Understanding Term Sheets
Term sheets define the terms of investment. Here's what the key terms mean and what to watch for.
A term sheet is a non-binding document outlining the key terms of an investment. It’s the blueprint for the legal documents that follow. Understanding term sheets is essential—bad terms can haunt you for years.
Term Sheet Basics
What It Is
A summary of key terms, typically 3-8 pages.
Key points:
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Usually non-binding (except confidentiality, exclusivity)
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Precedes final legal documents
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Forms basis for negotiation
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One lead investor typically sets terms
Getting to Term Sheet
Signals you’re close:
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Deep diligence completed
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Partnership approval (for VCs)
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Discussion of terms verbally
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“We’d like to lead”
When to expect:
After partner meeting, if they’re interested.
Exclusivity
Most term sheets include “no shop” or exclusivity period.
Typical: 30-60 days
Purpose: Investor does diligence without you shopping the deal.
Implication: You can’t negotiate with others during this period.
The Economic Terms
Valuation
Pre-money valuation: What the company is worth before investment.
Post-money valuation: Pre-money + Investment amount.
Example:
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Pre-money: $8M
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Investment: $2M
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Post-money: $10M
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Investor ownership: 20%
Price Per Share
Valuation divided by shares outstanding (pre-money).
Used to issue new shares to investors.
Option Pool
Reserve of shares for future employee equity.
Watch out:
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Is the option pool included in pre-money or post-money?
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Pre-money inclusion dilutes existing shareholders more.
Example:
“$8M pre-money valuation with 10% option pool included in pre-money” = effective lower valuation for founders.
Liquidation Preference
Who gets paid first in an exit.
1x Non-participating (Standard):
Investors get their money back OR their ownership percentage, whichever is more.
Example ($2M investment, 20% ownership):
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$5M exit: Investor takes $2M (1x preference)
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$50M exit: Investor takes $10M (20% ownership—better than $2M)
Participating (Avoid):
Investors get their money back AND their ownership percentage.
Example ($2M investment, 20% ownership):
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$50M exit: Investor takes $2M + $9.6M (20% of remaining $48M) = $11.6M
Participating preferred is founder-unfavorable. Negotiate it out if possible.
Dividends
Many term sheets include dividends.
Non-cumulative: Accrue only if declared.
Cumulative: Accrue whether declared or not.
Most startups never pay dividends, but cumulative dividends add to liquidation preference over time.
Control Terms
Board Composition
Who controls the board.
Typical early-stage:
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Founders: 2 seats
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Investor: 1 seat
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Or: 2 founders, 1 investor, 1 independent
Later stages:
More investor seats, potentially losing founder majority.
Matters because:
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Board approves major decisions
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Can hire/fire CEO
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Controls company direction
Protective Provisions
Investor veto rights over certain actions.
Common (reasonable):
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Changing the charter
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Issuing new stock classes
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Taking on major debt
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Selling the company
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Changing board size
Aggressive (negotiate):
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Approving budgets
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Hiring key executives
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Everyday business decisions
Make sure you can operate without constant approval.
Voting Rights
How shares vote on matters.
Preferred shares often vote:
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As a class on certain matters
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On as-converted basis for others
Understand when investors vote together vs. with common shareholders.
Other Important Terms
Anti-Dilution
Protects investors if future rounds are at lower valuation (“down rounds”).
Full ratchet (Bad for founders):
Investors get repriced to new lower price completely.
Weighted average (Standard):
Investors get partially repriced based on how much is raised at lower price.
Broad-based weighted average (Better):
Includes option pool in calculation, less dilutive.
Pro-Rata Rights
Right to invest in future rounds to maintain ownership percentage.
Founder perspective:
Generally fine to grant—investors wanting to invest more is good.
Right of First Refusal (ROFR)
Company or investors have right to buy shares being sold by other shareholders.
Purpose: Control who ends up on cap table.
Co-Sale (Tag-Along)
If founders sell shares, investors can sell proportionally.
Purpose: Founders can’t cash out and leave investors behind.
Drag-Along
If majority approves a sale, minority must agree.
Purpose: Prevents minority from blocking acquisitions.
Information Rights
Investor rights to financial information.
Typical:
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Monthly or quarterly financials
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Annual budget
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Cap table updates
Generally reasonable for significant investors.
Registration Rights
Rights related to registering shares for public sale (IPO context).
Rarely matters for early-stage but often included.
Negotiating Term Sheets
What’s Negotiable
Generally negotiable:
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Valuation (within market range)
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Option pool size
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Board composition
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Some protective provisions
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Participating vs. non-participating
Hard to change:
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Major structural terms
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Standard investor protections
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Industry norms
Leverage Factors
You have leverage when:
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Multiple term sheets
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Strong traction
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Hot market
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Unique company
You have less leverage when:
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Only one offer
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Running out of cash
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Weak metrics
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Cold market
What to Focus On
Most important:
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Valuation (within reason)
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Board control
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Liquidation preference (1x non-participating)
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Anti-dilution (weighted average)
Less important:
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Minor protective provisions
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Information rights
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Standard terms
When to Walk Away
Some terms are unacceptable:
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Participating preferred above 1x
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Full ratchet anti-dilution
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Loss of board control too early
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Egregious liquidation multiples
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Terms that don’t match market
Bad terms now create problems later.
Red Flags
On Valuation
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“We’ll decide valuation after diligence”
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Valuation contingent on unclear conditions
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Significantly below market without explanation
On Control
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Investor majority board from start
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Extensive approval requirements
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Unusual governance provisions
On Economics
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Greater than 1x liquidation preference
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Participating preferred
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Full ratchet anti-dilution
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Cumulative dividends
On Process
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Extremely long exclusivity
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Unusual confidentiality provisions
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Pressure to sign immediately
Getting Help
Work with a Lawyer
For term sheet:
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Founder-friendly startup lawyer
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Experience with VC financing
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Can explain implications
Cost: Often deferred or discounted for startups.
Resources
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NVCA model term sheets (industry standard)
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“Venture Deals” by Brad Feld
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Your existing investors/advisors
Key Takeaways
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Term sheet outlines key investment terms—usually non-binding except exclusivity
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Valuation: pre-money matters; watch how option pool is treated
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Liquidation preference: 1x non-participating is standard; avoid participating preferred
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Anti-dilution: broad-based weighted average is founder-friendly; avoid full ratchet
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Board composition: maintain founder control as long as possible
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Protective provisions: ensure you can operate without constant approval
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Multiple term sheets create leverage for negotiation
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Use an experienced startup lawyer—they’ll pay for themselves
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Some terms are worth walking away from; bad terms compound over time
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Focus on what matters most: valuation, board control, liquidation structure
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