The term sheet essentially sets the “rules of the marriage” between a startup and its investors. According to the SmartUp methodology, the most critical elements to watch for are valuation, type of stock, liquidation preference, participating preferred, and governance and control.
Valuation determines how much of your company you’re giving up. The pre-money and post-money valuations dictate the exact dilution founders will face. If you raise $5 million at a $10 million pre-money valuation, your post-money valuation becomes $15 million, meaning investors now own 33% of your company.
Investors typically receive Preferred Stock, which comes with special rights that Common Stock (what founders and employees hold) doesn’t have. One of the most important clauses is Liquidation Preference, which determines who gets paid first when the company exits. Usually, investors get their money back before founders see a dime. In more aggressive term sheets, newer investors may even demand priority over earlier investors.
Watch out for Participating Preferred, this is a particularly founder-unfriendly term that lets investors “double dip.” They get their initial investment back first, then participate in the remaining distribution based on their ownership percentage. It’s basically getting paid twice.
The term sheet also covers governance and control, including who sits on the board and what voting rights exist. These provisions can give investors the power to fire the CEO or force a pivot if growth targets aren’t met.
While term sheets summarize the deal in a few pages, the final contracts can balloon into lengthy, complex documents. The terms reflect the power dynamic at signing time. If your company is desperate for cash and unprofitable, you have zero leverage and investors can dictate aggressive terms. This creates a dangerous “fake success” scenario where a company sells for what sounds like a respectable amount, but founders walk away with nothing because all the proceeds go to investors first.
