Understanding Term Sheets: What You Are Signing Away

What Is a Term Sheet?

A term sheet is a non-binding document that outlines the key terms of a proposed investment. It is the starting point for negotiation, not the final agreement. Once both parties agree on the term sheet, lawyers draft the definitive legal documents that make the deal binding.

Even though a term sheet is non-binding, treat it seriously. Most of the important negotiation happens at this stage. Once the term sheet is signed, it is very difficult to reopen major terms without blowing up the deal.

The Terms That Matter Most

Valuation

There are two numbers you need to understand:

Pre-money valuation: What the company is worth before the investment.

Post-money valuation: Pre-money valuation plus the investment amount.

Example: If your pre-money valuation is $4 million and the investor puts in $1 million, the post-money valuation is $5 million. The investor owns 20% ($1M / $5M).

Why it matters: Valuation directly determines how much of your company you are selling. A higher pre-money valuation means you give up less equity for the same amount of capital.

Watch out for: Investors who quote post-money valuation to make the deal sound bigger. Always clarify whether a number is pre-money or post-money.

Liquidation Preference

This is arguably the most important economic term in any term sheet, and the one founders most often misunderstand.

A liquidation preference determines who gets paid first and how much they get when the company is sold, merged, or wound down.

1x non-participating preferred: The investor gets their money back first (1x their investment) before common shareholders receive anything. After that, remaining proceeds are split based on ownership percentage. This is the most founder-friendly version.

1x participating preferred: The investor gets their money back first AND then participates in the remaining proceeds based on their ownership percentage. This is sometimes called "double-dipping" because the investor gets paid twice.

2x or 3x liquidation preference: The investor gets two or three times their investment back before anyone else sees a dollar. These are very investor-friendly terms that can leave founders with nothing in a moderate exit.

Example: Investor puts in $2M for 20% with a 2x participating preference. The company sells for $10M.

• Investor gets $4M (2x preference) off the top, leaving $6M
• Investor gets 20% of remaining $6M = $1.2M
• Investor total: $5.2M (52% of exit)
• Founders and employees split $4.8M (48%)

Anti-Dilution Protection

Anti-dilution protections come into play if the company raises a future round at a lower valuation (a "down round"). They adjust the investor's conversion price so they get more shares, protecting their percentage while diluting the founders more.

Full ratchet: The conversion price drops to match the new round's price, regardless of how much was raised. This is extremely aggressive and highly unfavorable to founders.

Weighted average (broad-based): The conversion price is adjusted based on a formula that considers how many new shares were issued and at what price. This is the standard and more reasonable approach.

Board Composition

The term sheet will specify how many board seats exist and who gets to appoint them. A typical seed-stage board might be:

• 2 founder-appointed seats
• 1 investor-appointed seat

By Series A or B, it might shift to:

• 2 founder seats
• 2 investor seats
• 1 independent (mutually agreed upon)

Why it matters: The board approves major decisions including executive compensation, future fundraising, and whether to sell the company. Losing board control means losing decision-making power on existential issues.

Protective Provisions

These are veto rights that investors hold regardless of board composition. Common protective provisions give investors the right to block:

• Issuing new shares or changing the capital structure
• Selling or merging the company
• Taking on significant debt
• Changing the company's charter or bylaws
• Declaring dividends
• Changing the size of the board

What to negotiate: Some of these are reasonable (like blocking a sale of the company without investor consent). Others can be overly restrictive. Push back on provisions that give investors veto power over day-to-day operational decisions.

Vesting and Founder Stock

Most term sheets require founder stock to be subject to vesting, typically over four years with a one-year cliff.

Four-year vesting, one-year cliff: You earn 25% of your shares after one year, then the remainder vests monthly over the next three years. If you leave before the one-year cliff, you forfeit all unvested shares.

Acceleration clauses: Single-trigger acceleration means all your shares vest immediately if the company is acquired. Double-trigger means your shares accelerate only if the company is acquired AND you are terminated. Push for at least double-trigger acceleration.

Right of First Refusal and Co-Sale

Right of first refusal (ROFR): If a founder wants to sell personal shares, the company and/or the investors have the right to buy them first at the same price.

Co-sale (tag-along): If a founder sells shares, investors can sell a proportional amount of their shares in the same transaction.

These provisions prevent founders from cashing out early while investors remain locked in. They are standard and generally reasonable.

Drag-Along Rights

A drag-along provision allows a majority of shareholders (or sometimes the board) to force all shareholders to sell their shares if a sale is approved. This prevents a minority shareholder from blocking an acquisition.

What to watch: What threshold triggers the drag-along? Is it a majority of all shares or a majority of each class? A lower threshold gives more power to investors.

No-Shop and Exclusivity

The term sheet will typically include a no-shop clause that prevents you from soliciting or entertaining other offers for 30 to 60 days while the deal is being finalized.

What to negotiate: Keep the exclusivity period as short as possible. 30 days is reasonable. 90 days is too long. And make sure the exclusivity expires automatically if the investor does not close by a specified date.

Red Flags in Term Sheets

• Multiple liquidation preferences (2x or higher) without strong justification
• Full ratchet anti-dilution instead of weighted average
• Cumulative dividends that increase the investor's preference over time
• Redemption rights that let the investor force the company to buy back their shares
• Overly broad protective provisions that give the investor operational control
• Super-majority board control by investors at an early stage
• Unusually long exclusivity periods designed to prevent you from shopping the deal

Negotiation Principles

Get Multiple Term Sheets

The best way to negotiate favorable terms is to have more than one offer. Competition among investors gives you leverage on valuation and terms.

Focus on Economics and Control

Valuation, liquidation preferences, and board composition are the terms that will affect your life the most. Spend your negotiating capital on these items.

Hire an Experienced Startup Lawyer

A good startup attorney has seen hundreds of term sheets and knows which terms are market-standard and which are outliers. This is not the time to use your family attorney who handled your house closing. Budget $10,000 to $25,000 for legal fees in a financing round.

Ask Other Founders

Talk to founders who have raised from the same investor. Ask about their experience with the terms they agreed to and whether the investor has been a good partner after the deal closed.

Term sheets are where the most consequential decisions in fundraising get made. Take the time to understand every provision, and never sign anything you do not fully understand.