Term Sheets Decoded: What Founders Should Know Before Series A Funding

Term sheets are the first real test of a startup’s readiness for institutional capital. While nonbinding in most respects, term sheets outline the major deal terms for startup funding. They set the stage for valuation, control, and economic rights.

 

Founders who treat the term sheet as a formality or rush to sign one risk agreeing to conditions that may limit their flexibility, dilute their ownership, or create friction down the line.

 

The final article in Legal Basics for Startups: A Practical Series for Founders unpacks the key components of a Series A term sheet. It focuses on what founders need to understand before negotiating.

 

Valuation: Pre-Money, Post-Money, and the Stock Option Pool

The headline number in a term sheet is usually the valuation, but which one does it describe? Investors will likely refer to the pre-money valuation (the company’s value before the investment) and define how much capital they are putting in. This determines the post-money valuation (pre-money plus new investment) and the investor’s percentage of ownership.

 

One common mistake is ignoring the stock option pool adjustment. Investors often require the company to increase its option pool before closing. Investors will likely want that increase included in the pre-money valuation.

 

This means that while the investment appears to value the company at, say, $10 million pre-money valuation, a larger option pool lowers the effective valuation for the founders. Founders should model the impact and confirm whether the stock option pool is being “added in” before or after the valuation is calculated.

 

For example, imagine a term sheet with a $10 million pre-money valuation and a $2 million investment. If the investor requires a 10 percent stock option pool calculated in the pre-money, the founders—not the investor—absorb the dilution. That means $1.2 million worth of new options must be carved out before closing, effectively reducing the founders’ ownership. Had the option pool been added post-money, the dilution would have been shared more equally.

 

Liquidation Preferences: Downside Protection for Investors

Most venture investors receive preferred stock, which comes with economic rights that common stockholders do not have. Chief among these is the liquidation preference. A liquidation preference gives investors the right to get their money back before common shareholders receive anything in a sale, merger, or liquidation.

 

A 1x nonparticipating preference is typical at the Series A stage. This means the investor receives either their original investment amount or their pro rata share of the proceeds, whichever is greater, but not both.

 

However, some term sheets include participating preferred stock. This allows investors to take both the preference and their equity share, creating more dilution for founders.

 

Liquidation preferences become especially important in downside scenarios. Founders should clarify the terms and ensure they understand how proceeds would be distributed in various exit outcomes.

 

Anti-Dilution Protection: Safeguards Against Down Rounds

Anti-dilution provisions protect investors if the company issues new shares at a lower price than the investor paid. The most standard version is broad-based weighted average protection, which adjusts the investor’s conversion price to account for the lower-priced round.

 

Less common, and more aggressive, is the full-ratchet anti-dilution provision, which resets the investor’s price to match the lowest price issued regardless of how many shares are involved.

 

Founders should push for broad-based weighted average if anti-dilution protection is required and avoid full-ratchet provisions where possible. While these terms rarely affect high-growth companies, they can significantly impact ownership and valuation during tough fundraising periods.

 

Board Composition and Voting Rights

Institutional investors will usually request a seat on the board. At the Series A stage, founders typically maintain majority control with investors holding one seat and relying on protective provisions for additional influence. If the board later expands, independent directors may be added by mutual agreement between founders and investors.

 

Beyond board seats, the term sheet may include protective provisions or veto rights, requiring investor approval for major decisions, like issuing new shares, selling the company, or taking on debt. These are standard, but the scope can vary.

 

Founders should review these carefully and make sure that operational decisions remain within their control while investor consent is limited to significant structural or financial moves.

 

Drag-Along Rights: Everyone Goes Together

Term sheets generally include drag-along rights, which require all shareholders to participate if a majority approves a sale. For founders, this means they cannot hold out if the board and a majority of the investors agree on an exit. Drag-along rights help avoid deadlock at the finish line, but it is worth reviewing who has the power to trigger them and under what conditions.

 

Restricted Stock vs. Options: Equity Incentives and Cap Table Planning

Founders should understand how equity compensation plans fit into the cap table. A stock option pool must be large enough to attract and retain key employees but small enough not to create excessive dilution for existing shareholders.

 

Many companies grant employees stock options rather than restricted stock, though restricted stock is sometimes used for very early hires when the company’s valuation is low. Stock options give the holder the right to purchase shares in the future at the stock’s price at grant, usually subject to a vesting schedule.

 

Restricted stock is generally issued upfront to founders and early team members, typically with vesting and forfeiture provisions. To potentially obtain more favorable tax results, recipients often file an 83(b) election, which allows them to pay taxes on the fair market value at issuance rather than the anticipated higher value at vesting.

 

Stock options, on the other hand, are granted at fair market value. Nonqualified stock options are taxed as compensation on the spread at exercise, while incentive stock options may be subject only to capital gains tax at disposition, though the alternative minimum tax may apply at exercise. Both stock options and restricted stock carry significant tax and accounting implications.

 

As a best practice, founders should ensure that equity incentives are granted under a board-approved plan and modeled alongside the proposed investment to see the full impact on ownership.

 

Founder Vesting: Commitment in the Eyes of Investors

Even if founders already hold their stock, some investors may ask that a portion be subject to a vesting schedule. This “reverse vesting” ensures that if a founder leaves early, unvested shares can be repurchased by the company. Although not present in every deal, when used, the schedule often mirrors employee vesting (four years with a one-year cliff).

 

Own Your Term Sheet

The term sheet is the beginning of the deal. It sets expectations and a legal framework that can be difficult to change later. Founders who understand the building blocks will be better positioned to negotiate terms that support their long-term vision.

 

Our team can help your startup read between the lines, model outcomes, and enter investment negotiations with clarity and confidence.

 

For more insights for founders and entrepreneurs, review all the articles in the series:

Avoiding Common Legal Pitfalls for Startups: Lessons from the Trenches

The Founder’s Equity Dilemma: Vesting, Dead Equity, and Cap Table Health

Convertible Notes and SAFEs: Fast Money, Hidden Costs

Picking the Right Legal Structure for Your Startup

A Startup’s Introduction to Trademarks, Copyrights, Patents, and Trade Secrets

 

This article outlines general best practices and is provided for informational purposes only. It does not constitute legal advice or create an attorney-client relationship. Readers should seek legal counsel before taking action relating to the subject matter of this article. For more information, please visit our Terms of Use.