfall is not understanding the jargon. It is crucial to always ask for simple explanations, and if a clause seems unclear, do not sign until you get legal advice. It is also easy to underestimate the long-term impact of term sheets. Although term sheets are mostly non-binding, they shape the final deal. If something is in the term sheet, it will likely appear in the legal documents.
Key Takeaways
A term sheet is more than just a preliminary document – it is the foundation of your relationship with investors. Whether you are raising your first round or scaling up, understanding the legal protections (and pitfalls) in a UK term sheet is essential. Hence, it is essential to always get advice before signing.
If you need assistance in navigating term sheets, LegalVision provides ongoing legal support for all businesses through our fixed-fee legal membership. Our experienced corporate lawyers help businesses across industries manage contracts, employment law, disputes, intellectual property, and more, with unlimited access to specialist lawyers for a fixed monthly fee. To learn more about LegalVision’s legal membership, call 0808 196 8584 or visit our membership page.
Frequently Asked Questions
Yes, usually. Generally, most of the term sheet is non-binding, meaning either side can walk away before final agreements are signed. But you are still legally bound by clauses like confidentiality and exclusivity.
The term sheet sets the tone for the entire deal. Even though it is usually not fully enforceable, the terms in it usually carry over into the final legal documents. A lawyer can spot hidden risks, negotiate fairer terms, and explain legal jargon in plain English – which can save you from costly mistakes later.
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