Early-stage founders have been known to often narrate their first term sheet in the same manner people narrate a foreign contract they unknowingly agreed to: I signed the contract because everyone else was doing the same thing and they seemed to understand it, so I indulged myself.’
One thing to always remember is that term sheets are not mystical legal scripts, as they are wrongly interpreted most times. They’re simply a roadmap, a negotiation document that defines the funding that will go into your company from an investor and what they stand to gain after investing. And because it is common for first deals to set the tone for every other negotiation that’ll happen in the future, having a clear understanding of this roadmap will prove vital in testing your mettle and defining if you will build a company with control, clarity, and leverage or if you’ll spend the next couple of years sorting out the mess from clauses you never quite understood.
A term sheet is one of the key moments in the early stages of a startup when it migrates from an idea with potential to a company that’s committed to its institution. It’s also one of the most misunderstood documents in early-stage fundraising.
Certain times, founders make the mistake of confusing it with a full contract or assuming that as soon as they sign the contract, it’ll immediately guarantee them a long-term commitment. While in reality, a term sheet is mostly non-binding, except for a few clauses. It defines the suggested structure of the deal, and not all the final legal details.
Irrespective of that, a team sheet is powerful because it signals the start of everything: your shareholder rights, your board structure, your founder vesting agreement, and your ability to raise future funding.
Understanding the distinction can aid you in differentiating between a fair offer and another one that’ll compromise your control silently. It can also help you evaluate alternatives; examples include figuring out whether a safe agreement is better than a price round or if you should put a preferred equity term sheet over a more flexible structure.
This article dissects term sheets in plain English, gaining insight from credible sources like WilmerHale, MIT OpenCourseWare, Morgan Lewis, Orrick, and SEC filings to ensure accuracy.
It’s penned for founders who do not possess a legal degree, don’t want to be patronized, and are only after what matters, excluding the jargon. It also dissects the essentials of a term sheet in an easy, friendly language that’ll be easy for founders to grasp. It’ll be easy to ask the right questions, properly negotiate equity in a startup, and also learn to avoid the commonly made mistakes that stop many founders from building durable, fundable companies.
At its core, a team sheet is best defined as a summary.
According to MIT’s Early-Stage Capital Course, the main purpose of its existence is to outline key terms before legal costs escalate. This is a practical checkpoint before both sides will delve into spending weeks trying to draft the final agreements.
A typical preferred equity term sheet includes:
It’s a framework and not a contract. Regardless, that framework is vital in determining nearly every important decision you’ll make later.
Having a grasp of the difference is important, especially when it comes to comparing agreements (e.g., shareholder agreement vs. bylaws), because each branch oversees different areas of your rights as a founder.
Every term sheet comes down to two aspects:
* Board composition
* Voting rights
* Protective provisions
* Drag-along clauses
In a 2020 memo from Morgan Lewis, partners buttressed the fact that founders often put too much focus on valuation and too little focus on governance. And the latter is a major determining factor in the founder’s real power post-financing.
A slightly lower valuation with better control will lead to a much healthier company most times.
A question most founders always have is whether they should raise using a SAFE (Simple Agreement for Future Equity) instead of entering negotiations for a full-priced term sheet.
A SAFE:
YC’s SAFE guide famously defines a SAFE as a way to put money into a startup without considering the price.
Google’s safe agreement PDF is a go-to for founders when they want to compare versions, but it is crucial to pull the official versions from Y Combinator’s website and not from random templates.
A preferred equity term sheet, by distinctiveness, sets valuation today and welcomes the introduction of more structure. There is no universally better choice. The right choice is dependent on speed, leverage, and market conditions.
Investors will always want to make the smart decision of making sure that the founders who get their money stay committed. And this is where founder vesting agreements come in.
Common structures:
Reverse vesting simply means that if you decide to leave the company, some of your personal shares will go back into the company’s pool.
According to WilmerHale’s financing guide, a lot of VCs consider vesting as a non-negotiable option because of the protection that it provides the company from early departures.
It is important for founders not to see vesting as punishment for leaving but rather as alignment. Because if you’re fully committed to the company, vesting simply formalizes that.
Negotiations are all about clarity, and they do not need to be hostile.
There are a couple of key questions that every founder should ask:
Excessively harsh liquidation choices or stacked anti-dilution clauses can chase future investors away.
If your board is controlled by a 2-1 investor in a seed round, then that’s a potential red flag.
This includes:
* GTM guidance
* Hiring help
* Follow-on capital potential
* Operational expertise
A friendly piece of advice that always pops up from
Amplify Partners, Orrick, and early-stage investors are quite simple to understand: do not make negotiations about valuation in isolation. The terms surrounding the valuation often matter more.
Below are the sections that appear in almost every credible term sheet, explained simply.
Common: 1x non-participating; this means that the investor is going to get their money back.
Protects investors if the next round is at a lower valuation.
When the weighted average is standard; the full cycle is rough on founders.
A 2-1 founder-friendly board is common at seed.
Right of First Refusal (ROFR): This simply means that investors can buy shares before the general public can.
This is a clause that states that if the majority of shareholders sell their shares, everyone else must sell. This facilitates exits.
Going through several public SEC term sheets, a regular theme emerges: founders often disregard how long certain clauses can alter the company’s future.
Some of these common founder blind spots include:
These are terms with consequences in the real world and they’re consequences that many founders only come to terms with during an exit event.
To wrap up, term sheets weren’t created to be intimidating. But because it demands clarity, founders are required to approach term sheets with curiosity, a willingness to learn, and the necessary questions until they understand every clause.
Having a clear understanding of the difference between a preferred equity term sheet, a SAFE, and a shareholder agreement vs bylaws will give founders the advantage to make negotiations from a solid place. Being knowledgeable in making negotiations about equity in startups isn’t about milking investors; it’s about creating conditions that’ll help the company have sustainable growth in the long run.
The founders who maintain healthy relationships with their investors and raise several rounds are rarely the ones who win the negotiating battle. They’re the ones with a clear understanding of the negotiation process, and that’s why they’re most successful.
Term sheets are a form of commitment and discipline. They compel both sides to shed light on their expectations. Founders are expected to go over them carefully, ask questions about what they don’t understand, and ensure that the terms you’ll sign will still serve you when you’re raising your Series A or planning an exit.
Your first term sheet won’t define your startup. But the transparency that it produces will shape everything that comes next.