5 term sheet mistakes startup founders must avoid

Negotiating term sheets and landing the capital to grow your business can be both challenging and exciting. In some rare cases, the fundraising process can be fraught with pitfalls that lead to unfavourable investment agreements.

It pays to arm yourself with the knowledge and legal help to make sure your company gets the best deal possible. Typically, investors are willing to work with you to create a win-win situation for everyone. Many investors know that the alignment between founder and shareholder is important for realizing a good return on capital.

Before you even begin accepting venture capital term sheets and meeting with investors, familiarize yourself with what you can expect. Here are five mistakes to avoid with term sheets during the fundraising process.

1. Your term sheet arrives weeks apart

If you are lucky enough to have multiple term sheet offers, you’ll have a choice over which VC to partner with. Getting two or more independent term sheets at the same time is an excellent way of evaluating your company’s value. Comparing competing term sheets can give you a more rounded view of how investors are appraising your company and help you negotiate the best deal.

However, not timing your fundraising activities well may lead to term sheet offers arriving weeks apart. If so, you will be under pressure to take the term sheet that came in early, instead of selecting the best deal for you and your team. On the other hand, waiting too long to accept a term sheet may cost you the deal.

2. Not learning common terms and red flags

Take some time to learn what’s founder-friendly and what’s not before going into a negotiation on the term sheet. You can do so easily by learning how to read a term sheet by reviewing a publicly available template. Knowing key terms such as different flavors of liquidation preference, anti-dilution and pro-rata rights will enable you to evaluate incoming term sheets effectively, so that you can quickly highlight concerns with your investors. If you see red flag terms such as 2x participating preferred rights and full ratchet anti-dilution, you should speak up.

3. Not understanding valuation concepts

Not educating yourself on valuation concepts can lead to misunderstandings in the actual ownership percentages and other economics. For instance, not understanding the differences between pre-money and post-money valuation can lead to different estimates of valuation by the founder and investor. It signals to the investor that you are inexperienced.

You may be surprised to find out that you own much less than you expected due to the option pool that’s usually set aside before the investors come in. Also, you should be aware of how your valuation is benchmarked against other companies in your space and location.

4. Not time limiting the “No Shop” clause

A no-shop agreement is typically part of the final term sheet once you’ve chosen your lead investor among your available options. Part of the process of negotiating the final term sheet with this investor is agreeing to commit to getting a deal done.

Founders may want to bind the no-shop clause to a time period of around 30-60 days to make the commitment mutual. The founder agrees not to shop the deal while the VC investor agrees to work towards a close within a reasonable time period.

Depending on the investment size and other factors, you should discuss the implications of accepting such a clause with your lawyer.

5. Not getting professional legal advice

Although it’s not often that you’ll get a term sheet with tons of aggressive terms, it’s important to be familiar with what is considered off-market terms. These are terms that your legal advisor can help you decide if they’re in your best interest to accept or not. One of the biggest mistakes founders make is not contracting a lawyer with a track record in startup fundraising.

Some lawyers can also model the terms and guide you through a range of situations to help you consider the projected results for your company.

Once you have legal help, it’s important to avoid delegating everything to the lawyers. Founders must continue to be involved in the negotiating process. Lawyers can’t always immediately determine what conditions and terms are best for your company.

You’ll want to strategize with your lawyer on which terms are important for your company’s growth. As each round goes by, you’ll become more comfortable with the process and learn more about how to structure the best deal for your company.

Final takeaways

Finding a good match between startup founders and VC investors is an essential part of the fundraising process. The term sheet matters because it summarizes the investment agreement, which directly affects how the partnership with the VC will work out with your company.

Using a document security solution like Digify can help you manage and distribute sensitive business information with investors and your team. It’s also a secure and convenient way to send pitch decks so you can evaluate investor engagement and quickly respond to feedback. Many founders and even VCs use Digify’s due diligence data rooms for closing their rounds. See if Digify’s document security and data room services are right for your company’s needs with a 7-day free trial.

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