What is an Equity Term Sheet?

An equity term sheet is a non-binding agreement that outlines the basic terms and conditions under which an investor will make an equity investment in a startup. It serves as the foundation for more detailed legal agreements and is crucial for setting expectations between founders and investors.

*Main Points Covered in a Term Sheet*

1. *Valuation:* This defines the pre-money valuation (the value of the company before the investment) and the post-money valuation (the value after the investment).

2. *Investment Amount:* The amount of money the investor is putting in.

3. *Equity Stake:* The percentage of the company the investor will own after the investment.

4. *Type of Shares:* The type of equity being issued, such as common stock or preferred stock, and their respective rights.

5. *Board Composition:* Details on how the board of directors will be structured post-investment, including who will have the right to appoint members.

6. *Liquidation Preference:* Specifies the order in which investors get paid in case of an exit or liquidation, often giving them priority over other shareholders.

7. *Anti-Dilution Protection:* Clauses that protect investors from dilution in future financing rounds, typically by adjusting their ownership percentage if new shares are issued at a lower valuation.

8. *Voting Rights:* The rights that investors will have in decision-making processes, including veto rights on key decisions.

9. *Vesting of Founder Shares:* The terms under which founders' equity will vest over time, ensuring they remain committed to the company.

10. *Exit Provisions:* Details on how and when investors can exit their investment, such as through an IPO or acquisition.

*What Startup Founders Need to Know*

1. *Non-Binding Nature:* The term sheet is generally non-binding except for certain clauses like confidentiality and exclusivity. However, it sets the stage for final negotiations, so it should be taken seriously.

2. *Understand Valuation and Dilution:* Founders must clearly understand how the proposed valuation affects their ownership and control of the company.

3. *Board Control:* Be cautious about giving up too much control over the board, as this can affect decision-making power.

4. *Liquidation Preferences:* Ensure you understand how liquidation preferences work, as they can significantly impact the returns for founders and other shareholders in an exit scenario.

5. *Vesting Schedules:* Founders should negotiate vesting schedules that reflect their commitment and contribution to the company while protecting themselves from premature dilution.

*Seed Round vs. Series Round Term Sheets*

• *Seed Round:*

o Typically simpler and more founder-friendly.

o May include fewer investor rights and simpler terms like convertible notes or SAFEs (Simple Agreements for Future Equity).

o Valuation is often lower, with fewer structured protections for investors.

• *Series Round:*

o More complex, with detailed investor rights, protections, and governance structures.

o Involves larger sums of money, higher valuations, and stricter terms.

o More negotiation over board seats, liquidation preferences, and anti-dilution clauses.

*Acceptable vs. Unacceptable Points*

• *Acceptable Points:*

o *Reasonable Valuation:* Aligns with market standards and company potential.

o *Standard Liquidation Preferences:* Typically 1x liquidation preference without participation.

o *Balanced Anti-Dilution:* Weighted-average anti-dilution protection is standard.

• *Unacceptable Points:*

o *Excessive Liquidation Preferences:* Multiple liquidation preferences (e.g., 2x or more) can be detrimental to founders.

o *Full Ratchet Anti-Dilution:* This can heavily dilute founders in future rounds.

o *Excessive Board Control:* Investors demanding too many board seats or veto rights can stifle the founder's ability to lead.

*Conclusion*

Founders should approach a term sheet with a clear understanding of its implications on their company’s future. Negotiating terms that protect their interests while also attracting investor support is key to long-term success. Understanding the difference between seed and series term sheets, and what is acceptable versus what is not, can help founders navigate this critical stage in their startup journey.

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