Understanding Term Sheets: A Complete Guide for Founders
A term sheet outlines the key terms of an investment. Understanding it protects your interests.
What Is a Term Sheet?
A non-binding document outlining the principal terms of an investment. It covers:
- Economics (valuation, ownership)
- Control (board, voting)
- Exit provisions
- Protective provisions
Economic Terms
Valuation
Pre-money valuation determines ownership percentages.
Option Pool
Shares reserved for employees, usually 10-20%.
Liquidation Preference
What investors get paid first in an exit.
1x non-participating: Investors get money back OR convert to common
1x participating: Investors get money back AND share in remaining
Anti-dilution Protection
Protects investors if you raise at lower valuation.
Full ratchet: Very founder-unfriendly
Weighted average: More common, less dilutive
Control Terms
Board Composition
Who sits on the board and votes on major decisions.
Common structures:
- 3 seats: 2 founders, 1 investor
- 5 seats: 2 founders, 2 investors, 1 independent
Protective Provisions
Investor veto rights over certain actions:
- Selling the company
- Issuing new shares
- Taking on debt
- Changing business
Voting Rights
How different share classes vote on matters.
Other Important Terms
Pro-rata Rights
Investor right to maintain ownership in future rounds.
Information Rights
What information you must share with investors.
Founder Vesting
Your shares vest over time (usually 4 years).
No-shop Clause
You cannot talk to other investors during negotiation.
What to Negotiate
High Priority
- Valuation
- Liquidation preference
- Board composition
- Anti-dilution type
Medium Priority
- Option pool size
- Protective provisions scope
- Pro-rata rights
Lower Priority
- Information rights
- No-shop duration
- Minor representations
Red Flags
- Multiple liquidation preference (2x+)
- Full ratchet anti-dilution
- Excessive protective provisions
- Board control to investors
- Unusual vesting terms
Negotiation Tips
- Understand every term
- Know what matters most
- Get experienced counsel
- Compare to market norms
- Pick your battles
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