An equity term sheet is a non-binding agreement that outlines the basic terms and conditions under which an investor will make an equity investment in a startup. It serves as the foundation for more detailed legal agreements and is crucial for setting expectations between founders and investors.

Main Points Covered in a Term Sheet

Valuation: This defines the pre-money valuation (the value of the company before the investment) and the post-money valuation (the value after the investment).

Investment Amount: The amount of money the investor is putting in.

Equity Stake: The percentage of the company the investor will own after the investment.

Type of Shares: The type of equity being issued, such as common stock or preferred stock, and their respective rights.

Board Composition: Details on how the board of directors will be structured post-investment, including who will have the right to appoint members.

Liquidation Preference: Specifies the order in which investors get paid in case of an exit or liquidation, often giving them priority over other shareholders.

Anti-Dilution Protection: Clauses that protect investors from dilution in future financing rounds, typically by adjusting their ownership percentage if new shares are issued at a lower valuation.

Voting Rights: The rights that investors will have in decision-making processes, including veto rights on key decisions.

Vesting of Founder Shares: The terms under which founders’ equity will vest over time, ensuring they remain committed to the company.

Exit Provisions: Details on how and when investors can exit their investment, such as through an IPO or acquisition.

What Startup Founders Need to Know

Non-Binding Nature: The term sheet is generally non-binding except for certain clauses like confidentiality and exclusivity. However, it sets the stage for final negotiations, so it should be taken seriously.

Understand Valuation and Dilution: Founders must clearly understand how the proposed valuation affects their ownership and control of the company.

Board Control: Be cautious about giving up too much control over the board, as this can affect decision-making power.

Liquidation Preferences: Ensure you understand how liquidation preferences work, as they can significantly impact the returns for founders and other shareholders in an exit scenario.

Vesting Schedules: Founders should negotiate vesting schedules that reflect their commitment and contribution to the company while protecting themselves from premature dilution.

Seed Round vs. Series Round Term Sheets

Seed Round:
Typically simpler and more founder-friendly.
May include fewer investor rights and simpler terms like convertible notes or SAFEs (Simple Agreements for Future Equity).
Valuation is often lower, with fewer structured protections for investors.

Series Round:
More complex, with detailed investor rights, protections, and governance structures.
Involves larger sums of money, higher valuations, and stricter terms.
More negotiation over board seats, liquidation preferences, and anti-dilution clauses.

Acceptable vs. Unacceptable Points

Acceptable Points:

Reasonable Valuation: Aligns with market standards and company potential.
Standard Liquidation Preferences: Typically 1x liquidation preference without participation.
Balanced Anti-Dilution: Weighted-average anti-dilution protection is standard.

Unacceptable Points:

Excessive Liquidation Preferences: Multiple liquidation preferences (e.g., 2x or more) can be detrimental to founders.
Full Ratchet Anti-Dilution: This can heavily dilute founders in future rounds.
Excessive Board Control: Investors demanding too many board seats or veto rights can stifle the founder’s ability to lead.

Conclusion

Founders should approach a term sheet with a clear understanding of its implications on their company’s future. Negotiating terms that protect their interests while also attracting investor support is key to long-term success. Understanding the difference between seed and series term sheets, and what is acceptable versus what is not, can help founders navigate this critical stage in their startup journey.