What Your First Term Sheet Really Means: Key Terms, Dilution, and Exits

Understanding Your First Term Sheet: A Guide for Startup Founders

Receiving your first term sheet is a landmark moment for any founder. It validates your hard work and provides a tangible path toward capitalizing your vision. After the initial excitement, however, the document itself can be intimidating. It is often dense with unfamiliar legal and financial language that defines your company's future.

For founders in SaaS, Biotech, or Deeptech, who are often managing finances in spreadsheets without a dedicated CFO, this document represents a high-stakes negotiation. This guide provides term sheet basics for startup founders. We will demystify the key components and help you navigate this critical process with confidence, focusing on what really matters for early-stage companies in the UK and USA. For related guides, see the broader hub on Finance for Technical Founders.

What is a Term Sheet? It’s a Blueprint, Not a Binding Agreement

Before diving into specific clauses, you must grasp the fundamental nature of a term sheet. With few exceptions, it is a non-binding agreement. Think of it as a blueprint or a letter of intent that outlines the proposed terms for an investment. It forms the basis upon which lawyers will draft the final, binding investment agreements.

The primary purpose is to ensure all parties are aligned on the major points before incurring the significant legal costs of drafting definitive documents. This includes alignment on valuation, board structure, and key investor rights. You can review model legal documents from organizations like the NVCA to familiarize yourself with standard structures.

While most of the term sheet is not legally enforceable, pay close attention to certain clauses that are. Sections like “No-Shop” or “Confidentiality” are typically binding. These clauses prevent you from soliciting other investment offers for a set period, giving the investor exclusivity while they complete their diligence.

Part 1: The Core Economics and Understanding Equity Dilution

The first section of any term sheet covers the economics of the deal. Understanding the interplay between valuation, investment amount, and the employee option pool is fundamental. The key questions you need to answer are: what is the company worth, and what percentage will I own after the deal closes?

Pre-Money and Post-Money Valuation Explained

The deal starts with two key terms: Pre-Money and Post-Money Valuation. The pre-money valuation is what the investor values your company at today, before their investment. The post-money valuation is simply the pre-money valuation plus the new investment amount. For example, if an investor offers $2 million on an $8 million pre-money valuation, the post-money valuation becomes $10 million.

The investor’s ownership is calculated against the post-money figure. In this case, they would own 20% of the company ($2 million divided by $10 million). If you are considering convertible instruments instead of a priced equity round, you can learn more about their mechanics in our guide to SAFE Notes vs Equity Rounds.

The Employee Option Pool (ESOP) Shuffle

Unfortunately, the ownership calculation is rarely that simple. For most pre-seed to Series B startups, investors will almost always require the creation or expansion of an Employee Stock Option Pool (ESOP). The market standard for a Post-Financing Employee Stock Option Pool (ESOP) is 10-15%. This pool is essential for attracting and retaining key talent.

Crucially, investors insist this pool be created from the pre-money valuation. This means it dilutes the existing shareholders, primarily the founders, not the new investor. Their logic is that hiring is an operational expense, and the company should be fully equipped with a talent budget before their investment capital arrives. This is where the math gets critical. Let’s walk through a numerical example to see the dilutive effect.

An Example of ESOP Dilution

Consider a SaaS startup with this offer:

• Pre-Money Valuation: $8,000,000
• New Investment: $2,000,000
• Founder Shares: 8,500,000 (representing 100% of the company pre-deal)
• Required Post-Financing ESOP: 15%

Without the ESOP, the math is straightforward: the founder would own 80% of the $10 million post-money company. But the ESOP requirement changes the capitalization structure entirely. The 15% ESOP is calculated based on the final, post-investment share count, and the shares for it are issued from the pre-money capitalization.

Here is the impact on the founders:

1. The founder's 8,500,000 shares no longer represent 100% of the pre-money equity. They now represent only 85% of it, because the other 15% has been carved out for the new option pool.
2. This mechanic effectively lowers the "true" pre-money valuation of the founders' stake. The $8 million pre-money valuation is now spread across both the founder shares and the new ESOP shares.
3. The founder’s ownership post-investment drops significantly. Instead of 80%, their stake is now just 68% (which is their original 80% stake, reduced by the 15% ESOP carve-out that dilutes them).

Understanding this mechanic is a vital part of negotiating investment agreements. You should always model this in a cap table spreadsheet before agreeing to the terms.

Part 2: The Exit Scenarios and Who Gets Paid First

While valuation grabs the headlines, the terms in this section determine how proceeds are distributed upon an exit, such as a sale or IPO. Decoding these investor-friendly clauses is essential, as they can dramatically alter a founder's payout, especially in modest-to-good outcomes. For founders building capital-intensive Biotech or Deeptech companies with long regulatory timelines, like the FDA IND review, these terms are especially important.

Liquidation Preference

This clause dictates that investors get their money back first, before any other shareholders, in an exit scenario. The market standard is a 1x, non-participating preference. This structure gives the investor a choice: they can either receive 1x their original investment back, or they can convert their preferred shares into common stock and share in the proceeds pro-rata with founders and employees. They will choose whichever option yields a higher return.

Any terms beyond this standard should be carefully scrutinized. A preference multiple >1x (e.g., 2x or 3x) are considered founder-unfriendly. An even more problematic term is Participating Preferred Stock, which allows an investor a "double-dip." They get their initial investment back first, and then they share pro-rata in the remaining proceeds alongside common shareholders. This is considered a relic to be strongly resisted.

Let’s model two exit scenarios for a company that raised $5 million at a $20 million post-money valuation, giving the investor 25% ownership.

Case Study: Exit Payouts

• Scenario A: Great Success - Company sells for $60M
  • With 1x Non-Participating (Standard): The investor can take $5M (their 1x) or convert to common stock to receive 25% of $60M, which is $15M. They will convert and take $15M. The remaining $45M goes to founders and employees.
  • With 1x Participating (Off-Market): The investor first gets their $5M back. Then, they get 25% of the remaining $55M, which is $13.75M. Their total take is $18.75M. This term costs the founders $3.75M.
• Scenario B: Modest Success - Company sells for $15M
  • With 1x Non-Participating (Standard): The investor can take $5M (their 1x) or convert to 25% of $15M, which is $3.75M. They will take their $5M preference. The remaining $10M goes to founders and employees.
  • With 1x Participating (Off-Market): The investor first gets their $5M back. Then, they get 25% of the remaining $10M, which is $2.5M. Their total take is $7.5M, leaving only $7.5M for everyone else.

Anti-Dilution Protection

This term protects investors if the company raises a future funding round at a lower valuation, known as a “down round.” The standard is Broad-based weighted average protection. This provision adjusts the investor's conversion price based on a formula that accounts for the size and price of the new round, offering a fair and balanced form of protection.

A much more punitive version, Full Ratchet Anti-Dilution, reprices all of the earlier investor’s shares to the new, lower price, regardless of how many new shares are issued. This can be devastatingly dilutive to founders and employees. This is considered rare, punitive, and a major red flag.

Part 3: The Operating Rules and Negotiating Control

Beyond the economics, a term sheet establishes governance. It answers the key question: who gets to make the major decisions? For founders, this is about negotiating control provisions without sacrificing the long-term agility needed to run the company effectively. These terms set the rules for the relationship between you and your new partners.

Board of Directors

The board has ultimate authority over the company. For early rounds, a Typical Seed/Series A Board Size is 3 to 5 seats. A balanced board is crucial for healthy governance. A Common 3-Person Board Composition is 1 Founder, 1 Investor, 1 Independent. The independent director, mutually agreed upon by the founder and investor, is critical for providing an objective, tie-breaking voice and preventing deadlocks. A strong independent director also brings valuable industry expertise. You can learn more about managing your Board of Directors in our related guide.

Protective Provisions (Veto Rights)

Protective provisions grant investors the right to block certain corporate actions. These are not about day-to-day management; you still run your company. Instead, they are designed to protect the investor’s minority stake from major decisions that could negatively affect the value of their investment. Standard protective provisions are generally reasonable and include the right to veto actions such as:

• Selling the company
• Changing the company's line of business
• Issuing stock senior to the current investors
• Taking on significant debt

Drag-Along Rights

Drag-along rights enable a majority of shareholders to force a minority group to agree to a sale of the company. This provision is important because it prevents a small number of shareholders from holding up a beneficial exit that the majority supports. The threshold is key; a common standard is a majority of common and preferred shares voting together. This structure ensures that both founder and investor interests are represented in such a critical decision. For more details on this process, see our guide on Exit Planning: Acquisition vs IPO Math.

Practical Takeaways for Your Negotiation

Navigating your first term sheet is a process of understanding the core trade-offs between economics and control. It is one of the most important startup funding documents you will encounter. What founders find actually works is to focus on aligning incentives for the long term, not just optimizing for a single round.

1. Model Everything. Before signing, use a spreadsheet to model the cap table and potential exit scenarios. Map out exactly how your ownership changes with the proposed ESOP and how liquidation preferences affect payouts at different sale prices. This transforms abstract clauses into concrete numbers, which is essential for any founder-led financial modeling in a tool like QuickBooks or Xero.
2. Know the Standards. Benchmark every term against market norms. Deviations are not automatically bad, but they require a clear justification. If an investor proposes an off-market term, it is fair to ask why they feel it is necessary for your specific company and stage.
3. Negotiate with a Rationale. When you push back, do it with a clear, calm rationale based on market standards and long-term alignment. For example, if faced with a 2x liquidation preference, here is a professional way to respond:

We appreciate the offer and are excited to partner. Regarding the 2x preference, our understanding is that a 1x, non-participating preference is the market standard in both the US and UK for a company at our stage. We believe it's the best structure to align all shareholders for a successful outcome and would prefer to stick with that standard to ensure our incentives are aligned for the long term.

1. Hire Great Legal Counsel. This article is a guide to the business terms, not a substitute for legal advice. A good startup lawyer who has seen hundreds of these deals is your most valuable asset. They will protect you from hidden pitfalls and ensure the final, binding documents accurately reflect the business deal outlined in the term sheet.

A term sheet is the beginning of a partnership. By understanding these core components, you can negotiate a fair deal that sets your company, and your relationship with your new investors, up for success. For broader materials and related guides, visit the Finance for Technical Founders hub.

Frequently Asked Questions

Q: What is the difference between a term sheet and a shareholders' agreement?
A: A term sheet is a non-binding outline of the key terms of an investment, used to align parties before drafting legal documents. A shareholders' agreement is a detailed, legally binding contract that governs the relationship between the company and its shareholders, based on the principles agreed upon in the term sheet.

Q: How long does it take to go from a signed term sheet to closing the deal?
A: Typically, it takes between 30 to 60 days. This period allows the investor to conduct final due diligence on legal, financial, and technical aspects of your business. During this time, lawyers for both sides will draft and negotiate the definitive legal agreements, such as the Stock Purchase Agreement.

Q: Is a "No-Shop" clause standard, and should I agree to it?
A: Yes, a no-shop clause is a standard and binding part of a term sheet. It grants the investor exclusivity for a fixed period (usually 30-60 days) to complete diligence. It is considered a reasonable request, as investors expend significant time and resources evaluating a deal and want assurance you will not accept another offer during that process.

Q: Can I negotiate every clause in a term sheet?
A: While nearly everything is negotiable, it is wise to pick your battles. Focus on the terms that have the greatest economic and control impact: valuation, ESOP size, liquidation preference, anti-dilution rights, and board composition. Pushing back on standard, non-controversial clauses can signal inexperience and may damage the negotiation dynamic.