Receiving a term sheet is a significant step in any fundraising process. The document is usually short and written in plain commercial language, which can make it seem more straightforward than it is. That impression is misleading, because despite its informal tone, a term sheet sets out the economic and control terms that the long-form documents will later implement.
A term sheet is usually expressed to be non-binding, other than the exclusivity, confidentiality and governing law and jurisdiction clauses. In practice it is difficult to renegotiate the key commercial terms set out in the term sheet without risking the deal. Founders should therefore take the time to understand the main terms before agreeing to them.
Set out below are five provisions that typically have the biggest impact on founder ownership, control and outcomes.
Price per share and the option pool
Valuation is often the figure founders focus on first, but the headline number does not by itself determine the price per share. That price is calculated by dividing the pre-money valuation by the share count used as the denominator, and investors will usually ask for that denominator to be the fully diluted share capital, meaning existing shares plus all outstanding options, warrants and any unallocated option pool. Founders are better served by the narrower issued share capital basis, meaning only the shares actually held by shareholders today, but should expect the investor’s fully diluted position to be the starting position rather than something unusual. Using the fully diluted basis lowers the price per share and increases the number of shares issued to the investor, so the point is worth negotiating rather than just accepting on the assumption that the investor’s starting position is fixed.
The unallocated option pool referred to above is not a fixed quantity either, and investors will often ask for a pool of around 10 to 15 per cent to be created ahead of their money coming in. Pre-money creation, counted on the fully diluted basis described above, is the more common outcome, and it means the cost of the pool falls entirely on the founders rather than being shared with the new investor. Founders can and often do negotiate for the pool, or part of it, to be created post-money instead, so that the cost is shared with the incoming investor. Founders should ask exactly when the pool is being created, how it is being sized and whether it is calculated pre-money or post-money, since identical headline numbers can produce materially different founder outcomes depending on the answer.
Liquidation preference
Early-stage investors in the UK may invest through preference shares, which carry additional rights on an exit. The most important of these is the liquidation preference, which determines the order in which proceeds are distributed.
A standard position is a 1x liquidation preference, meaning the investor receives an amount equal to their investment before ordinary shareholders receive anything. Liquidation preferences are either non-participating or participating. A non-participating preference requires the investor to choose between taking their preference or converting into ordinary shares, and in a strong exit a non-participating investor will convert rather than take the preference, since their pro rata share of the proceeds as an ordinary shareholder is worth more than the fixed preference amount. A participating preference allows the investor to take their preference and then share in the remaining proceeds as well, regardless of how strong the exit is.
Participating preferences and multiples above 1x can cut founder returns substantially in moderate exits and are generally considered aggressive in early-stage UK deals.
Anti-dilution protection
Anti-dilution provisions protect investors if a future funding round is raised at a lower valuation. The most founder-unfriendly version is a full ratchet, which effectively resets the investor’s conversion price to the lowest future price regardless of the size of the round. This means that when the investor’s preference shares eventually convert into ordinary shares, typically on exit, each preference share converts into a larger number of ordinary shares than it would have done at the original price, resulting in substantial additional dilution for founders and other shareholders.
A weighted average mechanism is a more moderate alternative to full ratchet, adjusting the investor’s price by reference to both the price and the number of shares issued in the down round rather than resetting it outright. Broad-based weighted average anti-dilution includes the option pool and outstanding convertible securities in that calculation, producing a smaller price adjustment than a narrow-based calculation, which counts only issued share capital. UK deals gravitate towards the broad-based version because it spreads the impact of a down round more thinly across the cap table.
If a term sheet refers to anti-dilution without specifying the mechanism, founders should ask for clarification.
Board rights and investor control
Investors will usually seek governance rights alongside their investment, typically the right to appoint a director or observer, a list of reserved matters requiring investor consent, and ongoing information rights such as monthly management accounts and annual budgets. Reserved matters commonly cover significant actions such as issuing shares, amending constitutional documents, incurring debt above an agreed threshold or selling the business, and are usually subject to a consent threshold tied to the investor’s shareholding rather than a single investor’s veto.
These rights are meant to safeguard the investment rather than interfere with day-to-day management, though problems tend to arise when consent rights are drafted too broadly or restrict operational decision-making as the company grows.
Leaver and vesting provisions
Term sheets often include leaver provisions, which govern what happens to a founder’s shares if they leave the company. Investors often require founders to agree to reverse vesting, usually over a four-year period with a one-year cliff. Unvested shares can be bought back or cancelled if a founder departs early.
Term sheets also distinguish between good leavers and bad leavers; a bad leaver can lose all their shares, sometimes for nominal value, while a good leaver usually keeps their vested shares. The definitions used are therefore critical and can shift from one deal to the next.
Leaver arrangements vary from one investor and one deal to the next, so a term sheet reference to “standard leaver provisions” tells a founder very little on its own. The actual definitions used should be read and understood before anything is agreed.
Negotiating the Term Sheet
A term sheet does more than record commercial terms, because it also sets the reference points that the long-form agreements will later expand on. Understanding the mechanics behind each provision, not just the headline terms, makes it easier to negotiate and to spot points that depart from market practice.
If a term is unclear or looks aggressive, it is worth asking why it has been included and whether it can be removed or narrowed. Raising that question is far easier while the term sheet is still open for discussion than after signature, so involving advisers at this stage is worthwhile.
How we can help
We regularly advise founders, investors and growth companies on term sheets, investment rounds and fundraising documentation. Whether you’re raising capital for the first time or negotiating a later-stage investment, we can help you navigate the process and protect your position. If you would like advice on any of the issues covered in this article, please get in touch. You can also find out more about our experience in this area by visiting my profile page.
