Demystifying venture capital term sheets: everything founders need to know

Karolina Kukielka
5 min readJul 10, 2023

Given the capital requirements that many founders face as they seek financing, navigating and finally agreeing on terms is a learning curve!

Getting your first capital

In the realm of startup funding, the initial influx of capital often marks the first challenging step to get it right. While VCs traditionally get involved at the seed stage, it is more frequent to see angel investors as the first source of external funding, effectively filling the critical gap at the beginning of a startup’s journey. Angels would typically receive common stock for their capital or invest through convertible notes or similar debt instruments that provide a means of making deferred equity investments with minimal transaction costs.

With time, as startups engage in sequential (equity) rounds issuing preferred stock with various protective terms and designated board seats, it becomes increasingly critical to know how to navigate the process. Mistakes made early on regarding terms and dilution can have long-lasting consequences, potentially hindering the company’s ability to secure further funding.

getting into a fair-terms sheet” was initially discussed at the VC-series hosted by Startup Aarhus. Inspired by the numerous interesting questions, the post below aims not only to level up playing field for founders but also delve into aspects that were not fully covered during the session, providing a comprehensive and detailed perspective.

Let’s start from “cap table”

(usually prepared by the company’s legal counsel)
When discussing a potential venture capital deal, it’s crucial for both parties — founders and investors — to come to an agreement on economic terms. To ensure smooth negotiations, founders can take proactive steps by preparing capitalisation table addressing the issue of share price, the amount to be raised, dilution, and valuation. By understanding the implications and calculations behind these figures, founders are able to make more informed, better decisions!

I highly recommend simulating further rounds as well. In partnership with Melinda from Fast Track Malmö, I am excited to share the ownership benchmarks from the region of Denmark and Sweden. Serving as a valuable resource, they are offering guidance to determinate ownership stakes in successive funding rounds.

Caveat: agreeing to a high level of dilution may jeopardise the ability to secure future funding from institutional investors.

Link: Cap Table Simulations

What is a term sheet?
The term sheet (TS) is a crucial document that determines the final deal structure of an investment. Unlike a letter of intent, the term sheet is a formal offer that outlines all the significant details of the proposed investment. While it can differ quite a lot, it typically encompasses two main categories: economics and governance.

Economics:
The economics category outlines the financial aspects of the investment, including:

  • Investment amount: the proposed investment amount.
  • Pre-money valuation: the valuation of the company before VC makes the investment.
  • Price per share (PPS): the value of the individual shares, as determined by the pre-money valuation.
  • Post-money valuation: the valuation of the company after receiving the investment, it dictates the investors’ ownership stake. Mathematically, pre-money + amount of investment = post-money.
  • Liquidation preference: a provision intended to protect investors if a company is sold for less than the amount of capital invested. Specifically, it establishes the priority of payment that investors receive in relation to other shareholders. The standard for liquidation preference is typically a 1x non-participating preferred, which guarantees the original investment back to the investor. The term “non-participating” implies that the stock does not have a claim to any additional proceeds from the liquidation or sale. Instead, the investor receives either the liquidation preference or the stock converts into common shares, and the investor receives their as-converted basis.
  • Vesting: it is often four years for founders.
  • ESOP (equity stock option plan): known as the employee pool or option pool, is typically negotiated during fundraising, and at the seed stage, it usually amounts to 10% of the company’s total equity. This pool is set aside to be granted to employees, advisors, and consultants as part of their compensation package. By offering equity incentives, companies can attract and retain top talent while also aligning employee interests with those of the company.
  • Anti-dilution: it protects investors when the company issues equity at a lower valuation than in previous financing rounds.

Governance:
The governance category details the decision-making and control rights of the investors, such as:

  • Board of directors: The term sheet outlines the size of the board of directors, which may vary based on the company’s growth stage. It is not uncommon to include an odd-numbered board, which is often preferred by both investors and founders to prevent decision-making deadlocks. While certain corporate actions require shareholder votes, the board typically has the power to advise and ratify the most significant corporate strategies!
  • Protective provisions: in essence, they are veto rights that investors have on certain actions taken by the company. These provisions give investors the ability to protect their investment and ensure that the company is being managed in a way that aligns with their interests.
    Examples of protective provisions include:
    (i) increase in the option pool
    (ii) any change to the rights, preferences, and privileges of any shares
    (iii) increase or decrease in the board size
    (iv) significant capex (outside of approved annual budget/business plan)
    (v) annual budget and business plan
    (vi) IPO or listing of shares
    - protective provisions are often the most negotiated aspect of a TS. While founders may prefer fewer protective provisions, investors typically seek veto control over a range of actions the company may take.
  • Drag along: it gives a subset of investors the ability to force all of the others to do a sell.
  • No-shop agreement: a clause stipulating the founders can’t use the term sheet to leverage other investors into participating in the round.
  • Information rights: it entitles investors to receive updates on the financial performance of the company.

Who prepares the term sheet?
The term sheet is typically drafted by the VC firm and provided to the founders. Often, the VC firm’s legal counsel is involved in crafting and reviewing the term sheet to ensure its legal soundness and alignment with the firm’s investment strategy.

What happens after a term sheet is signed?
Once a term sheet is signed, the legal representatives for both parties can begin to finalise the deal’s details and prepare the formal investment documents.

books to read: to better to understand term sheets, I highly recommend:

  1. “Secrets of Sand Hill Road” by Scott Kupor
  2. “Venture Deals” by Brad Feld and Jason Mendelson

Both books provide practical advice and insights on term sheets! “Secrets of Sand Hill Road” focuses on the broader landscape of venture capital, while “Venture Deals” dives deeper into the legal mechanics of term sheets.

Why this blogpost?
The presence of the so called ‘dirty term sheets” as they crept down into the ecosystem at early-stage in my view underscores very much the need to level up the playing field for founders! While getting fair and reasonable terms is not always easy for many different reasons, it is important to discern between standard & predatory terms. The basics above I hope help to support founders but also the collective startup ecosystem as a whole!

If you enjoyed reading this post, just connect with me on Linkedin or share your thoughts by leaving a comment below. Your feedback is greatly appreciated!

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Karolina Kukielka

Seasoned tech investor, super keen to discover and uplift the most visionary and data software startups in Europe!