A term sheet is the starting point for negotiations between founders and investors in a priced funding round. It’s a document that summarizes the key terms of a potential deal, including a startup’s valuation, the proposed investment amount, liquidation preferences, pro rata rights, no-shop periods, and more. Most of the terms aren’t legally binding, but they signal an investor’s intent to provide funding.

Below, we’ll discuss what a term sheet is, key terms you might see in one, how the negotiation process works with investors, and how a term sheet differs from a Simple Agreement for Future Equity (SAFE).

Key takeaways

• A term sheet is a nonbinding summary of the key terms an investor proposes for a priced financing round. It serves as the starting point for negotiations between investors and founders before the agreement is finalized.

• Liquidation preferences, antidilution provisions, and board seat allocation can affect a founder’s economic interest, decision-making power, and control over the business’s direction beyond the initial funding round.

• After negotiating and agreeing to the terms, investors will complete their due diligence before the legal documents are drafted and signed by all parties and the funding round is closed.

• Established startups generally use term sheets because they require founders and investors to agree on a company’s valuation, governance, and ownership rights. Preseed and seed startups typically use SAFEs because they’re faster and cheaper than term sheets and don’t require the parties to agree on a valuation.

What is a term sheet and why does it matter?

A term sheet is a nonbinding outline of the key terms an investor proposes for a financing round. It serves as the starting point for negotiations between investors and founders before legal documents are drafted to finalize an agreement for a priced funding round. Most of the provisions—including the proposed valuation, protective provisions, and antidilution rights—aren’t legally binding. However, some clauses (e.g., confidentiality, no-shop periods) can be enforceable once all parties sign the document.

What are the key terms founders should understand?

The terms you might see in a term sheet can vary, but common ones include the following:

• Valuation: The parties agree on how much the startup is worth before the investment (premoney) and how much it’ll be worth after receiving investor funds (postmoney).

• Investment amount: Investors disclose how much funding they’re willing to provide. A term sheet could also stipulate how long investors must stay invested before they can sell their shares.

• Liquidation preference: If a company is sold, dissolved, or goes public, liquidation preferences dictate the order in which investors, founders, and employees get paid and how much money they receive. This provision generally helps protect investors if the company fails or sells for less than expected and there isn’t enough money to repay everyone.

• Pro rata rights: These rights give current investors the opportunity to participate in future funding rounds before a startup brings in new investors. Existing investors aren’t required to invest in future rounds, but exercising their pro rata rights allows them to maintain their ownership stakes and helps prevent dilution of their investments.

• Antidilution rights: When subsequent funding rounds occur at a lower valuation (these are known as “down rounds”), earlier investors’ shares are worth less than they would be during a fundraising round that occurs at a higher valuation. Antidilution rights help investors minimize losses and maintain more of their ownership stakes.

• Board composition: The people you appoint to your startup board control the day-to-day operations and future decision-making for the company.

• Protective provisions: Preferred shareholders can stop a startup from taking certain actions, such as initiating a liquidation event and starting a new fundraising round. Investors frequently receive preferred shares of stock, and protective provisions allow them to block activities they don’t agree with.

• No-shop period: No-shop periods prevent founders from talking to new investors, which can inhibit a startup’s ability to raise funds. The length of no-shop periods typically ranges from 30–60 days.

• Confidentiality: All parties involved in the negotiation agree not to disclose the potential terms of the deal and keep all sensitive and proprietary corporate information private.

• Founder vesting schedule: This schedule outlines when shares awarded to founders will vest. Investors might want longer timelines to increase the likelihood that the original founders will stay involved in the company. Founders could be more successful in negotiating a shorter vesting schedule, including having a portion of shares vest as soon as the funding round closes, if they can show that their business has the potential to deliver strong returns.

Which terms can most affect founder control and dilution?

When you negotiate the terms of a deal, you’ll want to pay particular attention to the items that can affect your financial interest and decision-making power.

Liquidation preferences

Liquidation preferences determine the order in which shareholders get paid in the event of a liquidation or sale of the company and how much they receive. Because investors typically receive preferred stock, they usually get paid first in an exit. However, the amount they receive before common shareholders depends on how their liquidation preferences are structured.

When an investor holds a nonparticipating liquidation preference and there’s a liquidation event, they can either get paid out according to their liquidation preference (plus unpaid dividends) or convert their preferred shares to common stock and sell them at the share price. Liquidation preferences are often expressed as a multiple (e.g., 1x, 2x, 3x) of the original investment.

For example, in exchange for $10 million in funding, an investor might receive a 25% ownership stake in a company and hold a 1x liquidation preference. If the startup is sold for $35 million, the investor can choose between recouping their $10 million investment or converting their shares to common stock and getting 25%, or $8.75 million, of the proceeds. Investors will select the option that provides the largest return.

With a participating liquidation preference, an investor gets their liquidation preference and they can exercise their pro rata rights. That means they also get to sell their ownership stake in the company before other investors get paid. Using the example above, the same investor would receive their initial $10 million investment back. They would also get 25%, or $6.25 million, of the remaining $25 million, for a total of $16.25 million.

Antidilution protection

Antidilution protection helps shield investors from losses that can occur when a startup raises funds at a lower valuation than in previous fundraising rounds. However, the more protection there is for investors, the less there is for founders and employees. How these terms are negotiated can affect the future ownership stakes of founders, investors, and employees, as well as a startup’s ability to raise funds in future rounds.

Board seat allocation

Board members have the power to make major decisions about your company, including when to raise another round of funding, whether to amend the charter, whether to launch a new product, and more. Maintaining a balance between founders, investors, and independent members helps ensure you can take advantage of investor experience, expertise, and connections that can help your startup grow, without shifting too much control from the founders to investors. Allocating too many seats to investors could give them the power to vote founding members out of the company.

Term sheet negotiations are about more than just your immediate need to raise funds. They also represent your startup’s long-term funding and business goals. Because the terms you negotiate today can set a precedent for future funding rounds, it’s worth working with a lawyer who specializes in helping startups. This can help protect your economic interest and decision-making power.

How does the term sheet negotiation process work?

After you receive the initial term sheet, you’ll work with the lead investor to finalize the terms before you draft the contract. You probably won’t need to negotiate every point, so consider focusing on the ones that have the most impact on your financial interest and control of the company (e.g., the board composition, antidilution provisions, pro rata rights, and other protective provisions).

When all parties have agreed to the terms, the founders and investors sign the term sheet. Investors then complete their due diligence, which frequently includes a review of financial statements, legal structure, intellectual property (IP), customer contracts, and team credentials. Then, the legal documents are drafted. When the contract is signed, the funding round is formally closed and the investors transfer the funds to the startup.

Term sheets for priced rounds vs. SAFEs: What’s the difference?

The main difference between a term sheet and a SAFE is that a term sheet requires investors and founders to agree on a company’s valuation, governance, and ownership before the funding round can be completed, while a SAFE doesn’t. Term sheets are generally reserved for established startups because they include more detailed and complex terms that typically require negotiation and can extend the time it takes to reach an agreement.

A SAFE is simpler than a term sheet because it relies on only three major terms: valuation caps, discounts, and most-favored-nation (MFN) clauses. This allows preseed and seed startups to quickly raise capital before the first priced round. A SAFE is the most common instrument for early-stage US startups because it’s faster and cheaper than a term sheet.

What’s a simplified example of how to read a term sheet?

Here’s an abbreviated version of a term sheet template that shows the key terms an investor might propose.

In this example, after investing $20 million, a venture capital firm has a 20% ownership stake in the company and a nonparticipating liquidation preference. This provides downside protection to the investors and upside protection to the founders and employees.

Changing the liquidation preference to 2x or 3x the original investment or shifting it to a participating preference would provide the investor with more upside potential. However, it would increase the likelihood that founders and employees wouldn’t receive a payout if the company failed or sold for less than expected.

With an equal number of founders and investors on the board, the independent member has the power to cast the tie-breaking vote. The stage of the startup generally dictates board composition. In earlier stages, board composition often favors founders, but in later stages, control shifts toward investors.

Comparing terms against typical benchmarks for the round’s stage and size can help you determine how reasonable the proposed terms are and identify areas where it makes sense to negotiate before signing.

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FAQs about term sheets