What Startup Founders Need To Know About Term Sheets From Sophisticated Angel Investors & VCs

March 2024
Author: Andrew (Drew) Piunti

A startup’s receiving its first term sheet is generally an important early milestone. And while investor term sheets are not generic, they are designed to protect the investor’s investment – not the company. So, it is not uncommon for founders and sophisticated investors to diverge on what the investment should look like.

Because term sheets are largely non-binding, the investment occurs only if and when the parties agree on definitive deal documents. Those documents are supposed to reflect with detail the term sheet’s high-level expression of items – such as, “the holders of Series Seed shall receive customary restrictive covenants.” There is nothing wrong with a term sheet’s short-hand expression; this is its purpose.

But what founders wants to avoid is agreeing unwittingly to a term sheet that bakes in a materially imbalanced right. Having already agreed in principle to the provision under the term sheet, the founder may or may not be unable to ratchet that item back after it retains counsel to review the definitive documents – as presented by the investor – and advises of its full implications.

In our experience, imbalanced deal terms arise most often when a first-time founder negotiates the deal’s economics him-or-herself, glosses over the rest, and retains us as corporate counsel after—not before—he or she signs the investor’s term sheet.

Beyond valuation and deal economics

When considering a term sheet, valuation and deal economics are naturally at the forefront of the founder’s focus, and, consensus on pre-money valuation can be challenging to achieve. This is why very early investments sometimes defer pre-money valuation through use of the startup community’s alternative to what used to be the convertible note, the so-called simple agreement for future equity (Safe).

So, while pre-money valuation is important, founders—in Series Seed rounds in particular—can overemphasize it to the exclusion of other provisions, not always appreciating that a savvy investor may be able to “undo” through those other provisions much of what the founder thought he or she gained on the startup’s valuation.

While sophisticated investors certainly expect a valuation that secures a big enough piece of the company to justify the investment, they are just as keen on provisions that lock in their liquidation rights, protective provisions, and management rights. These are the provisions, often expressed in shorthand, intended to get the investors paid back first in a down-side scenario, mitigate their investment’s being diluted by future investment rounds or equity grants to employees, block others from achieving liquidity ahead of them, secure a way to get their money back in as many scenarios as possible, and, importantly, ensure material participation in the startup company’s decision making process—including controlling certain founder behavior. This can include investor designees on the company’s board being given an effective veto over certain company agreements—including debt transactions, executive salaries, option awards, and others. It can also include requiring separate investor approval, often by super-majority vote, in order for the company to buy or sell material assets or issue future rounds of stock.

Achieving a fair financing round is facilitated when one knows which, and to what extent, the investor’s proposed rights and protections are customary and the degree to which each is likely negotiable. Many of these items are best addressed, modified, or eliminated at the term sheet stage at risk of losing the opportunity to do so effectively later.

Experienced founders avoid giving short shrift to any provision in an investor’s term sheet, which is why they tend to consult with corporate counsel, if not before, upon receipt—and definitely not after—signing a term sheet.