Lesson 6: Understanding Term Sheets – What Investors Actually Care About
Why Term Sheets Matter
A term sheet is one of the most critical documents in fundraising. It sets the foundation for your relationship with investors and dictates the financial and legal structure of their investment. Understanding term sheets ensures you make informed decisions and avoid costly mistakes.
A well-negotiated term sheet can mean the difference between a smooth funding process and long-term challenges with investor relationships, control, or dilution.
What is a Term Sheet?
A term sheet is a non-binding document that outlines the basic terms and conditions of an investment. While not legally enforceable, it serves as the blueprint for final agreements like the investment contract and shareholder agreements.
A term sheet includes three main components:
- Economics – How much money is being invested and at what valuation.
- Control – Who gets decision-making power and board seats.
- Investor Protections – Terms that protect investors from downside risks.
Key Terms to Know
1. Valuation
- Pre-money valuation: The value of your company before new investment.
- Post-money valuation: The value after the investment (pre-money + new investment amount).
- Dilution: How much of your ownership percentage decreases after new shares are issued.
2. Investment Amount & Equity Stake
How much the investor is putting in and what percentage of the company they will own.
Example: If an investor puts in $2M at a $10M pre-money valuation, the post-money valuation is $12M, and they own ~16.7% of the company ($2M / $12M).
3. Liquidation Preference
Determines how proceeds are distributed if the company is sold.
- 1x liquidation preference (most common): The investor gets their money back first before other shareholders receive anything.
- Participating vs. non-participating:
- Participating: Investors get their money back AND share in the remaining proceeds.
- Non-participating: Investors choose between getting their initial money back or converting their shares to common stock.
4. Board Composition
Specifies how many board seats the investor receives and who controls decision-making.
Founders should ensure they do not lose control of the board too early.
5. Protective Provisions
Certain actions require investor approval (e.g., selling the company, issuing new stock, taking on debt).
These provisions protect investors but can restrict founders from making major decisions freely.
6. Anti-Dilution Protection
Protects investors if the company raises future rounds at a lower valuation (down round).
- Full ratchet: Adjusts the investor's ownership as if they had invested at the lower valuation (very investor-friendly).
- Weighted average: More balanced, adjusting ownership based on the number of shares issued in the down round.
7. Option Pool
Shares reserved for future employees, often created before an investment.
A larger option pool means more dilution for founders.
8. No-Shop Clause
Prevents the company from negotiating with other investors for a set period.
Usually lasts 30-60 days, allowing the investor time to finalize the deal without competition.
Negotiating a Term Sheet
- Understand what really matters. Not all terms are equally important; focus on valuation, control, and liquidation preference.
- Leverage multiple offers. The best way to negotiate is by having other investors interested.
- Think long-term. Some terms that seem acceptable now can cause problems later (e.g., too many board seats for investors can limit founder decision-making).
- Seek legal advice. Term sheets have long-term implications; always consult a lawyer before signing.
Common Mistakes to Avoid
- Focusing only on valuation. Higher valuation is not always better if it comes with bad terms.
- Giving up too much control. Investors should not have the ability to override key business decisions too early.
- Ignoring liquidation preferences. Founders often underestimate how these terms affect their exit payout.
- Not planning for dilution. Understand how future funding rounds will impact ownership.
Before You Sign
- Review all terms carefully and ensure you understand their implications.
- Compare term sheets from multiple investors, if possible.
- Discuss key terms with a trusted advisor or experienced founder.
A well-structured term sheet sets up a successful partnership with investors. Take the time to negotiate wisely.