How to negotiate your term sheet as a founder

If you’re fundraising for your company, the first document you’ll have to negotiate will be a term sheet. It’s a document that sets out the key terms of what you and your investor have agreed. It gets you thinking about what you both want the final deal to look like.

In this article, we’ll explain the key elements of a term sheet. Plus, we’ll go over how you can negotiate it to protect your own rights without falling out with your investors.

What is a term sheet?

A term sheet outlines the key terms of the investment in your company. It’s not legally binding, but it is still important. That’s because it’s used as the base for the final (more detailed) legal documents to be written. The point of a term sheet is to make sure both parties agree on the key elements of the deal. Plus, it’s usually legally binding in relation to keeping information private (“confidentiality”) and not seeking other offers (“no-shop”).

Why do I have to negotiate the term sheet?

The term sheet sets out the terms of the investment in your company. What goes in there can have a huge impact on things like how your company is controlled, what happens if it’s sold and other things like that. So, you need to make sure it aligns with your company’s goals and protects your interests.

It isn’t legally binding – but once it’s agreed, you don’t want to go back on what’s in there without special circumstances (that could damage your relationship with your investors). Plus, the term sheet negotiation stage lets you show your investor that you understand the priorities for your business and how to achieve its full potential.

What are the key clauses in the term sheet?

Term sheets can get pretty lengthy and detailed (you can download the term sheet from the National Venture Capital Association if you want to have a look at one).

In this section, we’ll explain the most important terms you’ll want to focus on at this stage.

These are the seven key clauses you’ll want to make sure you get right. You might not see all of them in your term sheet if they’re not relevant to your situation (for example, if you’re only raising funds from angel investors, they probably won’t expect a board seat).

Pre-money valuation

This is the value of your company before any new investment is added – it determines how much of your company you’ll give up when raising the amount you want.

For example, if your company’s valued at $10 million pre-money and you raise a $2 million financing round, the post-money valuation would be $12 million, meaning the investor receives a 16.67% stake in your company (2 million ÷ 12 million = 16.67%).

But if your pre-money valuation was $5 million, and you raised the same $2 million financing round, the post-money valuation would be $7 million, and the investor would receive 28.57% of your company (2 million ÷ 7 million = 28.57%).

That’s exactly why valuation is so important.

Make sure the valuation you’re giving accurately reflects where your company is now and where it could realistically go. Pushing for an overly high valuation might seem beneficial, but it could complicate future funding rounds. For example, if you have to lower your valuation in the future, it’ll be harder to get funding (also, read the “Anti-dilution provisions” section below).

Liquidation preference

Liquidation preference determines the order and amount investors are paid back if your company’s sold, goes public or is otherwise liquidated (like if it went out of business).

For example, let’s say an investor has a “1x non-participating liquidation preference” on a $1 million investment. This means that, on a liquidation, they can either take their $1 million first, or convert their preferred stock to common stock and take their share of the remaining proceeds.

So, if your company’s sold for $5 million, the investor can choose to receive their $1 million upfront, with the remaining $4 million then divided among the common stockholders (as a founder, you’d usually be a common stockholder). But if converting to common stock would give them more than $1 million, they would choose that option instead.

In most early stage investment rounds, venture capitalist (VC) investors would want a 1x non-participating liquidation preference to give them some protection on their investment. Avoid giving more than a 1x liquidation preference, as that could give you a lower return on an exit of the company.

Board of directors (and voting rights)

The board of directors make key decisions on how the company’s run. And if an investor’s on the board, they may be able to influence these decisions.

If you’re getting investment from a VC, they’ll typically want a seat on the board – they’ll want to have a say in how their money is being used. But for angel investors, it’s unlikely you’ll need to give them this level of control.

Anti-dilution provisions

Anti-dilution provisions are designed to protect investors from losing value in their stock if the company issues new stock at a lower price in future rounds (called a “down round”).

For instance, if a future fundraise takes place at a lower valuation, an investor with anti-dilution provisions could convert their preferred stock into more shares of common stock to top them up. There are different types of anti-dilution provisions which determine how much stock an investor would receive:

• Weighted average anti-dilution: This gives protected investors shares calculated based on both the number of new shares issued and the price at which they’re issued. It’s more balanced between protecting investors while not excessively punishing founders and common stockholders. If anti-dilution provisions are ever requested by investors, this is typically the most common type. “Broad-based weighted average” includes a larger pool of shares in its calculation and is generally more founder-friendly because it results in less dilution for the founders. On the other hand, “Narrow-based weighted average” considers a smaller pool of shares and tends to be more investor-friendly as it provides greater protection to investors by resulting in more dilution for the founders.
• Full ratchet anti-dilution: This calculates the number of shares the investor receives by looking at the price of the new shares issued in the down round – regardless of how many new shares are issued. It’s less founder-friendly than weighted average as it heavily dilutes founders and existing common stockholders. Full ratchet anti-dilution is very rare in early stage fundraising.

So, if your investors push for anti-dilution provisions, try to give broad-based weighted average anti-dilution rights – these will be the least damaging to you and future investors in a down round. Fortunately, they’re also most common in the market.

You should also watch out for “non-dilution” provisions – they might sound like anti-dilution, but they’re not! If an investor gets a non-dilution clause, their ownership percentage stays the same no matter what, even after future fundraising rounds. So, if they start with 10%, they’ll get extra shares in the future to keep that 10%. You should never give this to any investor at any stage. It can make it tough to raise more money because new and existing investors would have their ownership diluted as you’d have to give ‘free’ shares to the non-dilutable investor – and they won’t be happy about that.

Founder vesting

Founder vesting requires that you ‘earn’ your equity over time rather than owning it all upfront.

“Vesting” is shorthand for “reverse vesting.” You technically own all your shares from the beginning, but if you leave the company during the vesting period, you must transfer the unvested shares back to the company. So, if you leave the company, you’ll only own the shares you’ve earned (“vested”) by that time. This is to ensure that founders are incentivized to stay with the company for the long haul.

The period over which your shares vest is called the vesting schedule. For example, the market standard vesting schedule is described as “a four year monthly vesting period with a one-year cliff”. This means you would earn 25% of your shares after one year (that’s the “cliff”), with the remaining shares vesting monthly over the next three years. So, if you left the company after two years, you’d only keep 50% of your shares.

To the extent your shares aren’t already subject to vesting, founder vesting may be included in VC term sheets. Vesting isn’t designed to keep your shares away from you – it’s to give your investors confidence that you’ll stay at the company. You can try to make your vesting period as short as you can. Or, if you’ve already spent a lot of time on the company, you can ask for the vesting start date to be in the past. What’s most important is that you understand how your shares will vest over time.

Protective provisions

Protective provisions give your investors the right to block certain company decisions.

For example, if you wanted to raise more money or change your company’s bylaws, you might need investor approval, which could mean you might be delayed or even refused.

You should only agree to these where it makes sense to give the investor control over major company decisions. If you give away too many of these rights, you won’t have the flexibility to decide how to run the company. In a VC deal, you’ll probably need to agree to some protective provisions. But if you think any of them would interfere with your ability to run the company efficiently, you should explain this and ask to have them dropped.

No-shop and confidentiality

The no-shop clause restricts you from looking for other investment offers after signing the term sheet. And the confidentiality clause means you have to keep what’s in the term sheet private. These are usually the only two clauses that are legally binding in a term sheet.

Once you sign the term sheet, you won’t be able to consider offers from other investors for a set period (usually between 30 and 90 days). It effectively locks you into negotiations with the current investor.

Try to keep the no-shop period as short as possible – ideally 30 to 45 days – to avoid being locked out of other opportunities for too long, and to incentivize your investor to close quickly. Also, the confidentiality clause won’t stop you sharing term sheet details with your lawyers – so get advice if you think you need it. Some term sheets might also include a break-up fee that you’ll have to pay the VC if you breach the no-shop clause. But these aren’t common in early stage fundraisings.

How do I negotiate the term sheet?

Negotiating with angel investors

Angel investors are typically individuals or small groups who invest their own money in a company (they’ll usually invest less than VCs). They are more focused on the relationship with the founder and the vision of the company rather than strict financial metrics.

Usually, angel investors want a simpler deal structure. They won’t want to discuss all the key terms – but there might be some negotiation on some things (like valuation). Their priority is generally to invest their money, hoping for a financial return and to get favorable tax treatment (check out our guide on how investors can save millions in tax on their startup investments).

When raising from angel investors, you should try to send them the term sheet – meaning you’re in the driving seat. And you can create your term sheet on the SeedLegals platform.

Negotiating with VCs

VCs are funds that are typically investing other people’s money, which means the negotiation will be much more structured and formal.

They’ll want to discuss all the key terms we’ve covered and more – things like liquidation preferences, board composition, and anti-dilution clauses. This leads to more detailed (and longer) term sheets.

When negotiating with VCs, you’ll probably have less flexibility on key terms (for example, they’ll almost certainly want to join the board). VCs are generally more concerned with the company’s scalability, market potential, and exit strategies – and they’ll want you to be able to discuss these aspects of your company with them.

When raising from VCs, they’ll usually send you their term sheet first, which you can then start to negotiate. Once you’ve agreed to the term sheet, you can input the terms into the SeedLegals platform which will then generate all the documents you need for the funding round, ready to share with the investors for signing.

Do I need a lawyer to negotiate the term sheet?

If you’re negotiating the term sheet yourself, there’s a risk if you don’t fully understand what you’re agreeing to. That’s why we write guides like this – to help you cut through the jargon and understand what these terms really mean.

However, even though a term sheet isn’t legally binding, you don’t want to backtrack on what you agreed at this stage (it could damage your relationship with the investor and slow down the deal). To avoid this, it’s a good idea to seek legal advice, making sure you’re fully informed before committing to any terms.

As well as having the direct support of our team, and the ability to engage a lawyer via our platform, when you create your term sheet on the SeedLegals platform, you’ll see built-in guidance and data-led expert insights as you go along. So, you’ll know what other startups have agreed at this stage (this data will help you negotiate more effectively).

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