Why do venture capital term sheet provisions matter so much for your company’s future? What key elements should you understand before signing on the dotted line?
In Venture Deals, Brad Feld and Jason Mendelson explain how term sheets shape the relationship between founders and investors. From financial matters to governance issues, each provision carries significant weight in determining who owns what and who controls your company’s direction.
Keep reading to learn how to navigate these critical decisions and protect your interests as a founder.
Venture Capital Term Sheet Provisions
Feld and Mendelson write that, when negotiating venture capital, term sheet provisions are critical to understand. The term sheet outlines the deal structure that will shape your company’s future—it’s the blueprint for your relationship with potential investors. A well-written term sheet sets clear expectations for both sides, establishes a valuation for your company, and provides a roadmap to navigate potential disputes or misunderstandings down the line.
(Shortform note: One alternative to traditional term sheets are Simple Agreements for Future Equity (SAFEs). These differ from traditional term sheets in ways that make them potentially more favorable for some startups. A SAFE is an agreement between a startup and investor that provides the investor with rights to future equity in the company, without determining a specific valuation up front. In contrast, traditional term sheets require setting a company valuation upfront. SAFEs enable early-stage startups to bypass that process, helping them secure funding upfront without getting bogged down in negotiations over terms or valuations.)
Feld and Mendelson break down the components of a term sheet into two main categories: finance terms and governance terms. Let’s explore each.
Finance Terms
Finance terms include all the economic aspects of the deal. The authors explain that these include elements like pre-money valuation, the option pool, liquidation preference, and the cap table. We’ll explore these terms next.
Pre- and Post-Money Valuation
Feld and Mendelson say pre- and post-money valuations are key components of the term sheet. Pre-money valuation is what VCs think your company is worth before they invest. This valuation depends on factors like founder experience, industry, product potential, intellectual property, economic conditions, and interest from other investors. Post-money valuation is the company’s value after the investment.
The authors warn, however, that VCs might have a lower pre-money valuation in mind than you have for your company, which could result in them owning a larger post-money share of your company than you expected. For example, say you’re the founder of a tech startup that you believe is worth $2 million before any investment (your pre-money valuation). You’re seeking a $500,000 investment from a VC, for a post-money valuation of $2.5 million. In this scenario, you’d expect the VC to own 20% of your company post-investment ($500,000 is 20% of $2.5 million).
However, after negotiations, the VC’s final offer might estimate your pre-money valuation at only $1.5 million based on their assessment of factors like market size or competition. This would put the post-money valuation at only $2 million. If they still invest $500,000 based on that lower pre-money valuation, they’ll own 25% of your company post-money ($500,000 is 25% of $2 million)—not the 20% you initially expected.
The Option Pool
The option pool is another key component in a term sheet, according to the authors. The option pool is like a reserved pot of shares of stock in your company that you can offer to employees as part of their compensation package. Option pools provide an incentive for employees to join your team or stay with the company because they stand to benefit if the company does well.
Think about your company as a pie and shares of stock as slices. The more people getting a slice, the smaller each slice has to be. Thus, creating an option pool increases the total number of shares (slices) your company has. This dilutes the value of existing shares—including those owned by you and any investors—because now each share represents a smaller percentage of ownership in your company. The authors note that the size of this dilution effect could affect your company’s valuation.
This can impact negotiations with investors since they’ll be looking at what percentage (or slice) they get in exchange for their investment. A larger option pool could mean that you as a founder end up owning less of your own company. The authors explain that VCs often insist on expanding the option pool before investing. This move dilutes the founders’ equity and lowers the pre-money valuation because it increases the number of shares without adding any new capital.
Let’s illustrate this with an example: Assume you have a startup valued at $4 million (pre-money) with an existing 10% option pool. You’re seeking $1 million in investment for what you expect would give VCs 20% ownership of a $5 million post-money company. However, if your VC insists on expanding your option pool to 20% before investing, it changes things. The expanded pool comes out of your pre-money valuation, effectively reducing it to $3.6 million (that is, $4 million – $400,000 for the expanded option pool). Now, when the VC invests their $1 million, they get roughly 22% (that is, $1 million/$4.6 million) instead of 20%.
The authors suggest that entrepreneurs should negotiate both their valuation and their option pool size simultaneously since they are interrelated. If a VC insists on a large option pool, you might counter by asking for a higher valuation to offset your dilution. They also note that another option is to keep your initial option pool as small as reasonably possible while still being able to attract talent. You can always increase it later in subsequent funding rounds when, hopefully, your company’s increased value would mean less dilution for you.
Liquidation Preference
The authors write that liquidation preference is another key term sheet idea, one that determines who gets paid first and how much in the event of a sale of the company. They note that if you’re not careful about how you structure your liquidation terms, you could wind up with nothing when your company gets sold. Let’s look more closely at how this works.
Preferred stockholders, typically the investors, are first in line during such an event and get paid based on contractually defined ratios. Common stockholders, often including the founders themselves, get their payout next—if there’s anything left to be paid out after the preferred stockholders get their payday.
This order of payment can significantly affect what (if anything) common stockholders receive from an acquisition. If the sale price is less than what VCs have invested, common shareholders may end up with nothing.
For example, let’s say you’ve raised $4 million from VCs in exchange for 25% of your startup, and your term sheet stipulates that the VCs receive preferred shares with liquidation preference equal to their investment amount. Unfortunately, market conditions change drastically, and after some time, you have no choice but to sell your company for just $3 million. Here, due to the liquidation preference clause in place, the VCs get to recoup their $4 million investment before anyone else gets paid. However, since the sale price is only $3 million, that entire amount goes toward fulfilling as much of that original agreement as possible—leaving nothing for you.
The Cap Table
The cap table tracks all shares or ownership units in your company and who holds them. This includes you and your co-founders, investors, and employees with stock options. Understanding your company’s cap table is crucial for tracking changes in ownership over time; calculating the value of individual stakes in your company; informing decisions about fundraising, acquisitions, or profit distribution; and providing a clear picture of how ownership may dilute with future funding rounds.
(Shortform note: Many startups use proprietary software to manage their cap tables. However, recent news shows that it’s important to exercise due diligence when selecting your company’s cap table platform. Carta, a 14-year-old Silicon Valley provider of cap table software for startups, faced accusations in January 2024 from a customer who alleged the company misused sensitive information. The dispute began when Karri Saarinen, CEO of Linear (a project management software company and Carta customer), found out that without his consent or knowledge, a representative from Carta had reached out to an investor in Linear about selling shares.)
Governance Terms: Controlling the Board of Directors
In addition to finance terms, the term sheet includes governance terms that outline how VCs will influence your company’s decision-making processes. If finance terms are about money, governance terms are about power and control.
According to the authors, the composition of the board of directors is a key governance term. The board is a governing body that oversees the management and direction of a company. It’s responsible for setting broad policies, hiring top executives, and safeguarding the interests of the shareholders.
VCs often seek to influence the board of directors in various ways—for example, by securing a board seat as part of their investment deal. Securing a seat gives them a say in the company’s strategic decisions, which allows them to steer its direction to match their interests.
| Protect Yourself From Investor Takeovers Some writers note that handing over board seats to VCs can pose risks to founders. One of the challenges is that founders may find themselves ousted from their own companies, as happened to Elon Musk at PayPal, Travis Kalanik at Uber, and Jack Dorsey at Twitter (now X). Founders can, however, take steps to protect themselves. One protective measure is maintaining a majority of voting shares in your company. If you hold onto more than 50% of the voting shares, it’s much harder for VCs or other investors to force decisions without your approval. In addition, you can make founder seats irrevocable, which guarantees your involvement in the company at some level even if you lose your board majority. Finally, you can implement term limits for board seats, which enables you to replace hostile or uncooperative board members once their terms expire. |
Exercise
Board composition is a key governance term. If you were structuring your ideal board of directors, what specific expertise or perspectives would you seek to include and why? Would you include VCs on your board?
