Pre-money, post-money and the option pool
The first two terms are the valuation and the option pool, and they are linked. A term sheet that offers a $20 million pre-money valuation "including a 15 percent post-closing option pool" is asking the founders to create the pool before the investor buys in, so the dilution from the pool falls on the founders alone. The effective pre-money valuation is lower than the headline. The right responses are to size the pool to a real hiring plan for the next 12 to 18 months rather than a round number, and to negotiate whether the pool is created before or after the investment. The same arithmetic applies to the conversion of SAFEs and notes from earlier rounds: model the cap table after conversion, not before.
Liquidation preference and participation
A liquidation preference determines who is paid first when the company is sold. The standard term for a seed or Series A is a 1x non-participating preference: the investor receives either its money back or its share of the proceeds as converted, whichever is greater. Two variations change the economics considerably. A participating preference lets the investor take its money back and then share in the remainder, which at modest exit values can leave founders with far less than their ownership percentage suggests. A multiple preference—2x, 3x—does the same more directly. Seniority also matters: later investors often ask to be paid before earlier ones, so a stack of preferences can absorb the entire proceeds of a mid-sized sale.
Anti-dilution and pay-to-play
Anti-dilution protection adjusts the investor's conversion price if the company later raises money at a lower valuation. Broad-based weighted-average protection, which takes into account the size of the down round relative to the company, is the market standard and is usually acceptable. Full-ratchet protection resets the earlier investor's price to the new lower price regardless of how small the down round is, and can shift control of the company in a bad year; it should be resisted. Pay-to-play provisions, which strip protections from investors who decline to participate in a future financing, can be founder-friendly and are worth asking for.
Control: the board, protective provisions and drag-along
Valuation is about money; these terms are about who decides. The board composition term sets how many seats founders, investors and independents hold, and whether the founders can be outvoted. Protective provisions list the actions that require investor consent—selling the company, issuing senior stock, changing the charter, taking on debt above a threshold, changing the business—and the list should be read as a list of things the founders can no longer do alone. A drag-along clause obliges all holders to join a sale approved by a specified majority; the threshold and whether founders have a vote within it matter. Information rights and pro rata rights are standard but should be limited to major investors so that the company is not reporting to twenty angels.
Terms that apply to the founders personally
Investors commonly ask that founder shares already issued be made subject to vesting again, or to a longer schedule, and the acceleration on termination or acquisition negotiated now determines what a founder keeps in either event. Founder representations about the company's capitalization and intellectual property are usually given by the company, but some term sheets ask the founders to give them personally; that should be narrow and knowledge-qualified. Non-competition covenants are unenforceable against employees in California and limited in Washington, but investors may still ask for them in the founder agreements; what is reasonable depends on where the founder works. Key-person and insurance provisions, and the founders' continued employment terms, are often settled in the same negotiation and are easier to fix now than after closing.
What is binding, and what to do before signing
Most of a term sheet is non-binding; the exclusivity or no-shop clause, the confidentiality clause and sometimes an expense-reimbursement clause are binding and should be read as such. Before signing, confirm the closing conditions, the cap on investor legal fees the company will pay, and the timeline, and prepare the diligence file the investor will request: the minute book, cap table, IP assignments, employment agreements, material contracts and financials. For offerings relying on applicable exemptions such as Regulation D Rules 504 or 506, a Form D generally must be filed within 15 days after the first sale (as defined by SEC rules), together with any required state notices; updates its 409A valuation before granting new options, and sends the stock certificates or ledger entries that evidence what the investor bought. Term sheets are negotiated in days and lived with for years; the week spent understanding one is well spent.
References
How Lumen Law & Co. can help
A term sheet is negotiated in days and determines what founders actually receive at an exit. We help founders understand the economics and control effects of each term before they sign.
- Explain liquidation preference, anti-dilution, the option pool, board composition and protective provisions, and model the outcome under different exit scenarios.
- Separate the binding and non-binding parts and advise on the no-shop period, fee caps and closing conditions.
- Prepare the minute book, cap table and IP records that diligence will require, and review or draft the definitive financing documents.
- Handle the Form D and state notices, the 409A refresh and the stock ledger after closing.