Red Flags in Term Sheets: What Every Founder Should Watch Out For

Term sheets can be complex documents with terms that significantly impact your startup's future. This guide helps founders identify and navigate potentially problematic terms.

Understanding Term Sheets

Key Components

1. Economic Terms

   • Valuation and price
   • Liquidation preferences
   • Option pool
   • Anti-dilution provisions

2. Control Terms

   • Board composition
   • Voting rights
   • Protective provisions
   • Information rights

Major Red Flags

1. Aggressive Liquidation Preferences

• Multiple > 1x
• Participating preferred
• Stacked preferences

Example:

"In the event of liquidation, Series A investors will receive 2x their investment
plus participation in remaining proceeds on an as-converted basis."


2. Excessive Board Control

• Investor majority
• Special veto rights
• Unilateral decisions

Better Alternative:

"Board composition: 2 founders, 2 investors, 1 independent director
mutually agreed upon."


3. Broad Protective Provisions

• Operational constraints
• Future financing blocks
• Exit restrictions

4. Unfair Anti-dilution

• Full ratchet provisions
• No broad-based weighted average
• No exceptions for strategic issuances

Hidden Traps

1. Option Pool Shuffle

• Pre-money vs. post-money
• Size requirements
• Vesting conditions

2. Founder Vesting

• No acceleration provisions
• Harsh clawbacks
• Single trigger vs. double trigger

3. Right of First Refusal

• Broad coverage
• Complex notice requirements
• Transfer restrictions

Negotiation Strategies

1. Economic Terms

• Focus on post-money valuation
• Cap liquidation preferences at 1x
• Push for broad-based anti-dilution

2. Control Terms

• Maintain board balance
• Limit protective provisions
• Preserve operational flexibility

3. Rights and Restrictions

• Standard pro-rata rights
• Reasonable information rights
• Limited transfer restrictions

Market Standards

Early Stage (Seed/Series A)

• 1x non-participating preferred
• Broad-based weighted average anti-dilution
• Basic protective provisions
• Pro-rata rights

Growth Stage (Series B+)

• Senior liquidation preferences
• Enhanced information rights
• Strategic board seats
• Registration rights

Common Scenarios

1. Multiple Investors

• Lead investor terms
• Pro-rata allocation
• Major investor rights

2. Bridge Rounds

• Conversion discounts
• Valuation caps
• Pay-to-play provisions

3. Down Rounds

• Anti-dilution triggers
• Recapitalization options
• Founder protection

Due Diligence

1. Legal Review

• Experienced counsel
• Term comparison
• Market validation

2. Impact Analysis

• Cap table modeling
• Exit scenarios
• Future round implications

3. Investor Background

• Portfolio companies
• Past term sheets
• Reputation check

Alternative Financing

1. SAFE Notes

• Standard terms
• Valuation caps
• Discount rates

2. Convertible Notes

• Interest rates
• Maturity dates
• Conversion terms

Expert Insights

"The best term sheets are simple and align interests. Complex terms often hide unfavorable provisions."
- David Kim, Partner at Venture Law Group

"Focus on the big three: valuation, liquidation preference, and board control. Most other terms are negotiable."
- Sarah Martinez, Managing Partner at Growth Capital

Action Items

1. Initial Review

• Compare to market standards
• Identify red flags

2. Negotiation Prep

• Prepare counter-proposals
• Model scenarios
• Build consensus

3. Legal Support

• Engage counsel early
• Review similar deals
• Document concerns

Conclusion

Term sheet negotiation is a critical skill for founders. While some terms are standard, others require careful attention and negotiation. Focus on maintaining alignment with investors while protecting your company's future flexibility.

Next Steps

1. Book a Legal Advisory Call
2. Use our Startup Valuation Calculator to model terms