Evaluating term sheets: What every founder needs to know

A term sheet is a pivotal document in securing investment for your startup. It outlines the key terms and conditions of the deal, serving as a precursor to a legally binding agreement. Founders must carefully evaluate term sheets to ensure alignment with their business goals and long-term vision.

1. Understand valuation and ownership

Key considerations:

• Pre-money valuation: The company’s valuation before the investment.
• Post-money valuation: The valuation after the investment, reflecting the new ownership structure.
• Equity dilution: Ensure you understand how the investment impacts your and other stakeholders’ ownership percentages.

Founder tip:

Compare the proposed valuation to industry benchmarks and your startup’s growth potential. For instance, a pre-money valuation of $5M might sound appealing but could lead to excessive dilution if you’re raising a small round.

2. Assess control and decision-making rights

Key considerations:

• Board composition: Check if investors are demanding board seats.
• Voting rights: Understand what decisions require investor approval, such as hiring executives, raising new rounds, or selling the company.

Founder tip:

Ensure the control dynamics support your ability to make day-to-day decisions while giving investors enough confidence in your leadership. For example, if an investor demands two board seats on a five-member board, you could lose strategic control.

3. Examine liquidation preferences

Key considerations:

• 1x liquidation preference: Investors get their money back first before other stakeholders.
• Participating preference: Investors get their money back and then share in the remaining proceeds.

Founder tip:

Negotiate for non-participating preferences where possible to ensure fair distribution during exits. A participating preference could significantly reduce founder payouts in an acquisition.

4. Review anti-dilution provisions

Key considerations:

• Full ratchet: Adjusts share prices for investors to maintain their ownership during down rounds.
• Weighted average: A more founder-friendly approach that mitigates investor losses without excessive founder dilution.

Founder tip:

Push for weighted average anti-dilution clauses to protect your equity in case of a down round.

5. Understand investment timelines and tranches

Key considerations:

• Upfront investment: Entire investment delivered at once.
• Milestone-based tranches: Funding tied to achieving specific goals.

Founder tip:

If the investment is tranche-based, ensure milestones are clear and achievable. For example, tying funding to “revenue growth” might lead to disagreements unless it is quantified.

6. Beware of restrictive clauses

Key considerations:

• Drag-along rights: Allow majority shareholders to force minority shareholders to sell.
• No-shop clause: Prevents you from seeking other investment offers during negotiations.

Founder tip:

Ensure clauses like drag-along rights and no-shop agreements don’t undermine your leverage or create unnecessary risk for existing stakeholders.

7. Negotiate exit expectations

Key considerations:

• Exit timeline: Investors may expect an exit within a specific timeframe.
• Preferred exit strategies: Check if the investor prefers acquisitions, IPOs, or other liquidity events.

Founder tip:

Align with investors who share your vision. For example, some investors prioritize quick exits, while others may support long-term scaling.

8. Seek expert advice

Key considerations:

• Legal counsel: Engage an experienced startup lawyer to review the term sheet.
• Mentor or advisor input: Leverage experienced founders or advisors for insights.

Founder tip:

A lawyer specializing in startup deals can identify red flags and help you negotiate better terms. Don’t hesitate to ask mentors about their experiences with similar term sheets.

9. Think beyond capital

Key considerations:

• Value-add from investors: Look for investors who offer strategic support, industry connections, or mentorship.
• Follow-on funding potential: Check if the investor has a track record of supporting startups in future rounds.

Founder tip:

An investor offering market insights and network access could be more valuable than one offering only cash.

Summary Checklist for Founders

By meticulously evaluating term sheets and negotiating key terms, founders can secure the best outcomes for their startups while maintaining control and alignment with their vision.