Why Are Term Sheets Used?
Both Founders & Investors have a lot to gain from signing a term sheet at a given moment in the deal process:
Founders want to limit parties they negotiate with to save time and reduce info leakage. It also helps them validate VCs’ interest.
Investors want to make sure they agree on key parameters with Founders before engaging costly audits and contract drafting costs. In competitive bids, term sheets are used to select finalist(s).
Let’s take a moment to talk about due diligence here since it’s the next step after signing the term sheet.
We added two links below that you should absolutely read.
Mark Suster: Don’t Open Your Data Room Too Early
In a recent post, Suster takes a very unconventional view and advises Founders not to create a data room.
Data rooms are the online folders containing all the startup information needed for VC firms to conduct their audits (also called due diligence.)
Here are two takeaways from the post for our discussion on Why Are Term Sheets Used:
- The startup’s detailed information is very sensitive and should be shared only with parties that proved commitment to the deal;
- Term sheets are a useful way for Founders to test that commitment.
Note that in his graph on the typical VC process, which mirrors ours (Suster’s graph shows the process from the investor’s point of view), due diligence is mentioned before the term sheet step.
So, where’s the truth?
In fact, the due diligence that Suster mentions here is the portion conducted by the VCs themselves. As you can see under the box labeled “Term Sheet”, auditors and lawyers are mandated later.
You can go back to the corresponding lesson of the course, “What Do VCs Do,” if you need a reminder on the process.
Point Nine Capital’s Technical Due Diligence Calculator
Not sharing too much information too soon doesn’t mean it shouldn’t be ready.
One advice we often give fundraising Founders is that they need to have all the data and documentation ready before starting the roadshow.
VCs should also know what is the critical minimum information they need to pass their investment committees.
VC firm Point Nine Capital created a Technical DD Calculator for early-stage startups. Please take a look at it.