How to Read a Term Sheet Like Someone Who Has Been Burned

A term sheet is a 3-8 page document that determines who controls your company and who gets paid when it is sold. Most founders spend 95% of their negotiating energy on valuation and ignore the clauses that actually matter. I have made this mistake. I have watched founders I invested in make it. Here is what to look for.

Valuation is not the number you think it is

Pre-money valuation is what your company is theoretically worth before the investment. Post-money is pre-money plus the investment amount. If an investor offers 2M EUR pre-money and invests 500K EUR, post-money is 2.5M EUR. The investor owns 20%.

Most founders stop there. That is a mistake.

The number that matters is your fully diluted ownership after the round. Fully diluted means including the option pool. And here is the trick: most term sheets require you to create or expand the option pool before the investment, which means it comes out of the founders’ share, not the investor’s.

A “2M pre-money” deal with a 15% option pool carved out before investment is actually a 1.7M pre-money deal for the founders. The investor knows this. You should too.

Liquidation preference: the clause that eats exits

Liquidation preference determines who gets paid first when the company is sold. There are three flavors, and the difference between them can mean millions of euros.

1x non-participating preferred means the investor gets their money back first, then everyone splits the remainder by ownership percentage. This is standard and fair.

1x participating preferred means the investor gets their money back first AND their pro-rata share of everything left over. This is double-dipping. On a moderate exit, the investor makes significantly more and the founder makes significantly less than the ownership percentages suggest.

2x participating preferred means the investor gets twice their money back first, then participates in the remainder. I have seen this in term sheets from funds that target desperate founders. Walk away.

If an investor insists on participating preferred, negotiate a cap. “1x participating, capped at 3x” means the investor’s total return is capped at three times their investment, after which the participation converts to common.

Anti-dilution: protection that can dilute you

Anti-dilution protections kick in when a future round happens at a lower valuation than the current one (a “down round”). They give the current investor additional shares to compensate for the lower price.

Broad-based weighted average is standard and reasonable. It adjusts the investor’s conversion price based on how much new money came in and at what price. The dilution to founders is proportional.

Full ratchet is aggressive. It reprices the investor’s entire investment to the new lower price as if they had invested at that price originally. On a significant down round, full ratchet can cut the founders’ ownership in half. Avoid this if possible.

Board composition: who makes the decisions

A board of three is standard at seed: two founders, one investor. A board of five at Series A: two founders, two investors, one independent.

The independent board member matters more than most founders realize. If a dispute arises between founders and investors, the independent member breaks the tie. Make sure the process for selecting the independent member is clear in the term sheet. “Mutually agreed” is the right language. “Selected by the investors” is not.

Watch for observer rights. Investors who do not get a board seat but can attend all board meetings. Not a problem in itself, but five observers plus three board members means every board meeting is a performance rather than a working session.

Protective provisions: the veto list

Protective provisions give investors the right to block certain decisions: selling the company, raising more money, changing the company’s charter, hiring or firing the CEO.

Some of these are reasonable. An investor who put in 500K EUR should have a say in whether you sell the company for 100K EUR.

Others are overreaching. Provisions that require investor consent to hire any employee above a certain salary, or to spend more than a set amount on any single contract, effectively give the investor operational control without a board seat.

Read every line. Ask your lawyer to flag any provision that limits your ability to run the company day-to-day. Then negotiate those specifically.

Drag-along and tag-along

Drag-along rights let majority shareholders force minority shareholders to participate in a sale. If 70% of shareholders agree to sell, drag-along can force the remaining 30% to sell too, at the same price and terms.

Tag-along rights work the other way. They let minority shareholders join a sale on the same terms as the majority. If the founders sell their shares, tag-along lets the investors sell theirs at the same price.

Both are standard. The detail that matters is the threshold. Drag-along triggered at 50% is aggressive. Drag-along at 75% gives more protection to minority holders.

What to do with all of this

Hire a lawyer who has done at least 50 venture deals. Not 5. Not 15. Fifty. This will cost 3,000-8,000 EUR depending on the jurisdiction and it is the best money you will spend in the fundraise.

Read the term sheet yourself before the lawyer does. You will not understand everything, but you will understand enough to have an intelligent conversation. Mark every clause you do not understand and ask the lawyer to explain it with a concrete example.

Do not be afraid to negotiate. Most first-time founders accept the first term sheet they receive because they are afraid the investor will walk away. Investors expect negotiation. What they do not expect, and what kills deals, is silence followed by last-minute demands.

Negotiate early. Negotiate on specifics. And always negotiate liquidation preference before you negotiate valuation. Ownership on paper means nothing if the liquidation stack takes everything in the exit.

/Lech