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What startup founders need to know before signing a term sheet with an investor

Contrary to popular belief, the highest degree of control in a company is not determined by the shares percentage that your investor might have, but by the conditions you agree on when signing the investment term sheet.

Although ideally it should be a balanced document, with obligations and rights outlined prudently to both parties – the investor and the invested – one must always be very attentive of the real price that investors and invested alike will charge in the short and long term, especially if they affect your planning and decision-making routines.

A term sheet is basically a list, usually prepared by the investors in an early stage round and by the company in later investment rounds. It outlines terms and conditions of a tentative business agreement, with the investment terms and collateral. As the essential document towards a final agreement, the term sheet has a set of terms and conditions, and very importantly, the choice between funding and financing, besides all the needed references for writing a final contract or a business acquisition.

The vast majority of founders won’t want difficult, abusive, over-controlling and greedy investors on board. Investors on the other hand, won’t want unorganized, chaotic, world-saviors-through-their-invention founders that only want to take the money and run, or who do not accept criticism and a reasonable amount of discussion and guidance, especially in the prototyping and the go-to-market phases. This process can be simplified when using a third-party funding portal.

Usually, the invested company received a dilution in its shares of around 20% per round of financing. As a company to be invested, always try to avoid a situation when in the first rounds any investor will ask you more than 20% of the total equity. Even if you are at a seed stage and you feel it is ok to give up a good amount of equity, one thing is certain: that equity will not come back to you and your co-founders. Unless there is a very good reason for going beyond a 20% equity sale, like a strategic investor or “smart-money” group bringing in a portfolio of clients and partners to your company, consider not moving on this point.

When you, as a founder, are reviewing a term sheet proposed by potential investors, you should raise eyebrows if you find any of the situations below:

  • Investors that focus too much on the exit
  • Absence of realistic timelines and pressure on the sales numbers only, neglecting the business development needed time for your product or service
  • Aggressive debt financing and convertible note terms. This might put you out of business should the market turn, and it could bankrupt you
  • Investors looking for and demanding a large controlling stake
  • Terms limiting further fundraising or giving exclusivity to this investor to control the next investment rounds for more than 2 or 3 years, depending on your market and business.

Having considered all points above, a good term sheet includes basically these points:

  • A valuation which makes sense for both sides
  • Type of collateral being offered to investors
  • Concrete number of shares and price
  • Funding amount being offered
  • Exit clause – what happens if you get acquired in the period that your investors are still to receive their returns­?
  • What happens on liquidation, bankruptcy, full sale and IPO?
  • Voting rights – many times these are not proportional to the shares you own. Usually, capital will demand
  • Board seats division
  • Conversion options – the option for a shareholder to convert the preferred shares to common shares when the result is more advantageous to the shareholders. This situation usually happens when there is a cap on participation rights for the shareholder or a low liquidation preference multiple, and the company sells for a large amount.
  • Anti-dilution provisions
  • Investors rights to information, and its periodicity
  • Founders obligations
  • Who pays for the legal expenses in general?
  • Non-disclosure requirements
  • Rights to future investment
  • Names and positions of the signatories and their signatures – in many countries it is a must to certify the signatures to have any legal tender.

A last piece of advice: If investors are aiming to tire a founder who’s eager to wrap things up, or if they are being negligent with you as in scheduling meetings and not showing up or simply rescheduling in the last minute repeatedly, walk away. They almost certainly are not well organized themselves and this time waiting for them may take other opportunities away from your startup. Respect comes before any deal, and if they are not respectful now, they probably also won’t be after they have their capital poured into your operation.

Any provision included on your agreements may not make sense today, but one of them may be triggered in the long run and could put you, your co-founders, employees and co-investors in a bad situation, or better yet, shield you from abuse and unjustified moral harassment.

Editor’s Note: Some prominent European VC firms like Passion Capital and Forward Partners have actually published their standard term sheets for seed rounds online. You can check them out here and here.

Bernardo Arnaud
Bernardo Arnaud
Bernardo lives in Vienna and has been consulting and advising companies for 18 years in fintech, commodities trading, telecom assets management, messaging, jobs marketplaces, agribusiness, luxury, e-commerce and SaaS. He founded a few companies throughout his entrepreneurial journey.

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