Reading a term sheet without panic

A term sheet arrives and the eye goes straight to the valuation. It is the wrong first stop. Two term sheets at identical valuations can produce very different outcomes for founders, and the difference sits in terms that attract far less attention and are far harder to renegotiate later.

The definitive documents will be drafted to reflect the term sheet. Whatever is conceded here is conceded, so this is the moment to read carefully.

Liquidation preference

This decides who gets paid what, and in what order, when the company is sold. A 1x non-participating preference is the common and reasonable position: the investor takes either their money back or their percentage, whichever is greater. A participating preference means they take their money back and then share in the remainder. A multiple above 1x means they take more than they put in before anyone else sees anything.

Model the terms against a range of exit values, including unremarkable ones. At a good exit the differences are small. At a moderate exit — which is the most likely outcome — a participating 2x preference can mean the founders receive materially less than their shareholding suggests, and occasionally close to nothing. Run the numbers before you agree the headline.

Control and consent rights

Board composition and the list of reserved matters determine what you can do without asking. A short list covering fundamental decisions — new shares, debt, sale, changing the business, related-party transactions — is normal and reasonable. A long list that reaches into hiring, budgets and ordinary contracts can slow the company considerably and shifts day-to-day control in a way the equity split does not reflect.

Negotiate the list, not just the board seats. And check whether consent sits with the investor director or with the investor as a shareholder, because the two behave differently when the director has fiduciary duties to the company.

Anti-dilution

Full-ratchet protection shifts the entire cost of a lower-priced future round onto the founders and employees, repricing the investor's entire holding as though they had invested at the new lower price. Broad-based weighted average is the more common and more balanced position, adjusting for the size of the down round rather than ignoring it.

Down rounds happen to good companies. Assume yours might, and price the protection accordingly.

The option pool

Where the option pool sits relative to the valuation matters more than its size. A pool created pre-money dilutes the founders alone; created post-money it dilutes everyone. An investor asking for a large pre-money pool is, in effect, negotiating the valuation down without changing the headline number.

Size the pool against an actual hiring plan for the next eighteen months, and be ready to show that plan.

What is actually binding

Most of a term sheet is non-binding, but exclusivity and confidentiality usually are. Check the exclusivity period before you sign, because it removes your ability to run a competitive process for its duration — and a competitive process is the main source of leverage a founder has.

Thirty days is workable. Ninety days, during which you may not talk to anyone else, is a significant concession that should be traded for something.

Model the terms at a disappointing exit, not just a good one. That is where the differences show.

Have the term sheet reviewed before you sign it. Positions harden considerably once it is agreed, and the cost of a review at this stage is trivial against what the terms decide.