If you’re a founder or CEO, at some point, you’re inevitably going to find yourself needing to raise capital. And whether that’s in the form of equity or debt, you’ll be asked to sign a term sheet with an investor. A term sheet is an agreement that sets out the terms and conditions of the investment. And while it’s non-binding, any investor is going to expect you to honor it once signed. That’s why you need to know exactly what’s at stake and how to effectively negotiate the best term sheet possible for you and your business.

In a perfect world, a term sheet would have reasonable provisions for both you and your investors, and would help your investors safeguard their capital. The reality, however, is that term sheets aren’t always balanced or fair, and they can have lasting implications for your business. That’s particularly true if you’re considering raising equity rather than taking on debt. That’s because an equity investor will effectively become a partner in your business. It’s therefore crucial to make sure you negotiate the best terms possible before entering a deal.

Make a mistake with your term sheet and the stakes could be high. You might wind up handing over power to your investors to shape and influence important strategic decisions about your business, while substantially affecting the overall direction of your company. If you’re not savvy about the process, you could end up giving away more equity than you intended, and even losing control over your business.

To help you better understand term sheets, let’s look at their six key components.

Term sheet components at a glance

Most term sheets borrow standard language from templates published by either the National Venture Capital Association or the Canadian Venture Capital and Private Equity Association, which investors subsequently modify to suit their needs. But no matter who the investor is, a term sheet will always contain six key components, including:

1. A valuation

An estimate of what a company is worth as an investment opportunity. Valuations are usually expressed as a price per share calculated on a fully diluted basis, meaning the equity value of the company (i.e., the enterprise value minus debt) divided by all of the issued shares, securities convertible into shares, and all options issued and available for issue under the company’s Employee Stock Option Plan.

2. Securities being issued

The shares and/or other securities being purchased by the investor and the major terms (e.g., preferences upon a sale or dissolution of the company, dividends payable, rights to convert into common shares, rights to require a redemption, etc.). Venture investors typically request convertible preferred shares or convertible debentures.

3. Board rights

The right of the investor to appoint or elect nominees to a company’s board of directors. Investors will usually only request a right to appoint a minority of the board, but may insist upon approving independent directors who will hold the balance of power and/or bring one or more observers to all board meetings.

4. Investor protections

Key corporate actions requiring the approval of the investor. These usually include creating and issuing shares that are superior to the shares held by investors, incurring secured debt, corporate reorganizations, buying back shares, and declaring dividends on shares. They may also include management-level matters such as hiring and firing senior officers, and making material changes to the direction of the business.

5. Dealing with shares

The rights of a shareholder to sell shares, or to acquire shares of the company upon an offering or a transfer of shares by another shareholder, and the right of the company to force shareholders to sell their shares into an approved sale of the business.

6. Miscellaneous provisions

These include matters such as the right of the investor to conduct due diligence prior to closing, exclusivity provisions (the obligation of the company not to entertain other offers), and payment of the investors’ expenses (which can be upwards of $50,000 in document-heavy equity deals).

Why negotiating a successful term sheet is crucial

Raising capital is a huge leap for any business, and getting your term sheets right is vital. It’s high-stakes stuff, and just knowing what term sheets are isn’t enough. You need to understand who you are partnering with, how the process works, and where the pitfalls lie. To meet the needs of your own company and your investors, you need to know what problems could occur and how you can avoid them from the get-go. If you don’t, you could be risking more dilution than you intended, being restricted from raising additional capital in the future, or being squeezed out of your own business.

On the flip side, having a deep understanding of how term sheets and investors operate means you can negotiate a fair and balanced term sheet that meets both your needs and the needs of your investors. Download How to negotiate a successful term sheet to learn more about how to make sense of term sheets, issues and pitfalls to avoid, and tips for negotiating your next term sheet with confidence.