What are the most important terms in a term sheet?
Takeaway: While every term in a term sheet matters, the negotiation should be intensely focused on a few key provisions—valuation, option pool size, liquidation preference, and board composition—as these will have the most significant long-term impact on founder dilution and control.
A Series A term sheet can contain dozens of different legal and economic provisions. For a first-time founder, it can be an intimidating document. While you must understand every term, the reality of the negotiation is that your focus and negotiating capital should be spent on the four or five terms that truly drive the deal. These are the provisions that have the greatest impact on your ownership, your control of the company, and your future financial outcomes.
The "Big Four": The Terms That Matter Most
Valuation / Price Per Share: This is the most obvious and often most heavily negotiated term. The "pre-money" valuation directly determines the price per share of the Series A Preferred Stock and, therefore, how much of the company you are selling for a given investment amount.
The Option Pool Shuffle: This is the most common "trap" for founders. The term sheet will require the company to create a new employee stock option pool, and the size of this pool is a critical negotiation. Crucially, the standard term sheet structure requires that this new pool be created before the Series A financing, which means its dilutive effect is borne entirely by the founders and existing stockholders, not the new investors. A larger option pool means a lower effective valuation for the founders (which means more dilution).
The Liquidation Preference: This term dictates who gets paid first, and how much they get paid, in the event of a sale of the company.
1x, Non-Participating: This is the standard term. It means the investors get their money back first, and then the rest of the proceeds are distributed to the common stockholders. The way it is structured in the documents, the investors get the better of this 1x preference and the amount they would get if their Preferred Stock converted to Common Stock.
Participating Preferred: This is a much more investor-favorable term. It means the investors get their money back first and they also get to share "pro-rata" in the remaining proceeds with the common stockholders. This "double-dipping" can have a major negative impact on the founders' return in a modest exit.
Board Composition: This is the primary control term. The term sheet will specify the size and composition of the post-financing Board of Directors. A typical five-person board might be composed of two founders, two investors, and one independent director. The negotiation over who controls the majority of the board seats is a critical negotiation over the long-term control of the company.
While you should have your lawyer review every line of the term sheet, your strategic focus as a founder should be on optimizing these core economic and control provisions. These are the terms that will have the most lasting impact on your ownership, your wealth, and your ability to lead the company you are building.
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.