Are Term Sheets Binding? What Founders Need to Know

Agreeing on a term sheet is the first step (in terms of legal documentation) in the exciting process of raising money for startup founders. This investment term sheet sets out the parameters of the deal that will be executed in one or more legal documents after due diligence.

But you may be wondering: "Are term sheets binding?" The answer? It depends. While most of a VC term sheet is not a binding agreement, certain provisions are enforceable, and failing to negotiate in good faith can lead to legal consequences.

No-Shop and Confidentiality Provisions: The Binding Part of a Term Sheet

A venture capital term sheet typically consists of two types of provisions:

1. The No-Shop/Confidentiality Provision (Binding)
2. Everything Else (Non-Binding but Still Important)

What Is a No-Shop Provision?

Most VC term sheets contain a No-Shop provision, which is a legally binding document that limits a startup's ability to seek alternative funding from other lead investors during negotiations. This provision may:

• Prevent the startup from shopping around for other lead investors outside of the financing round.
• Require the startup to inform existing investors if a third party approaches them about an investment.
• Prohibit the startup from disclosing deal terms to anyone except specific authorized individuals.

💡 Why It Matters: Violating the No-Shop provision can result in significant damages for the startup, in addition to potential reputational damage.

Everything Else: It's Complicated

Nearly all venture capital term sheets explicitly state that they are not binding agreements. Courts will not force either party to follow through with the investment term sheet. However, courts in many states recognize a duty to negotiate in good faith, meaning that both parties must make a sincere effort to reach a final deal.

The Duty to Negotiate in Good Faith

While parties are not required to finalize an agreement (especially if issues arise during due diligence), they generally should not:

• Walk away from negotiations without a good reason.
• Engage in bad-faith tactics (e.g., pretending to negotiate without any intent to close the deal).

💡 Legal Consequences: If a party violates the duty to negotiate in good faith, courts may award damages, such as:

• Negotiation costs (e.g., legal fees, due diligence expenses)
• Lost opportunity costs (if a founder could have pursued another investor)

However, courts do not typically award lost profits because it’s impossible to determine what the final investment terms would have been.

Practical Issues

While the main clauses in term sheets pertaining to the substantive issues in an investment round are typically not legally binding, from a practical perspective, the term sheet lays out the core terms that the parties intend to execute in the financing. As such, unless key things change in the business or are discovered in due diligence, it is a bad look to try to change the terms after the term sheet is signed. 

While term sheets do not cover all issues that are important in a deal, the parties often anchor to the contents of the term sheet throughout the course of the negotiations that follow the execution of the term sheet. For that reason, it is important that the term sheet is carefully reviewed and negotiated so you do not find yourself in a position of trying to renegotiate the terms. 

Practical Examples of Real-World Implications for Founders and Investors

A term sheet acts as an engagement before the marriage—once it’s signed, both parties are expected to move forward in good faith. While not a binding document in most respects, backing out of a VC term sheet without a valid reason can have significant consequences.

For founders, reneging on a venture capital term sheet can lead to reputational damage, as investors often communicate with each other. A startup that backs out of an investment term sheet without justification may find it difficult to secure funding in the future. While legal consequences for failing to negotiate in good faith are rare, it could still lead to claims of bad-faith negotiations and impact future fundraising efforts.

For investors, a term sheet ensures key protections are in place (beyond the core economics of the deal). They expect to see protective provisions, such as veto rights over major decisions like raising additional capital, acquisitions, or executive compensation changes. They may also negotiate for board representation—a formal board seat or an observer role—giving them direct insight into the company’s direction.

Key Takeaways: What Founders and Investors Need to Know

• A term sheet is a starting point, outlining the main investment terms before legally binding documents are drafted.
• The No-Shop provision in a VC term sheet is a binding term, preventing startups from seeking alternative lead investors for a set period.
• While most term sheet terms are not binding agreements, parties must still negotiate in good faith, or they may face legal consequences.
• As a practical matter, even though most of the content in term sheets is not legally binding, it is difficult to re-negotiate the terms after the fact. 

What Venture Capitalists Look for in a Term Sheet

When evaluating an investment term sheet, venture capitalists assess several key factors to ensure the deal aligns with their interests.

1. Valuation & Equity Stakes – Investors need clarity on pre-money valuation and post-money valuation of the company. The difference impacts their ownership percentage and expectations. Investors will also negotiate whether existing convertible notes or SAFEs are included in the pre-money valuation or convert as part of the post-money valuation.
2. Preferred Stock & Liquidation Preferences – Most VC term sheets involve preferred stock, which grants investors certain rights over common shareholders. This may include anti-dilution provisions, liquidation preferences, the right to participate in future funding rounds, and protective provisions that safeguard their interests.
3. Board Representation – Investors may seek a board seat or at least an observer position to have oversight and influence in key business decisions.
4. Legal Fees & Due Diligence Costs – A venture capitalist will typically include a clause requiring the startup to cover legal fees associated with the financing. Founders should negotiate a reasonable fee cap to prevent excessive legal costs.

Investors also do not issue term sheets lightly. Founders often meet with dozens of potential investors before receiving even one VC term sheet, as investors take their commitments seriously.

What Happens After Signing a Term Sheet

While a term sheet is a starting point, signing it kicks off a detailed and time-intensive process. Here’s what founders can expect next:

1. Due Diligence Begins – Investors’ legal teams will request extensive documentation, including information on corporate structure, financials, cap table, and information on compliance with various laws. Founders who maintain an organized data room can speed up this process.
2. Legal Document Drafting – Unlike the concise VC term sheet, the final financing agreements often span 100+ pages across multiple documents, including the Stock Purchase Agreement, Investor Rights Agreement, Voting Agreement, Right of First Refusal and Co-Sale Agreement, and an Amended and Restated Certificate of Incorporation.
3. Negotiation with Lead Investor – The startup primarily negotiates with the lead investor, who sets the terms for the round and negotiates the details of the full deal (through their attorneys). Once finalized, these terms are presented to other potential investors who are generally expected to agree without further modifications (with some exceptions).
4. Collecting Signatures & Closing the Round – Once all parties involved have signed the agreements, the startup provides wire instructions, and funds are transferred to complete the financing. Some rounds may have multiple closings over several months.

By understanding this process, founders can navigate term sheets more effectively, ensuring they negotiate strong terms and avoid costly mistakes.

Contact our team today for help with term sheets and startup funding. Learn how we supported one company to acquire funding, from term sheet to closing.

DISCLAIMER: The information in this article is provided for informational purposes only and should not be construed or relied upon as legal advice. This article may constitute attorney advertising under applicable state laws.