A term sheet is the non-binding document that outlines the key economic and governance terms of a financing round before the definitive agreements are negotiated. Understanding a term sheet requires familiarity with concepts such as pre-money valuation, option pool mechanics, liquidation preferences, anti-dilution protections, and pro-rata rights. While term sheets are typically non-binding, they set the frame for the entire negotiation — terms that are agreed in a term sheet are very rarely renegotiated in the definitive documentation.
Convertible loans and SAFE (Simple Agreement for Future Equity) notes are popular instruments for bridging financing and early-stage seed rounds. They allow investors to provide capital quickly, with conversion into equity at a later financing round at a discount to the round price. Key terms include the conversion discount, valuation cap, interest rate (for convertible loans), and maturity date. While these instruments are simpler than full equity rounds, the terms still require careful legal review.
Investors in early-stage companies typically require a package of governance rights as a condition of their investment. These include: board representation or observer rights, information rights (quarterly reporting, access to accounts), consent requirements for material decisions (acquisitions, new issuances, changes to business plan), and anti-dilution protections. Understanding the practical impact of these rights — and negotiating appropriate carve-outs — is essential for founders who wish to retain operational flexibility.
A liquidation preference is a contractual right that gives investors priority over founders and employees in receiving the proceeds of a sale or liquidation of the company. A 1x non-participating liquidation preference — the market standard in Germany — means the investor receives back their invested capital (plus any accrued return) before common shareholders receive anything, but does not participate further once they convert. Participating preferences, which allow investors to take their preference and then share in the remaining proceeds, are more investor-friendly and should be resisted where possible.
Anti-dilution protection is a contractual mechanism that adjusts the conversion price of an investor's preferred shares downward if the company subsequently issues new shares at a lower price than the investor paid (a 'down round'). This compensates the investor for the dilution caused by the down round. There are two main forms: broad-based weighted average anti-dilution (the market standard, which adjusts proportionally) and full ratchet anti-dilution (which adjusts the price to the new lower price, very investor-friendly and should be avoided).
A drag-along right allows a majority of shareholders (often including the lead investor) to force all other shareholders to vote in favor of and sell their shares in a proposed transaction. This prevents minority shareholders from blocking an exit. From an investor's perspective, drag-along rights are essential to ensure exits can be executed. From a founder's perspective, the threshold for triggering the drag-along and the protections available to dragged shareholders (minimum price, conditions) should be carefully negotiated.
The amount of equity relinquished depends on the company's valuation and capital requirements. In practice, founders typically give up 10 to 25 percent of their shares in seed funding rounds, and often more in later rounds. It is crucial that founders retain significant control over the company even after several funding rounds – for example, through a majority of 50 percent plus one share or through veto rights on key decisions. Excessive dilution can significantly impair founders' motivation.
A Cap Table (Capitalization Table) is a clear overview of a company's equity distribution, including all shareholders, options, convertible loans, and potential dilution effects. It shows who owns how much of the company and how these stakes will change in future funding rounds. A clean Cap Table is essential for investor due diligence and should always be kept up-to-date to ensure transparency regarding ownership.
