Series A funding: What is a term sheet, and why is it important?

Simply receiving a Series A term sheet from a venture capital (VC) firm is a huge accomplishment for startups because it’s a very strong indicator that the investor is interested in your company. When you receive a term sheet, you’re edging closer to your goal of securing the funding you need to grow your startup and take your idea to the next level.

If you have received a Series A term sheet and aren’t sure what to look for, you’ve come to the right place. 

In this article, we’ll take a deep dive into startup term sheets, explaining what they are, why they are important, and point out some important tips for negotiating them.

What is a series A term sheet?

A Series A term sheet is a basic agreement between a startup and an investor that outlines all the terms and conditions of the investment. The term sheet is almost always drafted by the investor and sent to the startup for review.

Term sheets usually focus on two key areas:

• Control of company shares 
• How financials will be divided if an exit occurs

Any startup interested in raising funding must understand how to read a term sheet. However, it’s important to note that the term sheet itself is not legally binding and can’t be used as an investment contract. It’s in no way, shape, or form a promise that the VC will invest in your company. VCs will draft an actual investment contract at a later stage based on much of the information in the term sheet.

You can think of the Series A term sheet as a blueprint for a house — it shows the design and key details of what’s to come, but the actual investment contract is the construction that turns it into reality.

Term sheets may seem a bit generic and mundane, but you should go over them carefully and thoroughly, as the fine details are very important to review. Specific provisions, seemingly minor or unimportant, can have as much impact on your company as the valuation itself.

The term sheet can also be useful in determining if you and the VCs offering you funding are the right fit. If they won’t budge on any terms that don’t sit well with you or they seem unreasonable during this process, it may be better to look elsewhere.

Why are term sheets important?

Why do VCs and startups go through so much trouble drafting and agreeing on a term sheet if it’s not legally binding? The document brings a lot of benefits to both parties, helps clarify certain issues, and smooths out the kinks in the agreement. Naturally, the startup and the VC will have different objectives and will push for different terms to be included in the term sheet during negotiations.

The investor’s perspective

From the investor’s point of view, the term sheet is a crucial tool they’ll use to evaluate the investment they’re about to make.

It also helps them gain a deeper understanding of the eventual payout they can expect and identify potential obstacles that could cut into their profits. Investors will want to maximize the potential financial return of the investment and mitigate any potential risks. They’ll also want to secure a preferred position when providing additional capital if the investment progresses well.

The startup’s perspective

For founders, term sheets help to clarify investor expectations when it comes to growth, revenue, and roles in the business. Startups will want to maintain control of the company’s operations and keep as much of its equity as possible while still receiving enough capital to develop and operate with more flexibility.

The term sheet can also expose early friction and disagreements between the investor and the founders and allow both sides to work these issues out before they truly become business partners. 

Example of a Series A term sheet

Before we get into the intricacies of the term sheet and what important information it can include, let’s see what one could actually look like.

Here’s a sample Series A terms sheet template that we’ve put together:

Breaking down provisions in a Series A term sheet

Now that you have an idea of what a typical Series A term sheet might look like, let’s take a deeper look at the provisions and terms included in the term sheet and what they actually mean.

VCs will include various provisions in their term sheets, which is why we’ll try to cover as many of the most common ones as possible.

Offering terms

This provision outlines the most fundamental details of the investment agreement and paints a clear picture of who is investing, how much capital is being raised, and the company’s valuation.

The offering terms will include the following key information:

• The closing date
• Investor names
• Amount raised
• The price per share
• The company’s “pre-money valuation”

The initial valuation

The startup’s valuation will determine what percentage of the company’s equity the investor will receive in return for their investment. VCs use two types of valuation in the term sheet: “pre-money valuation” or “post-money valuation.” As the names suggest, the pre-money valuation represents the company’s value before the investment. On the other hand, the post-money valuation is calculated by multiplying the company’s shares after investment with the price per share at the moment the investment is made.

Let’s say, for example, your startup has a pre-money valuation of $10 million. During the Series A funding round, a VC firm invests $2 million in your company. The post-money valuation would then be $12 million ($10 million pre-money valuation + $2 million investment). 

If your price per share is $10, the investor will receive 200,000 shares (2 million divided by $10 per share) in return for their investment. This means the investor now owns 16.7% of the company.

VCs will usually use post-money valuations. However, it’s important to clarify the type of evaluation being used with the investor to avoid any confusion.

Need more advice on how to split equity in the early startup stages? Check out our comprehensive startup equity calculator.

Type of stock investors are getting

Early-stage investors will typically look to purchase “preferred stock” when investing in startups. Preferred stock differs from common stock in that it allows the VCs to add unique terms and conditions that will not apply to holders of common stocks (typically the founders). Voting rights in the company will be unevenly distributed to favor the preferred stocks.

Additionally, VC firms with preferred stock will be above common stockholders in the debtor hierarchy, meaning that should the company go under, the investor will get their money back before other stockholders.

Voting rights

Voting rights are another important provision that is almost always included in Series A term sheets. These represent the rights the investor has to vote on matters of corporate policy. Delineating and defining these rights in the term sheet is beyond crucial, as it will determine who controls the company.

Facebook is a well-known example of a company that gave away voting rights to an investor early on. In 2004, Peter Thiel invested $500,000 in Facebook in exchange for a 10.2% equity stake in the company and voting rights on the board. This allowed Thiel to have a major influence over company decisions in the early stages of the startup.

The most important aspect of voting rights is the relation between holders of preferred stocks and common stocks. The term sheet can stipulate that specific actions (selling the company, issuing dividends, determining budgets, signing contracts, etc.) need to be approved either by a preferred or common majority. Since the founders will usually be holders of common shares and investors will hold preferred shares, this term will be crucial in deciding who has the most control over creating and governing corporate policies.

It’s essential to keep in mind that preferred stocks can also have common voting rights attached and that you’ll need to carefully balance the voting rights to ensure that control over these types of issues is as equally distributed as possible.

The liquidation preference

Another common clause you’ll find in the term sheet is liquidation preferences. These are extremely important to pay attention to as they can have a major impact down the line. Liquidation preferences determine the order in which the entities that own the company will get paid during a liquidation event such as bankruptcy or a sale. This provision serves to protect early investors from risks, ensuring that they get the money invested back before other shareholders are paid out.

A liquidation preference of 1x will mean that if the company is sold, the VCs will first get their investment back, and then the other shareholders will be able to divide what’s left. A liquidation preference greater than 1x (2x or, less often, 3x) will mean that the money they invested will be doubled or tripled, which can obviously lead to a serious cut into the payout that other shareholders will receive.

The option pool

Most startups reserve equity in the form of an option pool to help attract and incentivize future hires. Doing so helps to tie the success of the company directly to the financial gain of employees.

Most experts recommend reserving around 10-15% of stocks in the option pool. However, if your company already has a strong management team and you’re not looking to attract many new top managerial hires, you should be able to keep the option pool smaller if necessary.

Right of first refusal and co-sale agreement

The right of first refusal (ROFR) is another term that might be included in your Series A term sheet. This provision gives investors the option to purchase shares that are being sold before any third party.

A co-sale agreement allows a group of shareholders the right to sell their shares under the same conditions if another group of shareholders decides to sell.

Board structure

Series A startups will typically have a small board of directors. It will usually be a mix of founders, VCs, and outside advisors. Early-stage boards should accurately represent the equity structure of the company, meaning that both the common holders and preferred holders (investors) should be equally represented.

Here’s a simplified example of what a typical board structure might look like:

• Series A preferred holders (the VCs) will elect one member of the company’s board of directors.
• Common stockholders (usually the founders) elect one member of the board as well.
• The remaining directors are either outside experts or selected with the mutual consent of the board of directors.

However, if the venture capitalists control more than 50% of the company, they generally require more representation. Keep in mind that many VCs will also require a D&O policy because the firm is agreeing to serve on your board.

Founder vesting period

Founder vesting is a process during which startup founders “earn” their shares in the company over a period of time. If an employee or a founder leaves the company before the vesting period, they forgo the total amount of stock. Series A startups should consider a 12-month cliff and a 48-month founder vesting period. This would mean that if a founder leaves the company before a year, they will forfeit all of their stock, and after the first year, 25% of their stock will vest annually until they are fully vested after four years.

Founder vesting incentivizes co-founders to stay with the company and keep the stock with the company in the case that a founder decides to leave early on in the startup’s journey.

Anti-dilution protection

VCs will want to have an anti-dilution provision added to the term sheet. Such provisions will protect the value of their equity during subsequent funding rounds. Most successful startups go through several funding rounds throughout their lifecycle. Each additional funding round will dilute the equity of the existing founders, which is why early investors typically look for protection. There are two parts to anti-dilution protection: ratchet-based anti-dilution and weighted average anti-dilution.

Ratchet-based anti-dilution or “the full ratchet,” as it’s commonly referred to, means that if a company issues new shares at a lower price than the Series A round, the Series A price is reduced or “ratcheted” to that price, giving investors more stocks for their initial investment.

Weighted average-based anti-dilution, on the other hand, offers less protection. This provision adjusts the price per share based on a weighted average formula, which takes into account both the price and the number of new shares issued in a subsequent funding round. It protects investors, but not as drastically as ratchet-based anti-dilution, making it a more balanced approach that is preferred by most startups.

Redemption rights

Another provision that most VCs will request in a Series A term sheet is redemption rights. This gives the VC the option to have their outstanding shares redeemed by the company at a previously specified price. This price will typically be slightly higher than the fair market value.

These rights provide investors with protection if the company doesn’t sell or go public but is still successful enough to stay in business. 

Keep in mind that for redemption rights to come into play, the redemption needs to be approved by a majority of shareholders.

Issuing dividends

A dividend is a sum of money that a company pays out to shareholders at regular intervals from its profits. Most Series A startups won’t issue massive dividends, as they’ll typically need to burn a more significant portion of their investment money quickly to accelerate growth. 

Despite the fact that these dividends might not be huge, it’s still prudent to clearly outline when and how the company will pay out this compensation to avoid future conflicts.

Pro rata rights

Pro rata or pre-emption rights is a specific type of anti-dilution provision that represents the rights of the investor to buy shares during future financing. This allows the investors the right to maintain their percentage of ownership during future financing rounds. However, it doesn’t obligate them to purchase any more equity.

The issue with granting extensive pro rata rights to investors is that you risk losing financing flexibility in later rounds. Some investors will only want to come on board to secure a sizable portion of the company. So, if you have large amounts of equity tied up in pro rata rights, letting new investors into the fold could prove to be impossible.

No shop clause

One of the easiest ways to upset a VC is to use their term sheets to try and leverage a better deal elsewhere. That’s why VCs will almost always require an exclusivity period during which your startup cannot contact other investors.

Most VCs require an exclusivity period of around 30 days. However, some investors may ask for 60.

There are many unique terms and phrases, so if you are feeling lost, don’t worry. Head over to our list of essential startup terms every founder needs to know.

Tips for negotiating a Series A term sheet

While Series A may only be the first funding stage for startups, it is one of the most important. In fact, in 2024, the average Series A funding round in the USA was $18 million. Securing this amount of capital can be a game changer, but it is still important to make sure you negotiate the best deal possible for your organization. Here are some tips for negotiating your Series A term sheet.

1. Prioritize control and governance terms

When you sell off bits and pieces of your company, you are bound to lose some control over your company, but it’s vital to stay in the driver’s seat. Depending on the level of the investment and the number of shares they plan to buy, the VC firm may want board seats, voting rights, and decision-making over certain aspects of the company. Aim for a balance—give VCs enough influence to feel secure, but not so much that you lose control over your business.

2. Be transparent and honest

At the end of the day, a Series A term sheet could open the door to a long-term business partnership, so it’s a good idea to be as transparent and direct as possible right off the bat. We recommend being upfront with your company’s long-term goals as well as your current needs or any challenges you are facing. 

Additionally, if you have concerns about the provisions in the term sheet, don’t hesitate to request changes early on in the process. Last-minute changes can cause unnecessary friction during the negotiations.

3. Get an opinion from legal financial advisors

It’s never a bad idea to get an expert to look over your Series A term sheet to point out any red flags or discrepancies. Term sheets aren’t rocket science, but they can be confusing, especially if you are new to the world of venture capital. To make sure you aren’t missing anything important, we recommend hiring an experienced business attorney to look over the term sheet before you move forward with the investment contract.

4. Don’t overlook founder protections

It’s easy to get caught up in the excitement of securing funding. That said, don’t forget to make sure the term sheet includes safeguards that protect your position as a founder. Some important provisions to look out for are vesting schedules, equity clawbacks, and anti-dilution clauses, all of which ensure you’re not pushed out of your own company as it grows. 

How long does it take to negotiate a term sheet?

In most cases, it only takes startups a few days or a week to negotiate the Series A term sheet. The time it takes to negotiate the term sheet is largely dependent on how much the VC is interested in investing in your startup. If they are truly excited about working with you, you’ll probably be able to work the terms out quickly. 

If both sides are willing and dedicated to making the deal happen, it shouldn’t take more than a week to get the term sheet finalized.

It’s also important to note that your Series A term sheet will have a massive impact on future funding rounds. Investors will use your early term sheets to guide their decisions on whether you’re worth investing in and what the new term sheet should look like.