- Start by making sure you’re working with an investor that’s right for you; then look at all the terms — not just valuation.
- Make sure you understand critical elements like liquidation preferences, the options pool and board seats.
- Venture capitalists (VCs) are experts and negotiation pros. Work with a good lawyer and learn when to dig in and when to accommodate.
"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. The details will be laid out in a term sheet. Understanding what these provisions mean is essential for every founder entering the fundraising process.
What is a term sheet?
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.
A term sheet is a non-binding agreement that summarizes the proposed terms of an investment before formal legal documents are drafted. It functions similarly to a letter of intent. Once signed, it opens a process of negotiation between your founding team and a VC that will result in a legal document detailing their investment.
Term sheets typically include valuation, investment amount, liquidation preferences, board composition and voting rights. Because final investment agreements follow the road map laid out by the term sheet, it is essential that you understand its provisions, the 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.
What is included in a term sheet?
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.
Valuation 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% of your company’s shares.
Still, valuation is not the only thing that matters. First-time founders often obsess over valuation while overlooking other critical provisions in the term sheet. Experienced investors point out that valuation is just one of many important terms, and that the provisions around it can be equally consequential for your startup’s future.
Stock option 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.
Many experienced founders recommend discussing as many key terms as possible during the term sheet stage — or even earlier if an investor raises them — to make sure both sides are aligned. Beyond the investment amount and valuation, you should focus on the option pool, liquidation preferences and board seats. When you establish a shared baseline on these core terms, the deeper negotiations that follow tend to go much more smoothly.
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 grasp the importance of liquidation preferences. Even seasoned entrepreneurs note that liquidation preferences are among the most complex terms to internalize. Understanding the scenarios around who gets paid, in what order and with what multiples when you exit are critical to protecting your financial outcome.
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. Founders are generally advised to negotiate for so-called 1x liquidation preferences, which are considered the most founder friendly.
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.
Working with a good startup attorney is essential. And while you should understand every deal term, you don’t need to negotiate each one. Knowing when to give, and when to dig in, are some of the most valuable skills you’ll develop through the fundraising process.
The majority of the work behind a successful term sheet negotiation happens well before you sit down to discuss the details. Like in any negotiation, leverage is key — and you should understand the leverage you do or don’t have. That 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
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 away board seats and voting control too early. A common best practice is to optimize for a small, highly functional board and give away as few board seats and observer seats as possible in your earliest funding rounds.
Another potential pitfall is if a director’s seat is held by someone other 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 investors ask for, the more these rights stack up in future deals since new investors will expect similar deals.
All of which underscores a fundamental principle in venture fundraising: get to know your investors, including thorough reference checks, to understand their values and how they make decisions. At the end of the day, few things matter as much as the people you’ll be professionally partnered with moving forward.
Why investor fit matters more than deal terms
An important piece of advice: don’t get so focused on the specific provisions of a term sheet that you lose sight of what matters most. Experienced venture investors and founders consistently say that the most important factor isn’t any single legal term — it’s who you’re working with. The firm, the partner leading your deal and their track record of supporting founders all deserve careful evaluation before you dive into the details.
Conclusion
A term sheet is more than a summary of valuation and investment size. It establishes the economic outcomes, governance structure and investor rights that can shape your startup for years to come, making it one of the most important documents you'll ever negotiate. It is important to understand key provisions such as stock option pools, liquidation preferences, board composition and protective rights.
Keep in mind, even the most favorable terms can't compensate for a poor investor partnership. The best fundraising outcomes happen when combining a strong command of deal mechanics with careful evaluation of the people and firms joining your cap table. When you approach term sheet negotiations with preparation, experienced legal counsel and a focus on long-term alignment, you can create a foundation for both productive investor relationships and sustainable growth.
