Key Considerations for Founders in Startup Term Sheets: Do’s and Don’ts

Key Considerations for Founders in Startup Term Sheets: Do’s and Don’ts

When negotiating a term sheet, startup founders are faced with critical decisions that can significantly impact their future. In this feature, we dive into the essential elements of term sheets, highlighting do's and don'ts that every founder needs to know. From valuation methods to liquidation preferences, these decisions can make or break your startup’s journey.

A term sheet is like a prenuptial agreement, outlining crucial aspects of an investor’s proposal but with one key difference—it’s non-binding. This gives both parties flexibility before moving forward with legally binding documents like shareholders' agreements. Founders should understand these terms to protect their interests while securing much-needed capital. Let's break down the core clauses:

1. Valuation: Pre-Money vs Post-Money

One of the first things a founder looks for in a term sheet is the valuation. Pre-money refers to the company’s value before any new investment, while post-money is the value after investment. The difference? It impacts both the dilution of your ownership and the attractiveness of the deal.

2. Liquidation Preference: Your Exit Strategy

Liquidation preferences dictate how much an investor gets paid if your company exits through a sale or IPO. There are two main types:

• Non-participative: Investors choose either a multiple of their investment or a percentage of the exit value—whichever is higher.
• Participative: Investors get both the multiple and a percentage of the exit value.

Founders should avoid participative preferences whenever possible, as they can be highly burdensome, limiting what’s left for them after an exit.

3. Anti-Dilution: Protecting Against Future Downrounds

In a down round—where your company's value drops after an investment—the anti-dilution clause kicks in. This protects investors from losing out if the value of their shares decreases.

• Full Ratchet: Provides full protection to investors by issuing them free shares if your company’s valuation drops.
• Weighted Average: A softer version, this reduces the impact on founders, making it a more founder-friendly option.

Always opt for weighted average if possible.

4. Tag-Along and Drag-Along Rights: Who’s in Control?

These clauses determine how shares can be sold if one party wants out:

• Tag-Along Rights: Protect minority shareholders, allowing them to sell on the same terms as larger shareholders.
• Drag-Along Rights: Allow majority shareholders to force the minority to sell under the same terms.

While tag-along rights are optional, drag-along rights are mandatory—be mindful of the balance between the two.

5. Redemption Rights: Risky Business

Redemption rights allow investors to demand a return on their investment after a specified period, putting financial pressure on the startup. As a founder, be cautious when agreeing to these clauses, especially those offering high multiples, as they could push your company into a corner.

6. Board Seats and Reserved Matters: A Balancing Act

Investors often ask for a seat on the board and veto rights on certain business decisions, known as reserved matters. While it’s standard practice, founders should be careful not to grant too much control. Ensure that board approval is only required for major decisions and not day-to-day operations, which could hinder your ability to scale.

Final Thoughts for Founders

Negotiating a term sheet is a crucial step in your startup’s journey. Founders should approach this process with caution, focusing on long-term sustainability rather than short-term gains. The clauses you agree to today could set a precedent for future rounds, making it critical to understand what you're signing. And remember, when in doubt, always seek professional advice.

At WOWS Global, we’re here to help you navigate these complex waters. Stay tuned for more insights and tips to help you grow your startup!

Want to dive deeper into term sheets? Watch the full video