Term Sheets and Cap Tables

Term Sheets: Anatomy of a Venture Deal

Term Sheet — a non-binding document (usually) that records the key terms of the investment. This is a "preliminary agreement" on the basis of which lawyers prepare the final documents (Stock Purchase Agreement, Investor Rights Agreement, Voting Agreement).

Key Economic Terms

1. Valuation

Important: Founders often focus on pre-money, investors — on ownership %. With $20M pre / $5M investment, the investor gets 20% ($5M / $25M).

2. Liquidation Preference

Liquidation Preference — the investor’s prior right to capital return upon exit (sale, liquidation).

Participating vs Non-Participating Preferred

Non-participating (standard): Investor converts to common for a large exit — founder-friendly

Participating: "Double-dip" — receives both preference and participation — investor-friendly

Capped participating: Participation up to a certain cap (for example, 3x)

3. Anti-Dilution Protection

Investor protection in a down round (subsequent round at a lower valuation):

Broad-Based Weighted Average Formula

$ NCP = OCP \times \frac{CS + NM}{CS + NS} $

Where:

• $NCP$ = New Conversion Price
• $OCP$ = Old Conversion Price
• $CS$ = Common Stock Outstanding
• $NM$ = New Money / OCP (shares if priced at old price)
• $NS$ = New Shares Actually Issued

Governance and Control Rights

1. Board Composition

2. Protective Provisions (Veto Rights)

Investors require approval for key decisions:

• Amendment of charter / bylaws
• Issuance of new shares (especially with senior rights)
• Sale of company / material assets
• Change in Board size
• Declaration of dividends
• Increase in option pool
• Significant debt obligations

3. Pro-Rata Rights

Right to participate in future rounds to maintain ownership %.

• Major Investors: Usually determined by size of position ($500K+)
• Super Pro-Rata: Right to increase position (rare)
• Pay-to-Play: Lose rights if not participating (investor-friendly)

Option Pool and Dilution

Option Pool Basics

Option Pool — a reserve of shares for employees (ESOP). Created before the investment, diluting founders.

Option Pool Shuffle

Investors insist on pool creation from pre-money, which dilutes founders disproportionately:

Example: $20M pre-money, $5M investment, 15% option pool

• Without pool: Founders have 80% post-money
• With pool from pre-money: Founders have 68% (80% × 85%)

Investor: 20% ownership undiluted

Cap Table: Structure and Evolution

Simple Cap Table (Post-Seed)

Cap Table Evolution (Post-Series A)

Founder-Friendly vs Investor-Friendly Terms

Negotiation Dynamics

Leverage is determined by:

• Company momentum: Hot deal = founder leverage
• Market conditions: Bull market = founder-friendly terms
• Alternatives: Multiple term sheets = negotiating power
• Stage: Later stage = more standardized terms
• Investor reputation: Top-tier VC may get worse terms for brand

Red Flags in Term Sheets

• Participating preferred with no cap
• Full ratchet anti-dilution
• Excessive protective provisions
• Unusual liquidation multiples (3x+)
• Founder vesting reset
• Pay-to-play provisions (for founders)
• Redemption rights
• Unusual board control provisions

Recommendations for Understanding Deals

• Valuation is not everything: Bad terms on a high valuation = poor outcome
• Model scenarios: Calculate waterfall at different exit values
• Understand stacking: Multiple rounds preferences stack against founders
• Cap table hygiene: Clean cap table is important for subsequent rounds
• Legal review essential: Nuances in documents matter enormously