Negotiating startup term sheets: Fuel to successful funding

In 2023, a staggering 4.73 million new business applications have been filed, per the US Business Formation Statistics (BFS). Now, if you’re a part of this wild wave of fresh-faced entrepreneurs with a genius idea and a killer pitch deck, you know the importance of a successful funding round. 

Startup term sheets fuel this journey of funding from “Eureka!” to “Show me the money.” 

Here’s what our client SaaS Alerts, a leading cybersecurity platform, has to say about these documents:

Let’s review the term sheet definition and how to safeguard your team’s interests while negotiating with top-tier investors.

What is a term sheet?

Akin to the roadmap of a business deal, a term sheet is a non-binding legal agreement that lays out the key terms and conditions of a potential investment. When you’re raising money for your B2B SaaS startup, investors use this document to outline the key points of their offer, such as:

• How much money is on the table
• What the investors get in return
• What are the rules of investment 

Generally used during seed fundraising or the Series A round, term sheets are the first formal declaration of an investor’s interest in your company. 

During startup investment term sheet negotiations, you typically agree not to engage with other investors at the same time. Once you settle the final conditions, a formal legal contract is drafted by lawyers to formalize the agreement.

Example of a term sheet for startups

Over time, term sheet templates have adopted a standardized format, providing a framework for both startup founders and investors. This standardization alleviates the burden on founders, offering them a clear understanding of what to expect from venture capital (VC).

The two prominent examples of startup term sheet formats are:

1. Y Combinator term sheet template 

One of the first startup accelerators, Y Combinator offers a standard, single-page term sheet template based on their experience of nurturing thousands of companies. This template is tailored primarily for Series A funding.

Here are the basic elements of Y Combinator’s term sheet template:

2. NVCA term sheet template

The National Venture Capitalists Association (NVCA) offers an advanced template of a term sheet for investors, backed by a database of over 100,000 transaction histories. Their template enables investors to draft proposals while comparing them to current market trends, leveraging insights from various NVCA database members.

Here’s a sample of the first page of NVCA’s term sheet template.

Importance of a term sheet for startup founders

A study found that 47% of startups failed in 2022 due to a lack of financing and investor interest. A well-negotiated term sheet helps founders deal with this challenge by paving a mutually beneficial partnership with investors (e.g., Insight Partners, Sequoia Capital and Y Combinator). 

Carefully reviewing and storing this document in the data room for investors helps you in the following ways:

• Clarification of intent: Investors have diverse ways of engaging with startups, ranging from acquisitions to regular equity funding rounds. The term sheet clarifies the underlying intent, as these engagements have different implications for the startup’s ownership structure, strategic direction and overall trajectory. 
• Legal protection: While the investor term sheet is not a definitive agreement, it lays the foundation for legally binding documents. It safeguards the interests of startup founders by clearly defining terms and conditions, reducing the risk of misunderstandings or disputes during the subsequent stages of the investment process.
• Negotiation framework: Navigating the negotiation process is complex, especially for early stage startups seeking seed funding. A term sheet provides a structured negotiation framework by outlining critical elements such as valuation, investment amount and governance rights. This approach fosters a more transparent and efficient exchange of ideas and expectations.

How to read term sheets for startups (AKA how to not get screwed)

Understanding the key elements of startup term sheets can be the difference between a fair deal and, well, getting “screwed.” So, fasten your seatbelts, as we go beyond the meaning of term sheets so you don’t get stuck with the short end of the stick.

To begin with, the document covers two fundamental aspects of any funding round:

1. The investment aspect: Encompassing terms and conditions related to fund distribution, liquidation scenarios and exit procedures.
2. The ownership aspect: Governing the degree of ownership and participation shared between the startup founders and the investors.

Economics

The clauses involving economics refer to the percentage of the company investors will own based on the company’s valuation and the amount of money invested. 

Pre-money and post-money valuation

Investors perceive company valuation from two angles: 

1. Pre-money is the estimated value of the startup before any external funding is injected. It includes the company’s existing assets, intellectual property and prior investments.
2. Post-money valuation is essentially the sum of pre-money valuation and the amount of new investment. In simple terms, it reflects the total value of the startup after adding external funding.

An example of pre-money and post-money valuation:

Pre-money valuation	VC investment	Post-money valuation	% Owned by VC investor	% Owned by founders
$10m	$5m	$10m + $5m = $15m	$5m/$15m = 33.33%	$10m/$15m = 66.67%

Both valuations contribute to aligning the interests of founders and investors. You need to strike the right balance between securing adequate funding and ensuring a reasonable level of ownership for yourself. An appropriate valuation sets a realistic foundation for the startup’s growth and makes subsequent fundraising efforts more achievable.

Liquidation preferences

Liquidation preferences outline the order in which various shareholders receive distributions in the event of a liquidity event, such as the sale or acquisition of a startup.

This provision is primarily for investors who own preferred shares. When a VC investor is issued shares of preferred stock, they get priority over common stock in receiving the distribution of assets. 

Founders should be cautious while negotiating this term and not agree to more than 1x returns in a dilution scenario. If the preferred stock has a 3x liquidation preference, the investors get triple their money back before common stockholders receive anything.

Dividends

Dividend provisions in a startup term sheet outline how and when a company will pay a portion of its profits to shareholders. There are two types of dividends:

1. Cumulative: These dividends benefit the preferred shareholders at the expense of common shareholders. If, for any reason, the company cannot pay these dividends in a given year, they accumulate and are carried forward to subsequent years. This accumulation continues until preferred stockholders receive the total amount of dividends or until the right to dividends terminates.
2. Non-cumulative: In this case, investors don’t receive any previously unpaid dividends. Founders prefer these dividends because of the greater flexibility in managing the company’s financial resources and prioritizing other aspects of business growth.

Option pools

Commonly called employee stock ownership plans (ESOPs), option pools are the stocks reserved for a company’s current or future employees. Startups use these plans to attract and retain employees. Because ESOPs are a part of the founder’s equity, increasing their number dilutes the founder’s capital. 

It is important to note that if your company is sold, the unissued ESOPs get canceled and investors share the sale proceeds proportionally with the founders — even though the options came from the founders. Hence, avoid creating a massive option pool to reduce the chance of unallocated equity.  

Investor rights

An investor right is a blanket term that requires focused legal consultation. The common investor rights include:

Right to exclusivity 

Suppose an investor has the right to exclusivity. In that case, for a specified period or under certain conditions, the startup cannot entertain investment offers or engage in certain transactions with other potential investors. 

This privileged provision allows the investor to secure additional ownership or involvement in the company without facing immediate competition from other investors.

Anti-dilution provisions

These rights safeguard investors from future stock issuances at lower valuations. In simpler terms, anti-dilution provisions kick in to adjust the investor’s ownership stake if a company issues new shares at a lower price than the amount the investor initially paid.

Pro rata rights

If the company decides to raise more capital, investors with pro rata rights can invest more money to prevent their ownership from being diluted. With these rights, investors maintain their percentage ownership in the company in subsequent financing rounds. 

Suppose an investor holds 20% of the company and the company decides to raise more funds.  With pro rata rights, they can invest enough to maintain their 20% ownership stake.

Conversion rights

Conversion rights allow an investor to convert their preferred shares into common shares. This conversion usually happens during specific events, such as an initial public offering (IPO).

Right of first refusal (ROFR) and approval of sale

If a shareholder intends to sell their shares, the existing shareholders with ROFR get the first opportunity to buy those shares at the specified terms. Along with an approval of sale clause in the investment term sheet, secretive transfers of stock are prevented, such as an investor selling your stock to a competitor. 

Here’s an example of how NVCA details ROFR in their template:

Governance and management

Addressing governance and management terms helps to create a fair and balanced structure that aligns the interests of all involved parties in a startup.

Voting rights

Voting rights in a term sheet define the shareholder’s right to vote on company policies. This clause divides voting rights across different types of shares (A, B, Preferred) and specifies the corporate actions requiring a majority vote. 

Voting rights determine who gets to make crucial decisions for the company. If you have more voting rights, your voice carries more weight in decisions.

Protective rights

Protective rights grant authority to investors to veto specific decisions, even those approved by the board of directors. This protection requires the consent of a certain percentage of preferred stockholders before proceeding. The two broad categories of protective rights are:

1. Standard protective provisions: These commonly accepted safeguards involve major events like:

• Selling the company: Investors often have a say in major transactions, such as selling the entire company, to account for investors’ interests when deciding on a change in ownership.
• Changing stock rights: Altering the rights associated with the company’s stock may impact the value and preferences of existing investors. For example, if a company decides to decrease the dividend rate on its stock, it will concern the investors relying on consistent dividends for income. To safeguard the interests of existing investors, investor approval is required before implementing proposed changes.
• Altering the number of shares: Any significant changes to the capital structure, such as issuing new shares or conducting a stock split, may require investor consent. This approval protects existing investors from dilution of their ownership.

2. Non-standard protective provisions: Some investors might seek additional safeguards beyond the standard ones. These could include: 

• Decisions about debt: Investors may want a say in decisions related to the company taking on debt, such as issuing bonds or taking loans. By having a role in such decisions, investors aim to ensure that the company’s financial structure aligns with their expectations and doesn’t pose undue risks.
• Executive changes: Investors may seek provisions that grant them a voice in decisions related to hiring or firing top-level executives (e.g., CEO, CMO). This reflects the importance of leadership stability and competence in the eyes of investors.
• Alterations to the business model: Changes to the fundamental way the business operates have significant implications for the company’s prospects and, consequently, for the investors. Venture capitalists may seek a say in major shifts in the business model to ensure that these changes are in line with their investment expectations. 
• Asset purchases: Investors look for approval rights over significant asset purchases such as other companies and intellectual property. They may want to ensure that these purchases align with the company’s strategic goals and do not unduly jeopardize their investment.

With enough negotiation power, startup founders can limit or eliminate many of the non-standard provisions.

Board seats

The board of directors is a crucial group representing shareholders’ interests in a company. They shape policies and make significant decisions. Post-funding, a balanced board often includes directors appointed by investors and founders, with an independent director for neutrality. 

Firms that invest significantly want more control over selecting the board members. Around 15% of VC investors with board seat privileges hold more than four seats, per PitchBook.

Losing control over the board could lead to losing control of your company, emphasizing the importance of vigilance in governance structures.

Founder vesting

These rights refer to the process through which founders earn ownership shares over time rather than being granted all at once. These vesting provisions ensure that founders remain committed to the startup’s success over the long term. If a founder leaves before fully vesting, the company retains unvested shares, creating an opportunity to find a suitable replacement.

You should negotiate vesting rights in a term sheet to accommodate your specific circumstances.

🏗️ As a startup founder, you will be wearing multiple hats including marketer’s. Learn how to build a B2B SaaS SEO strategy to gain online share of voice. 

Information rights

Under the right to information, you must regularly share the company’s financial status with investors through quarterly management reports and detailed annual financials.

Pitfalls to avoid in an investment term sheet

Dirty term sheets, filled with predatory provisions in the best interests of investors at the expense of founders, are becoming an increasingly common trend. 

For entrepreneurs navigating this path, here’s SaaS Alerts co-founder Charles Buck’s advice:

In this section, let’s unveil the potential pitfalls of dirty term sheets.

1. Redemption rights

The redemption clause allows investors to demand the return of their money within a certain amount of time. It has the potential to create a liquidity crisis for startups. 

While the clause might seem benign in certain scenarios, it becomes an issue when the startup grows and expands and the investor decides to pull back their funds. Management may find themselves in a tight spot, compelled to sell the company or hastily raise a rushed funding round.

The takeaway: Founders should approach redemption rights with caution, considering their potential impact on the company’s stability and growth trajectory.

2. Unnecessary fees

Unnecessary fees come in the form of board fees and monitoring fees. A board fee is a charge for an investor’s participation in board meetings, while a monitoring fee demands payment for overseeing investments. Such clauses are not only unfair but also unnecessary, with the potential to sour relationships with future investors. 

The takeaway: Founders should steer clear of these clauses, safeguarding their startup’s integrity and future investment potential.

3. Milestone based financing

In this investment model, the funding is conditional and split into parts. A certain amount is released at the start of a contract and the rest depends on achieving milestones. The investor can change the deal terms if your company doesn’t reach these goals. Sometimes, founders might not even get their funding until these goals are met.

The takeaway: While this clause is no longer common in term sheets, you should hold your ground if an investor suggests this type of financing.

4. Super pro rata rights

While pro rata rights allow investors to maintain their current ownership percentage, super pro rata rights give them the option to invest more than their pro rata share in subsequent funding rounds. This approach leads to disproportionate influence and ownership concentration in the hands of a single investor.

The takeaway: When negotiating term sheets, you should clearly define the extent of pro rata rights and ensure that they are reasonable and fair to all investors. 

🔎 Read our guide on how to use business traction to show your performance to investors.

You should also be aware of the following pitfalls:

Pitfall	Description	Example	Why it matters
Onerous liquidation preferences	Agreeing to aggressive liquidation preferences that favor investors over founders in exit scenarios	Imagine investors agree to put money in your company with a condition that, in the event of a sale, they get back a disproportionate share before you see any returns	Impact on founders' returns in sale events
Founder vesting terms	Ignoring or accepting unfavorable founder vesting terms	You and your co-founders may be required to stay with the company for a certain period before you fully own your shares	Unfair or excessively long vesting periods hinder the founder’s flexibility and motivation
Complex valuation terms	Agreeing to complex, vague or opaque valuation terms	The way your investors determine company's value might involve intricate formulas that are hard to understand	Complicated valuation structures lead to misunderstandings and disputes
Cumulative and payment in kind (PIK) dividends	Accepting terms related to cumulative or PIK dividends without understanding their impact	If you're receiving dividends in the form of additional stock, it further ties your financial gains to the company's valuation and performance	The company accumulates financial obligations and strains resources
Information rights	Overlooking implications of information rights granted to investors	Investors may have the right to access certain confidential information about your company	These obligations compromise confidentiality of your company's strategies and sensitive data

From term sheet to funding: Negotiate till death

In almost 500 words, a VC’s term sheet defines the critical terms of the investment, such as:

• How much your startup will be worth
• Who will control it 
• Who will earn maximum profit if the company is sold or goes public

While term sheets are negotiable, the final investment agreement typically follows the roadmap laid out by these documents. You must understand the sheet’s provisions to develop a robust negotiating strategy.

Put people before terms

Prioritize building positive relationships over focusing solely on the terms of the deal. Understand the motivations, concerns and goals of the investors.

Establishing trust and goodwill leads to more constructive negotiations. It fosters an atmosphere of collaboration, making it easier to find mutually beneficial agreements.

💡Learn how to close B2B SaaS deals with question based selling.

Get reliable legal assistance

According to CB Insights, 18% of startups fail because of legal and regulatory challenges. Engage legal professionals who specialize in startup investments and term sheets. These experts provide guidance and ensure the terms align with legal standards and your best interests.

Be a smart negotiator

Approach term sheet negotiations with preparation, strategic thinking and flexibility. Make a list of your priorities and the clauses where you can compromise.

Being a smart negotiator involves being well-informed, adaptable and focused on achieving your objectives. It ensures that you secure a deal that aligns with your startup’s vision and growth plans.

A cautionary tale of term sheet negotiations

As reported by CB Insights, Take Eat Easy secured a term sheet with a French state-owned logistics group for a 30 million euro investment. However, the company faced a setback during due diligence as, after three months of intensive scrutiny, the investor’s board rejected the deal.

This unexpected turn of events left Take Eat Easy without the anticipated investment, having negotiated exclusively with this investor and without a backup plan, highlighting the uncertainty that can arise even after reaching the term sheet stage.

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Frequently asked questions

Is there any AI software to help review a term sheet?

Yes. AI-powered contract review tools and platforms help to analyze legal documents, including term sheets. Kira Systems, Luminance, Dori and LawGeex are the top tools and platforms that might assist in reviewing a startup term sheet.

Are there startup-friendly legal services that can help with term sheet review?

Yes, there are several startup-friendly legal services to assist with term sheet reviews. The top options include UpCounsel, Priori Legal, SeedLegals and Rocket Lawyer. 

Do I need a lawyer or can I DIY the review of a startup term sheet?

In many cases, startups and entrepreneurs seek secondary advice, even if they have some legal knowledge because the stakes are high and the implications of the terms have a long-lasting impact on the business. Having a lawyer review the investor term sheet provides peace of mind and helps identify any potential pitfalls or areas that may need negotiation.

Can I get out of a term sheet agreement if I feel duped? 

Getting out of a term sheet agreement can be challenging and the ability to do so largely depends on the specific terms outlined in the agreement. While startup investment term sheets are generally considered non-binding agreements, some clauses may have legal implications.

Here are the top four factors to consider:

1. Non-binding language: While most terms are usually non-binding, sections such as confidentiality or exclusivity clauses may be binding. Review the language carefully to understand the legal implications of each provision.
2. Fraudulent misrepresentation: You can claim fraudulent misrepresentation if you believe you were intentionally misled or deceived during term sheet negotiation. 
3. Mutual agreement to terminate: If both parties agree, it may be possible to mutually terminate the term sheet.
4. Material adverse change (MAC) clause: Some term sheets include a MAC clause, which allows either party to back out of the deal if there is a significant negative change in the business or market conditions before the final agreement is signed. 

Do I need to sign a new term sheet for every round of funding?

Yes, a new term sheet is needed for each funding round in a startup. Each round represents a new stage, and terms may change based on the company’s progress. Negotiating and signing a new sheet for each round helps capture the specific terms and conditions for that investment stage.

Aditi Gupta

Aditi Gupta is a content writer with over three years of experience crafting content for diverse marketing channels – SEO blogs, leadership articles, social media and email copy. Skilled in writing conversion-optimized content, her storytelling approach focuses on addressing customer needs and leveraging data-driven insights. Apart from writing, Aditi can often be found reading hardcovers, sipping cold brew (even in -20°C Toronto winters) or exploring old bookstores. A self-proclaimed bibliophile, she can be found explaining how reading and collecting books are two different passions.