Just secured your first term sheet as a founder? Congratulations – but we’re not at the finish line yet! Too often, founders get caught in legal traps right when the excitement of a new valuation makes it hardest to slow down and read the fine print.
At Farukhi Law, we’re here to make sure that during this pivotal time, your economics are protected and you retain control of the Company.
Read along as we help you demystify the legal jargon and dodge term sheet traps.
Understanding the Term Sheet
The term sheet is generally a non-binding document outlining the key terms and conditions of a startup investor’s offer, though certain provisions (such as confidentiality and exclusivity) are typically enforceable. It ensures all parties are aligned on major points before incurring the legal costs of drafting and negotiating definitive agreements. Term sheets are typically used during priced equity rounds (e.g., Series A, Series B).
Why are term sheets important?
The term sheet is a key milestone in raising capital during funding rounds. By issuing a term sheet, an investor is signaling serious intent to invest in your company on specific terms. During this time, the company’s valuation is documented.
Top Three Components to Watch:
- Pre money vs post money valuation
- Economic rights
- Control rights
Five Term Sheet “Traps” and Strategies to Avoid Them:
Trap #1: Option Pool Shuffle
Context: Investors want to use an option pool (shares reserved for future hires) to ensure the team is incentivized.
Trap:If the pool sits in pre-money valuation, the dilution will come out of the founders’ pocket. You are paying for the employees the investor wants to hire.
Strategy: Keep the pool as small as necessary (10-15%), and push for the option pool to be created on a post-money basis so the dilution is shared proportionally among all shareholders.
Trap #2: Liquidation Preference Overkill
Context: Liquidation preference determines who gets paid first during an exit.
Trap: Avoid “Participating Preferred” stock. This will allow investors to take their initial investment back plus their ownership percentage of what’s left.
Strategy: Push for 1x non-participating preferred. This will ensure investors get either their money back OR their share of the proceeds, not both.
Trap #3: “Full Ratchet” Anti-Dilution
Context: Anti-dilution clauses protect investors if you raise money at a lower valuation later (i.e., a down round).
Trap: Do not accept “full ratchet” anti-dilution. It adjusts the investor’s original share price to match the new, lower price, regardless of how much money you raise in the down round.
Strategy: Only accept broad-based weighted average anti-dilution. This is industry standard and provides a much fairer balance.
Trap #4: Overbroad Information and Veto Rights
Context: Investors need to keep track of their investment, but some information rights and protective provisions extend too far into day-to-day operations.
Trap: Overbroad information rights can require you to disclose sensitive customer or operational data, while excessive protective provisions can give preferred shareholders veto rights that block a future sale.
Strategy: Limit data disclosures to high-level financial metrics. Negotiate to reduce the number of actions that require investor approval, and resist giving any single investor a standalone veto.
Trap #5: The “No-Shop” Clause
Context: Once you sign the term sheet, you typically enter into an exclusivity period.
Trap: A No-Shop prevents you from seeking other offers for 30-60 days.
Strategy: Keep the No-Shop period short (30 days) and ensure it only stays active if the investor is actively moving forward toward closing.
Farukhi Law Takeaway:
A term sheet sets the foundation for your entire relationship with your investors. The terms you agree to at this stage will carry forward into your definitive agreements and shape your rights, your economics, and your control of the company for years to come. Every clause deserves scrutiny, not just the valuation number. Before you sign, have startup counsel review the full-term sheet and flag any provisions that shift disproportionate risk to you or control to investors. The negotiation window is short, and your leverage is highest before you sign, not after. If you’ve received a term sheet and want a second set of eyes, reach out to Farukhi Law. We help founders negotiate from a position of strength.
Disclaimer: This post is for informational purposes only and does not constitute legal advice
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