📄 VC Term Sheet
Definition: A non-binding document outlining the key terms and conditions under which a venture capital firm will invest in a startup. The term sheet precedes the full legal agreements and sets the framework for negotiation.
Key courses: Stanford GSB Startup Garage, Wharton ENTR 611, HBS Entrepreneurship Key book: “Venture Deals” — Brad Feld & Jason Mendelson
🔑 Why Term Sheets Matter
Term sheets determine:
- How much of the company founders keep
- Who controls major decisions
- What happens to founders if the startup fails
- Who gets paid first in an exit (and how much)
Many founders focus only on valuation and miss the terms that matter more.
📐 Core Economic Terms
1. Pre-Money and Post-Money Valuation
Example:
- Pre-money valuation: $8M
- VC invests: $2M
- Post-money: $10M
- VC gets: 20% ownership
Founders’ dilution: If founders owned 100% before, they now own 80% (on paper — option pool may further dilute).
2. Option Pool Shuffle
VCs often require creating or expanding an option pool before investment:
- “We’ll invest at $8M pre-money, but you need a 20% option pool”
- The option pool comes out of the pre-money → founders bear the dilution, not the VC
Example (the trick):
- True pre-money = 8M pre + 20% pool
- Founders effectively valued at $8M
- Real dilution = investment dilution + option pool dilution
3. Liquidation Preference
Determines who gets paid first in a liquidation event (acquisition, bankruptcy):
| Type | Definition | Example |
|---|---|---|
| 1× non-participating | VC gets 1× investment back OR converts to common; picks the better | Most founder-friendly |
| 1× participating | VC gets 1× back THEN participates pro-rata in remaining | Expensive for founders |
| 2× participating | VC gets 2× back THEN participates | Very aggressive; only in down markets |
Example: VC invests 20M. VC owns 25%.
- Without preference: VC gets 25% × 5M
- With 1× participating: VC gets 15M = 3.75M = $8.75M
This is why term sheets matter more than valuation.
🗳️ Control Terms
4. Board Composition
| Scenario | Board |
|---|---|
| Seed round (common) | 2 founders, 1 VC |
| Series A (common) | 2 founders, 2 VCs, 1 independent |
| Later stage | More balanced or VC-heavy |
Board controls: CEO hiring/firing, M&A decisions, budget approval, future funding.
5. Protective Provisions (Vetoes)
VCs often get veto rights over:
- Selling the company
- Issuing new shares
- Taking on debt above a threshold
- Changing the certificate of incorporation
- Paying dividends
These protect VCs from founders making decisions that harm preferred shareholders.
6. Anti-Dilution Protection
If company raises a future round at a lower valuation (down round), anti-dilution protects VC’s ownership:
| Type | Effect |
|---|---|
| Full ratchet | VC’s price drops to new low price — aggressive, rare |
| Broad-based weighted average | Adjusts price based on size of down round — common, founder-friendly |
| Narrow-based weighted average | Less favorable to founders than broad-based |
7. Pro-Rata Rights
VC’s right to invest in future rounds to maintain their ownership percentage.
- Valuable to good VCs (can double down on winners)
- Less critical for founders
🔒 Founder Terms
8. Vesting
Founders’ shares typically vest over 4 years with 1-year cliff:
- Cliff: None vest until 12 months (then 25% vests at month 12)
- Remaining 75% vest monthly over months 13–48
Why VCs insist on this: Prevents a co-founder from leaving after 6 months and keeping 50% of company.
9. Right of First Refusal (ROFR)
If a founder wants to sell shares, the company (or VC) gets first right to buy at the offered price.
10. Co-Sale Rights (Tag-Along)
If founders sell shares, VCs can sell proportionally alongside them.
📊 Term Sheet Red Flags
| Term | Why It’s Dangerous |
|---|---|
| 2–3× participating preference | VC gets outsized payout even in moderate exits |
| Full ratchet anti-dilution | Catastrophic in down rounds |
| Large option pool pre-money | Hidden dilution |
| VC-controlled board majority | Founders can be fired |
| No drag-along provision | Minority shareholders can block acquisitions |
🔗 Connected Concepts
- LBO Model — PE version of deal terms; compare structures
- Startup Valuation — How pre-money is determined
- Fund Economics — VC’s carry and IRR incentives drive term negotiation
- Cap Table Management — Tracking ownership through multiple rounds
- Lean Startup — The company’s stage when term sheet is signed
← 🚀 Entrepreneurship MOC | Related: Startup Valuation · Fund Economics · LBO Model