The term sheet defines the “rules of the marriage” between the startup and the investor. According to the SmartUp methodology, the most critical elements in this document include valuation, type of stock, liquidation preference, participating preferred, and governance and control.
The valuation section establishes the company’s Pre-Money and Post-Money valuation, which dictates the mathematical dilution of the founders. For example, if a company raises $5 million at a $10 million pre-money valuation, the post-money valuation becomes $15 million, and the investors own 33% of the company.
The term sheet specifies that investors typically receive Preferred Stock, which carries special rights over the Common Stock held by founders and employees. A crucial clause is Liquidation Preference, which determines the payout order during an exit and often dictates that investors get their money back before founders receive anything. In aggressive term sheets, investors may demand to be first in line over previous investors.
Participating Preferred is a specific, founder-unfriendly term that allows investors to “double dip,” receiving their initial investment back first and then participating in the remaining distribution according to their equity percentage. The term sheet also covers governance and control, including board composition and voting rights, and may grant investors the power to fire the CEO or force a pivot if growth expectations are not met.
From the SmartUp perspective, Yonatan Stern warns that while term sheets summarize the deal, the final contracts can evolve into lengthy and complex documents. He emphasizes that a term sheet reflects the power dynamic at the time of signing. If a company is desperate for cash and not profitable, it has zero leverage, allowing investors to dictate aggressive terms. This creates a “fake success” risk, where a company is sold for a respectable amount, yet founders receive nothing because all proceeds go to investors first.
