Term sheets and due diligence for startup fundraising

The typical startup founder begins with the following powerful factors working in their favor:

•   A promising idea for business success
•   High reserves of energy dedicated to making the enterprise work
•   A small team by their side, with the practical skills to create the product or service
•   A business plan to help the startup enter the market

This list of assets is often impressive – but even with such a foundation, the simple truth is that most startups need more in order to get off the ground. Beyond other necessities, such as the relevant licenses and permits, forward momentum also requires:

•   A significant level of outside funding at each initial stage
•   The knowhow to secure that funding
•   Comprehensive and well-structured documentation to satisfy potential investors

Most entrepreneurs have little experience with this second set of requirements, and therefore find it difficult to advance to the next stage of business. One of the most important steps on a company’s fundraising path is the Term Sheet, which sets out the potential terms of agreement between itself and an outside investor that takes an interest in the company.

Setting the boundaries

In the world of business and investing, whenever money changes hands, a contract is sure to be involved.Term Sheets are non-binding descriptions of the terms and conditions of a potential agreement with an investor, and are issued from the investor to the startup. As there are many stages of startup financing – pre-seed funding, seed funding, Series A / B funding, and Series C funding – Term Sheets are a recurring element in the startup’s journey.

They cover transaction and valuation provisions, instruments of investment, share pricing, share transfer restrictions, exclusivity and non-compete terms, drag-along or tag-along rights, due diligence, and other related considerations.

Term Sheets are introduced early in the process, when potential investors first connect with startups. They serve to set up the next stages of a potential relationship, which include face-to-face meetings and Legal Due Diligence (LDD).

Passing the test

Investors are as careful with their money as you are, and so they want to learn as much about a potential investment as possible, which might mean doing a lot of research into you and your company. Preparing for LDD – though time-consuming and heavy on paperwork – can be one of the most important tasks for a startup in need of funds.

LDD heavily influences investor interest, as well as overall valuation. It begins with a complete description of the startup and its products, financial and market strategy, present operations, potential customers, as well as suppliers. From there, LDD also covers the following:

•   Corporate documents and shareholding structure, including minutes of board and shareholder meetings, a list of shareholders, tax registration, and more.
•   Financial documents, including audited and unaudited financial statements, as well as financing and loan documents.
•   Material agreements, particularly partnership agreements, agreements pertaining to the supply, maintenance, sale, and purchase of goods, lease agreements, licensing and franchise agreements, and other related documents.
•   Company assets, including documents on physical and intellectual property, as well as current inventory.
•   Permits and licenses, covering all aspects of company operations.
•   Human resources data, including the total number of employees, employment agreements, HR policy, work permits, and any current labor disputes.
•   Insurance information, particularly employee health insurance and asset insurance.
•   Information on pending litigation by or against the company, as well as any potential litigation, arbitration or investigation that may affect the company.

Taken together, this information gives investors a clear picture of the business and its operations. A well-organized startup can impress investors during the LDD stage, just as surely as a poorly prepared business will push investors away.

Planning ahead

Many entrepreneurs, with an understandable instinct to focus their efforts on building their core business, make the mistake of underestimating the importance of these administrative tasks, and leave them until the last minute.

But much of business success is about getting the details right, and few details are as important as securing a beneficial Term Sheet and then following up with full documentation for LDD. Each of these tasks requires a subtle understanding of the relevant issues and expectations, and so most startups have a lot to gain from expert advice in this area.

However, success at the various fundraising stages is the best way that a startup can ensure its own financial security – and all the added capability that new capital can provide. Instead of these fundraising obligations keeping entrepreneurs’ hands tied, they end up having the opposite effect: When handled well, they are the very keys to freedom and growth.