What are traps to avoid in term sheet negotiations?

Takeaway: The most dangerous term sheet traps are participating preferred stock, giving away too much board control, and agreeing to overly broad protective covenants that give investors veto rights over routine business decisions.

Receiving your first Series A term sheet is an exhilarating moment. But in the rush to secure funding, it’s easy to miss subtle provisions that can tilt the economics and governance of your company heavily in the investor’s favor. Most terms in a venture term sheet are relatively standard, but some provisions can become long-term traps if you are not careful.

Here are three of the most important to watch out for:

1. Participating Preferred Stock

  • The Trap: Participating preferred gives investors the right to “double dip.” In an exit, they first get their money back through their liquidation preference, and then they also participate alongside common stockholders as if they had converted to common.

  • The Problem: This structure can significantly reduce the payout to founders and employees, especially in modest exit scenarios.

  • The Market Standard: Non-participating preferred, where the investor must choose between taking their liquidation preference or converting to common, but not both.

2. Board Control

  • The Trap: Investors may push for disproportionate influence over the board by securing too many seats or by requiring that certain actions can’t be taken without their designated directors’ approval.

  • The Problem: Overly investor-controlled boards can leave founders without meaningful input into the company’s direction. Worse, if investors gain effective veto power, it can tie your hands in strategic decisions like hiring, fundraising, or pursuing acquisitions.

  • The Market Standard: Founders typically retain control over their Boards in the Series A round - often Board structure consists of two founder seats and one investor seat.

3. Overly Broad Protective Covenants

  • The Trap: Preferred stock typically comes with a set of “protective provisions” in the charter, giving investors the right to block certain major corporate actions. The NVCA model form lists these covenants, which cover actions like issuing new stock, amending the charter, or selling the company. Investors sometimes push to expand this list to cover day-to-day business decisions.

  • The Problem: When protective provisions go beyond major corporate matters, they effectively give investors veto rights over ordinary business operations—slowing execution and limiting a founder’s ability to run the company.

  • The Market Standard: Protective provisions should be limited to fundamental corporate actions—like changes to the charter, creating senior securities, mergers or acquisitions, or declaring dividends. They should not extend to routine hiring, spending, or commercial contracts.

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.