How to read a startup term sheet

Provisions are negotiable, and you should understand what is worth fighting for.

"Startup raises $X million at a $Y million valuation.” A version of that headline may someday announce your company’s Series A funding. But behind those bold-faced numbers you’ll find a list of critical provisions that will impact your startup’s course and determine how much you and your employees make in the event of an exit. They’ll be laid out in detail in a term sheet. We talked to VCs and founders whose advice will help you understand what these critical provisions all mean.

-- Kamir

Perhaps no single piece of paper is as pivotal in determining your startup’s future as the term sheet for proposed financing. In as little as 500 words, a VC’s term sheet lays out the financial terms of the investment, how much your startup will be worth, who will control it and who will profit the most if the company is sold or goes public.

The term sheet is akin to a letter of intent. Once signed, it opens up a process of negotiation between your founding team and a VC that will result in a legal document detailing their investment. But given that final investment agreements typically follow the road map laid out by the term sheet, it is essential that you understand its provisions and their implications, and develop a negotiating strategy.

What’s more, your first Series A term sheet will likely serve as the blueprint for any succeeding funding rounds, enhancing provisions favorable to you or magnifying mistakes that could result in loss of control or a smaller payout in the event of an acquisition.

While no two venture capital term sheets are exactly alike, they do tend to follow similar outlines. There are plenty of examples available online that should help you understand what they’re about.

People before terms

First, though, a word of advice from Andrew Beebe, managing director of San Francisco investment firm Obvious Ventures and a startup founder himself. Beebe says you shouldn’t get lost in the specific provisions of a term sheet at the expense of what matters most.

“The most important term in the term sheet is not a legal one — it’s really who you’re working with,” Beebe says. “Who’s the firm, and who’s the partner or lead on your deal? Choose wisely.” 

Don’t fixate (too much) on valuation

If your eyes focus immediately on the top of the term sheet, that’s understandable. It’s there that the dollar amount of the investment is specified and translated into the investors’ ownership percentage, and that the valuation of your company is set.

This is one of the most important parts of the term sheet. Depending on the valuation of your startup, venture investors in a Series A round could receive preferred stock equal to anywhere between 20% and 50%, typically, of your company’s shares.

Still, valuation is not the only thing that matters. Beebe says first-time founders often obsess on valuation while overlooking other critical provisions in the term sheet. “Valuation can matter, as can many other term sheet terms,” he says.

Options pool, liquidation preferences and board seats

For instance, the size of a stock option pool set aside to reward employees and attract future recruits and advisors is a fundamental variable that should be carefully thought through. A larger option pool will further dilute the founders’ ownership share, though by how much depends on the company’s valuation relative to the investors’ stake. 

“I prefer to discuss as many key terms as possible during the term sheet stage — or even before if the investor is asking — to help ensure both parties are on the same page,” says  Shanna Tellerman, a serial entrepreneur and founder and chief executive of Modsy, a startup whose 3D modeling software lets customers design and furnish their living spaces. Tellerman says that besides investment amount and valuation, founders should focus on the option pool, liquidation preferences and board seats handed out to investors. “With this baseline agreed upon,” she says, “much of the deeper negotiating becomes easier because you are on the same page for the key terms.”

Pay attention to pay-out provisions

Liquidation preferences are provisions attached to preferred stock that help VCs protect their investments, especially in situations where a startup has a middling exit, or worse. Many first-time founders fail to fully grasp their importance. “There were concepts that it took time — and two startups — for me to fully grasp,” says Tellerman. “The first was liquidation preferences. It is critical to understand the scenarios around who gets paid, in what order and with what multiple when you exit.”

The terms used in liquidation preferences are arcane and include non-participating preferred, capped participating preferred and uncapped participating preferred.

Behind the legalese are provisions that determine how much money investors — and thus founders, employees and other shareholders — will receive if the startup is sold. Tellerman strongly advises founders to negotiate for so-called 1x liquidation preferences. (A more detailed look at how liquidation preferences can affect your startup is available here.)

Get a good lawyer in your corner

As you gear up for negotiations over your term sheet, remember this: VCs write them for a living and have negotiated tons of deals; as a startup founder, this may be your first rodeo. Don’t go it alone.

“Have a good lawyer,” Beebe recommends. And while you should understand every deal term, you shouldn’t negotiate every one. “Learning when to give, and when to dig in is probably the biggest set of learnings I had from those early negotiations,” he adds.

Like in any negotiation, leverage is key — and you should understand the leverage you do or don’t have before you sit down to discuss term sheet details. “The vast majority of the work to be successful in a term sheet negotiation comes well before that,” says Richard Matsui, founder and chief executive of kWh Analytics, a San Francisco startup that provides risk management services for investors in solar projects.

That, adds Matsui, means having a clear understanding of your startup’s strengths and weaknesses, gauging overall investor demand and having a compelling story to tell.

When you should be a control freak

While a term sheet is primarily about money, it also lays out the power dynamics between you and your investors. Term sheets typically specify how many seats on a company’s board of directors will go to investors, and founders obviously don’t want to find themselves outvoted, particularly during a startup’s early stages.

A simple Series A board structure may have the lead investor designate one director while the founders name two. Because your level of control will diminish with follow-on investments, you want to be cautious about giving board seats and voting control too early, Tellerman says. “I have always tried to optimize for a small and highly functional board, giving away as few board seats and observer seats as possible,” he adds.

Another potential pitfall is if a director’s seat is designated to be held by the CEO, rather than a founder. As a founder/CEO you could lose your board seat if some day you are ousted from your executive position. And watch out for “protective provisions” that require major budgetary, hiring or operational decisions to be approved by holders of preferred stock. “The more rights your new investor asks for the more these rights stack up in future deals since future new investors will expect equal terms with prior equity round terms,” Tellerman says.

All of which underscores Beebe’s bottom-line advice: Get to know your investors, including thorough reference checks, to really understand their values and how they make decisions. “Nothing matters as much as the people you’ll be professionally wedded to moving forward,” he says.

Takeaway: Investment dollars and valuation are just the beginning

Once you’re certain the investors offering you a term sheet are a good match, go beyond the obvious. Investment dollars and valuation are critical, of course, but don’t overlook important details like option pools, liquidation preferences and the composition of your board. And when in doubt about something, consult with your lawyer.