Introduction to Term Sheets

When a startup begins speaking with investors, one of the first major documents they encounter is a term sheet. Although it is not the final binding contract, it is a crucial outline that shapes the direction of the deal. A term sheet acts as a roadmap for future legal agreements, making sure that both the founder and investor understand the expectations, obligations, and rights associated with the investment. Without it, negotiations can drift, misunderstandings can grow, and closing the deal becomes more difficult.

Why Term Sheets Matter in Investment Negotiations

Term sheets carry significant weight because they organize major points of discussion early in the process. They give investors a clear picture of what they are entering into while allowing founders to evaluate whether the proposed arrangement aligns with their long-term vision. By establishing valuation, ownership structure, governance rules, and other essential terms up front, the document reduces confusion later. It also signals commitment: once both parties agree on a term sheet, it suggests a shared intention to finalize the investment after due diligence is complete.

Many investors see a well-prepared term sheet as a sign that founders take professionalism seriously. For founders, it also serves as an opportunity to set boundaries and negotiate on issues that could later affect control, future rounds, or the company’s strategic direction.

What a Term Sheet Generally Covers

While every deal is unique, most term sheets revolve around several essential categories. These include the company’s valuation, the type and amount of equity the investor receives, the structure of the board of directors, and the rules governing how decisions are made. Other components look at what happens in an exit scenario or if new funding rounds occur. Because each of these points can impact the company for years, founders must understand them clearly before agreeing to anything.

Term sheets also often outline rights for investors that ensure their investment is protected, such as the right to approve major decisions or receive priority during liquidation events. Even if the document itself is not legally binding, certain clauses may carry legal force, particularly those dealing with confidentiality, jurisdiction, or exclusivity.

A Closer Look at Equity Dilution

Equity dilution is a concept every founder must understand well. At its core, dilution describes what happens when new shares are created and existing shareholders own a smaller percentage of the total company as a result. This typically occurs during fundraising rounds or when a business expands its employee option pool.

Although dilution can feel negative, it is not always harmful. If the company grows in value, a reduced percentage can still be worth far more in absolute value. The challenge is maintaining a healthy balance so founders retain enough ownership and decision-making control as new investors join over time.

How Equity Dilution Works in Practice

Consider a company with one million shares, all owned by the founders. If an investor contributes capital and receives new shares—say 250,000 of them—the total number of shares becomes 1.25 million. The founders still hold one million shares, but their ownership percentage drops, even though the value of their shares may increase as the company’s valuation rises. This example highlights why founders need to monitor dilution carefully, particularly as additional funding rounds occur. Without careful planning, the founders’ collective ownership can shrink to a level where they no longer control the direction of the business.

Breaking Down the Core Sections of a Term Sheet

Understanding the detailed structure of a term sheet helps founders anticipate investor expectations and negotiate from a position of knowledge. Though formats vary, many documents include the sections described below.

Offering Terms

This portion addresses the size of the investment and the company’s valuation, typically noted as pre-money and post-money. Pre-money valuation represents the company’s worth before funds are added. Post-money valuation simply adds the new investment amount to that number. These figures determine how much equity the investor receives and heavily influence future funding rounds.

Economic Terms

The economic section goes deeper into the financial mechanics of the deal. It specifies the type of shares being issued—such as ordinary shares or preferred shares—along with price per share, dividend structure, and whether an employee option pool must be expanded before the investment closes. Investors often request an expanded option pool so that future employee grants do not dilute their newly acquired stake, meaning the additional dilution is absorbed by existing shareholders instead.

Governance and Board Structure

This area defines how decisions will be made going forward. It may describe which parties will hold board seats, what actions require shareholder approval, and what special rights investors may have to protect their interests. These may include veto rights on major decisions, authority regarding executive hiring or firing, and provisions governing how shares are treated in an exit event. Because governance terms affect long-term control, founders must fully understand them before agreeing.

Liquidation Preferences and Exit Rights

This part of the term sheet outlines how proceeds are distributed if the company is sold or shut down. Investors typically want to ensure they receive their investment back before common shareholders receive payouts. These rules can dramatically impact founder returns during an exit, making it essential to review them with great care.

Anti-Dilution Clauses

Investors sometimes request protections to maintain their ownership percentage in the event of future fundraising rounds at a lower valuation. This can include the right to buy more shares during subsequent rounds (pro-rata rights) or formula-based adjustments to their share price. These clauses can complicate a founder’s cap table and should be examined closely.

Redemption Rights

Some term sheets include language allowing investors to ask the company to buy back their shares under specific conditions. These rights may activate if the company has not reached certain milestones or failed to deliver on projected timelines. While founders can negotiate these terms, they should be aware of the pressures redemption rights may create.

No-Shop Clauses

A typical term sheet prevents the company from seeking competing investment offers for a set period. Investors use this to protect the time they spend conducting due diligence. The length of this period should be reasonable; overly long no-shop clauses can put founders at risk if investors delay or ultimately withdraw.

Expenses and Closing Timelines

Finally, many term sheets clarify who pays for legal or professional fees associated with the transaction. They also establish an expiration date for the agreement, often around one to three months. If a definitive contract is not completed within this timeframe, the term sheet expires.

Common Pitfalls Founders Should Avoid

Negotiating a term sheet requires a careful mix of strategy and understanding. Founders often fall into traps that later prove costly. One common mistake is accepting a valuation that seems appealing in the moment but ultimately sets expectations too high for future funding rounds. Another is giving away too much equity too soon, leaving little room for subsequent rounds or employee incentives.

A lack of clarity around clauses such as liquidation preferences, voting rights, and anti-dilution mechanisms can also lead to surprises later. Finally, founders sometimes fail to negotiate, either due to inexperience or fear of losing the investor. In reality, investors expect negotiation, and pushing for fair terms helps build a healthier long-term relationship.

Who Can Help You Draft a Term Sheet

Because term sheets blend financial strategy with legal detail, founders should work closely with legal professionals experienced in venture capital transactions. A lawyer familiar with local regulations ensures the document aligns with the laws of the relevant jurisdiction. This is particularly important because term sheet standards vary by region. A version suitable in one country may not be valid or enforceable in another. Skilled advisers can also help founders identify clauses that may limit control, introduce unnecessary risk, or create complications in the future.

Important Questions and Answers

What is a term sheet in simple terms?

It is a document summarizing the main conditions of an investment deal before binding contracts are created.

Is a term sheet legally binding?

Most parts are not binding, but clauses like confidentiality, exclusivity, and governing law may carry legal force.

Why do investors use term sheets?

They help organize negotiations and ensure everyone agrees on expectations before drafting final contracts.

How does a term sheet affect valuation?

It formally states the company’s valuation, which determines how much equity the investor receives.

What is the difference between pre-money and post-money valuation?

Pre-money is the value before investment; post-money adds the new capital to that figure.

What is equity dilution?

It refers to a decrease in a shareholder’s ownership percentage when new shares are issued.

How can founders manage dilution?

By monitoring the cap table, negotiating option pool size, and raising capital strategically.

Why are liquidation preferences important?

They dictate who gets paid first when the company is sold or closed.

What are protective provisions?

These are rights investors receive to influence major decisions and protect their investment.

What is a no-shop clause?

It prevents the company from seeking other investment offers during a set period.

Should founders negotiate term sheets?

Yes. Negotiating ensures a fair balance between investor protection and founder control.

Who should help founders with term sheets?

Experienced legal counsel specializing in venture deals.