Term Sheets

Innovation & New Business Planning - TUHH Institute of Innovation Marketing & Institute of Entrepreneurship, Hamburg · part of my Technology Management MBA · study notes for revision.

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A term sheet is the document where a funding conversation stops being a conversation. Up to that point everyone has been talking about vision, traction and how big the market could be. The term sheet turns all of that into a set of contractual clauses that govern the rights and obligations of both the entrepreneur and the investor, and once those clauses are agreed they become the negotiation basis for the final legal paperwork: the corporate charter, the investor rights agreement and purchase agreement, and the founder employment agreements. The deck is blunt about the practical consequence: an entrepreneur handed a proposed term sheet should rely on experienced lawyers to interpret it, because the clauses interact in ways that are not obvious from reading them one at a time.

The reason this document deserves a whole session is that the headline number in it, the valuation, is the term everyone stares at and the term that decides the least. A large share of the economics is hidden in clauses about what happens if things go a particular way: if the exit is small, if the next round is priced lower, if a founder leaves, if someone wants to sell early. Those conditional clauses exist because nobody can write down every possible future, which is the formal problem the session opens with.

This chapter follows the deck’s own path. First the principles: what a term sheet is, the several roles it plays, and why contracts are inevitably incomplete so that clauses have to be made conditional through milestones. Then the four areas a term sheet governs: cash flow rights, control rights, founder compensation and employment, and the other rights around anti-dilution, future fundraising and liquidity. Every clause gets the same three questions asked of it: what does it do, who does it favour, and where is the tension between the two sides.

Tip

The one idea to carry through. A term sheet is a machine for splitting uncertain future money and uncertain future decisions between two parties who cannot see the future. Valuation is the most visible term and the easiest one for an entrepreneur to grasp, but the deck’s own conclusion is that cash flow rights can quietly undo a generous valuation. Read the clauses, not the headline number.

1 · What a term sheet is, and what it turns into

Term sheetthe set of contractual clauses governing rights and obligations of entrepreneur and investor

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Corporate charterthe constitution of the company, where share classes and voting live

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Investor rights agreement & purchase agreementwhat the investor buys and what protections come with it

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Founder employment agreementsfounders become employees, with salaries, vesting, IP and non-compete

The term sheet is not itself the contract. It is the negotiation basis for three documents that are, which is exactly why the deck insists on experienced lawyers to interpret a proposal before it is signed.

2 · The several roles a term sheet plays

It is tempting to read a term sheet as a price tag with legal decoration attached. The deck lists five genuinely different jobs it does at the same time, and each of them explains a different family of clauses.

Governrights, obligations, rewards

It sets out what each party is entitled to, what each party owes, and how the rewards are divided when money finally arrivesthis is the cash flow and control machinery

Shape incentivesfor all parties, employees included

It decides who works harder for what, and the incentive effect reaches beyond the two signatories to the employees who will be hired latervesting, option pools and participation caps all exist for this reason

Clarify expectationsforce the conversation

Negotiating it brings both parties to state what they actually expect to happen, which is often the first time the two forecasts get compared side by sidea disagreement discovered here is far cheaper than one discovered at exit

Allocate riskacross the two parties

It decides who carries the downside and who carries the upside, which is the whole reason preferred stock existsshifting risk is not free, it gets paid for elsewhere in the sheet

Bind external partiesemployees and future investors

It specifies the rights and duties of the parties towards people who are not in the room yet, namely employees and future investorsanti-dilution, pre-emption and protective provisions all constrain a round that has not happened

The last role is the one beginners underestimate. A clause signed today can restrict what a completely different investor is allowed to do in three years, which is why term sheets accumulate rather than reset.

3 · Contingent contracting: contracts are incomplete

Term sheets address highly uncertain prospects, and that uncertainty compounds a problem that exists in every contract anyway: it is naturally impossible to cover all possible future events and situations. Economists express this by saying that contracts are incomplete.

The answer is contingent contracting, where a clause applies only to certain situations rather than always. The contract stops trying to describe the future and instead describes a set of triggers with a different rule attached to each.

The problemuncertain venture + impossibility of listing all futures = incomplete contract

The fixcontingent contracting: clause C applies only in situation S

The 2016 Nobel work on incomplete contracts sharpens this into a distinction the deck draws explicitly, and it is worth memorising because it explains why so many venture clauses are about who decides rather than about what happens.

Clauses on verifiable actions need a milestone

• They tie an outcome to something both sides can observe and confirm
• They rely on the existence of precise circumstances that disclose information
• Workable only when performance can genuinely be measured

Clauses that allocate decision rights only name the decider

• They do not describe the outcome at all, they only identify who has the right to decide
• Built for cases where verification is not possible
• Which is the normal case in ventures, where information is opaque and difficult to interpret

When you cannot write down what should happen, you write down who gets to choose. That single idea explains board seats, veto rights and protective provisions.

4 · Milestones: how contingencies get written down

Term sheets define contingencies through milestones, which identify salient events that reveal information on whether the company’s progress conforms to expectations or not. The deck’s worked clause makes the mechanism concrete: the board of directors consists of five members and the investor nominates two, but if the company fails to generate sales within 12 months from the closing, the investor nominates two additional directors. Nobody had to predict the future. They only had to agree on a trigger and on what shifts when it fires. Notice also that what shifts here is a decision right, not money.

Milestone dimension	Typical examples from the deck
Financial	Sales, EBIT, operating cash flow, a financial ratio
Operational	Regulatory approval, a supply contract
Managerial	Hiring of a CxO, appointing an independent director
Technical	A working prototype, acquiring a licence
Commercial	Sales, customer renewals, a wholesaler letter of intent

Milestones carry four economic roles, and three real drawbacks that the deck is careful not to hide.

What milestones do for you

• Define performance targets that both sides have signed off on
• Align the expectations of entrepreneurs and investors
• Provide a focal point for renegotiation when things change
• Make valuation easier to negotiate by linking it to performance targets rather than to opinion

What they cost you

• Defining performance may be elusive: when is a prototype really working?
• Chasing them can cause under-pivoting, for example rushing the product to market instead of changing direction
• Chasing them can cause short-termism, for example distorting the business to hit a sales or production target

A milestone is a measurement, and every measurement becomes a target that people optimise for. That is useful and dangerous at the same time.

5 · The four areas a term sheet governs

Cash flow rightsControl rightsCompensation and employment for founders and key employeesOther rights: anti-dilution, future fundraising, liquidity

Everything that follows sits in one of these four boxes. When you are handed a real term sheet, sorting the clauses into these four piles is the fastest way to see what is actually being asked of you.

6 · Cash flow rights: why preferred stock and not common

Cash flow rights are allocated between entrepreneur and investors with one stated objective, to maximise the expected value of the venture. The deck says this is done in two ways at once: give investors downside protection, and give both parties strong incentives to work for high performance. Those two goals pull against each other, and the instrument that reconciles them is convertible preferred stock.

Investors therefore obtain convertible stock rather than common stock. Convertible stock gives its holder a right to choose between two payoffs:

If the company fails the debt-like leg

• The holder takes a debt-like payoff, that is a fixed claim paid before the common shareholders
• This is the downside protection

If the company succeeds the equity leg

• The holder converts into common equity and takes an ordinary ownership share
• This is profit sharing in the upside

One security, two possible payoffs, and the investor picks whichever is larger at the moment of exit. The founder holds plain common stock and gets whatever is left.

Convertible shares are always preferred, meaning they carry yearly preferred terms in the form of a dividend that is deferred and accrues over time rather than being paid out in cash. The value of those preferred terms is what the investor is owed before anyone else sees a cent.

Preferred terms, simple accrualPT = I + DIV = I + IDT

WhereI = investment, D = stated yield, T = time to exit

Preferred terms, compounded dividendsPT = I + I*(D)^T

The investor converts at exit when the cash flow from holding common shares would exceed the preferred terms. Writing Finv for the investor’s ownership fraction and X for the exit value, conversion happens when Finv*X beats PT, and rearranging gives the conversion threshold.

Convert whenFinv * X > PT

Conversion thresholdCT = PT / Finv

That gives the three-region payoff that is the single most important table in the whole session.

Exit value	Condition	Cash flow to investors	Cash flow to entrepreneurs
Large	X above CT	Finv * X	(1 - Finv) * X
Intermediate	PT below X below CT	PT	X - PT
Small	X below PT	X	0

Read the bottom row slowly, because it is the row founders forget. Below the preferred terms the investor takes everything and the founders take nothing. Plotted against exit value, the investor’s payoff is the 45 degree line up to X = PT, then flat at PT until X = CT, then the sloping line Finv*X afterwards. The entrepreneur’s payoff is a flat zero up to PT, then rises.

The WorkHorse example, non-participating

Variable	Notation	Amount
Common shares	Sent	1,250,000
Preferred shares	Sinv	416,667
Investor ownership	Finv	25%
Price per share	P	$4.80
Investment	I	$2,000,000
Time to exit	T	1
Dividend rate	DR	8%
Total dividends	TD	$160,000
Preferred terms	PT	$2,160,000
Lower switch point	X = PT	$2,160,000
Upper switch point	X = PT/Finv	$8,640,000

Exit value ($M)	Preferred terms ($M)	Equity value on conversion ($M)	Conversion attractive?	Cash to preferred ($M)	Cash to common ($M)	Ownership fraction of preferred
1	1	0.25	No	1	0	100%
3	2.16	0.75	No	2.16	0.84	72%
8	2.16	2	No	2.16	5.84	27%
8.64	2.16	2.16	Same	2.16	6.48	25%
9	2.16	2.25	Yes	2.25	6.75	25%
10	2.16	2.5	Yes	2.5	7.5	25%

Two things to notice. In the first row the exit is only $1M, less than the preferred terms, so the investor cannot collect the full $2.16M and simply takes the whole $1M, which is why the ownership fraction reads 100 percent. And at an $8M exit, an investor who nominally owns a quarter of the company actually collects 27 percent of the proceeds, because the preference is still worth more than the shares.

7 · Liquidation preference: multiples, participation and caps

The plain convertible preferred above already contains a 1x liquidation preference: the investor gets the capital back before the common. Three modifications make it progressively more investor-friendly.

Multiple liquidation preference. The convertible preferred may add a multiple, so the investor gets its capital back several times over before anyone else is paid.

Preferred terms with multiple MPT = M*I + DIV

The conversion threshold moves rightCTm = PT / Finv = (M*I + DIV) / Finv > CT

The multiple therefore does two things at once: it raises the flat portion of the investor payoff, and it pushes the point at which the investor is willing to convert further out, so the founders’ dead zone gets wider.

Participating preferred, the double dip. Participating preferred terms combine debt and equity features by adding a liquidation preference, possibly a multiple one, to the preferred dividend. The investor then takes the preferred terms and also shares in the common equity afterwards, instead of choosing between the two.

Participating preferred payoffCFinv = PT + (X - PT) * Finv

Exit value	Condition	Cash flow to investors	Cash flow to entrepreneurs
Larger	X above PT	PT + Finv*(X - PT)	(1 - Finv)*(X - PT)
Small	X below PT	X	0

Participating preferred with a cap. Because an uncapped double dip eats into the founders’ upside at every exit value, a cap may be imposed on the participation specifically in order to preserve the entrepreneurs’ incentives. Participation vanishes once the exit exceeds Xcap, and above the cap the investor eventually prefers to give up the preference altogether and convert to plain common.

Investor payoff once the cap bindsCFinv = PT + (Xcap - PT) * Finv

Exit at which full conversion to common becomes betterXcom = Xcap + PT*(1 - Finv) / Finv

The deck adds a practical note: the drop at the cap is usually smoothed out, because a sharp step creates perverse incentives at the moment of exit, where one side would rather sell for slightly less than for slightly more.

The WorkHorse example, participating with a cap

Same company as before, with a cap of Xcap = $20,000,000, which gives a full-conversion threshold of Xcom = 20 + 2.16*0.75/0.25 = $26,480,000.

Exit ($M)	PT ($M)	X - PT ($M)	Finv*(X-PT) ($M)	Investor cash flow ($M)	Cash to common ($M)	Ownership fraction of preferred	What is happening
1	1	0	0	1	0	100%	PT only
3	2.16	0.84	0.21	2.37	0.63	79%	Double dip
5	2.16	2.84	0.71	2.87	2.13	57%	Double dip
10	2.16	7.84	1.96	4.12	5.88	41%	Double dip
20	2.16	17.84	4.46	6.62	13.38	33%	At the cap
25	2.16	17.84	4.46	6.62	18.38	26%	Cap binding
30	0	30	7.5	7.5	22.5	25%	Converted to common

Compare this against the non-participating table. At a $10M exit the non-participating investor takes $2.5M; the participating investor with the same 25 percent takes $4.12M. The entire difference comes from one word in the clause.

8 · Why preferred securities at all

The deck gives three rationales, and the third is the one that is genuinely surprising.

1. Incentives for founders with a need for balance

• Because the founder holds the residual claim, they only get paid when the company clears the preference, which concentrates their effort on the upside
• The parenthetical matters: too much preference and the founder’s stake becomes worthless in most states of the world, killing the very incentive it was meant to create

2. Screening under information asymmetry

• The founder knows more about the venture than the investor does
• A preferred term sheet makes a weak venture look unattractive to its own founder, so weaker projects self-select out rather than having to be detected

3. Alignment of expectations

• Accepting a heavy preference is a statement that you expect a large exit
• Negotiating over it forces the two forecasts into the open

The mechanism behind screening

• Offer two term sheets, one participating preferred and one plain common, priced so that a genuine venture prefers the preferred one
• Whichever sheet a founder picks is itself information about what they privately believe

The self-selection numbers

Two ventures both claim an exit value of 100. The true exit value is 100 for the real one and only 60 for the fake one. The investor offers the same 20 either as participating preferred or as common, and the two offers are deliberately priced differently. All values in millions of euros.

Item	Participating preferred offer		Common offer
Investment	20	=	20
Investor share	30%	is below	60%
Post-money valuation	66.67	is above	33.33
Dividend, non compounding	10%	is above	0.00
Time to exit	5	=	5
Preferred terms	30	is above	0
Investor value with the true venture	51	is below	60
Founder value with the true venture	49	is above	40
Investor value with the fake venture	39	is above	36
Founder value with the fake venture	21	is below	24
Naive expected value for investors	45	is below	48
Expected value for investors with self-selection	51	is above	36

Follow the logic in the order the table sets it up. The preferred terms are 20 + 20*0.10*5 = 30. A founder with a true venture prefers the preferred sheet, 49 against 40, because the high post-money valuation of 66.67 leaves them a bigger slice. A founder with a fake venture prefers the common sheet, 24 against 21, because their exit is too small to clear the preference profitably. So the sheets sort the founders. The last two rows are the punchline: judged naively, without accounting for who accepts what, the common sheet looks better for the investor, 48 against 45. Once self-selection is allowed to operate, the preferred sheet earns 51 and the common sheet attracts only the fakes and earns 36.

9 · Founder compensation, employment and vesting

Upon funding, founders become employees. That is a bigger change than it sounds, and the deck names three consequences of the founder employment agreements.

They can be firedthe deck cites Steve Jobs and Travis Kalanick

They are subject to non-compete lawsthey cannot simply restart the same business next door

They confer their IP to the companythe invention stops being personal property

Signing the round converts a founder from an owner who happens to work there into an employee who happens to own shares.

Founder compensation may include a salary below market, a performance bonus, and stock options at later stages to restore incentives once the original equity stake has been diluted. Two guiding principles run through it: defer pay as much as possible to save cash, and provide incentives for long-term value creation.

Because most of a founder’s compensation comes from the future sale of common stock, that stock is vested, meaning it has to be earned back over time rather than being owned outright from day one. Two criteria are used:

• Time vesting - linear, with or without a cliff, and possibly with acceleration.
• Performance vesting - typically accelerated upon an IPO or an acquisition.

Vesting is lost in case of dismissal with cause, which is the sanction that gives the whole arrangement its teeth.

The vesting example, and what a cliff really does

A founder is allotted 60 percent ownership, vesting at a 6 percent quarterly rate with a cliff of one year.

Quarterly vesting6% of the company per quarter, out of a 60% allotment

Time to full vesting60% / 6% per quarter = 10 quarters

The cliffafter 9 months vested = 0%, after 12 months vested = 4 * 6% = 24%

The cliff is the part that catches people out. Vesting requires one full year of employment before it starts kicking in, so a founder who leaves after nine months walks away with nothing at all, while a founder who stays three months longer jumps straight to 24 percent. The clause is unforgiving on purpose: it is an anti-tourist device, designed so that a founder who was never really committed cannot collect a quarter of the company for less than a year of work.

10 · The employee stock option pool

Stock options come from an option pool that is typically set up at the first funding round, Series A, and replenished when needed.

Pool size: 10 to 20 percent of the fully diluted stock baseConsumption: many companies use 2 to 5 percent per yearDepends on the type of talent being recruited

Options are themselves subject to vesting, unless they come from a hiring bonus or a yearly bonus. Three further details from the deck:

• They have a strike price, often very small, or linked to the price of the last round.
• Exercising them may require a short-term loan from the company, because an employee may not have the cash to buy shares they cannot yet sell.
• Hence the emphasis on granting liquidity to employees: an option that can never be turned into money is not really compensation.

11 · Control rights

The company charter and by-laws provide three main types of control right, and they are ranked in strength rather than being alternatives.

Shareholders’ voting rightsthe base layer

Control proportional to shares held, exercised in the shareholders’ meetingblunt, and only as strong as your percentage

Board of directorswhere decisions actually get made

Board composition is negotiated seat by seat, and seats can themselves be made contingent on milestonesrecall the clause where failing to generate sales in 12 months hands the investor two more seats

Contractual rightsthe strongest layer

They can supersede both voting and board rights, come as veto rights or as affirmative rights, and are limited in time; typical subjects are the sale of the company and the appointment of the CEOthis is where protective provisions live

The distinction between veto and affirmative rights is worth holding onto. A veto right lets the investor block something; an affirmative right requires the investor’s positive consent before something can happen. An investor with a small minority stake can hold a decisive say over the sale of the company through a contractual right that never appears in the ownership percentages.

12 · Clauses that reach into future fundraising

Term sheets at every round set rules that affect future rounds and future investors. The deck groups five clauses here.

Protective provisionsAnti-dilutionPre-emption rightsRight of first refusalPay-to-play

Protective provisions are the contractual rights described above pointed specifically at future funding: they influence the details of future funding rounds, so a new investor arriving later has to negotiate with the old term sheet as well as with the company.

Anti-dilution

Anti-dilution protects investors in the case of a down round, defined as a round where the share price falls below that of the previous round. A flat round is one where the price does not increase. The clause compensates an investor for having paid a share price that turns out to have been too high, and it does so by specifying a rule for adjusting the previous round’s price retroactively, which issues that investor extra shares.

Two complementarity statements from the deck are the cleanest way to place this clause among the others:

• Convertible preferred protects against disappointing exits; anti-dilution protects against disappointing future rounds.
• Anti-dilution protects the value owned by the investor, which makes it complementary to pre-emption rights, which preserve the percentage owned.

The example runs two rounds, of $5M and $10M.

Round	Pre-money	Post-money	Share price
Series A	$10M	$15M	$1.00
Series B	$11.25M	$21.25M	$0.75

Full ratchet investor-friendly

• The whole first round is simply re-priced at the new low price, here $0.75
• It ignores how small the down round was, so even a tiny cheap issue re-prices the entire earlier round
• Harshest possible outcome for the founders

Weighted average entrepreneur-friendlier

• The first round is re-priced partway down, weighted by how much new money came in at the low price
• Narrow based counts only the Series A shares in the base
• Broad based also includes the entrepreneur’s shares, which enlarges the base and softens the adjustment further

Same trigger, three possible severities. Which word appears in the clause is worth several percentage points of the company.

Weighted-average re-pricingP1wa = P1 * (Sbase + I2/P1) / (Sbase + I2/P2), Sbase = existing shares

Broad based, Sbase = 15M sharesP1wa = 1 * (15 + 10/1) / (15 + 10/0.75) = 25 / 28.3 = $0.88

Narrow based, Sbase = 5M sharesP1wa = 1 * (5 + 10/1) / (5 + 10/0.75) = 15 / 18.3 = $0.82

The full ownership comparison, with the entrepreneur always holding 10.00M shares and Series B always buying 13.33M shares at $0.75:

Protection	Series A adjusted price	Series A shares (M)	Total shares (M)	Entrepreneur after round 1	Series A after round 1	Entrepreneur after round 2	Series A after round 2	Series B after round 2
A. None	$1.00	5.00	28.33	66.7%	33.3%	35.3%	17.6%	47.1%
B. Full ratchet	$0.75	6.67	30.00	60.0%	40.0%	33.3%	22.2%	44.4%
C. Weighted average, narrow	$0.82	6.11	29.44	62.1%	37.9%	34.0%	20.8%	45.3%
D. Weighted average, broad	$0.88	5.67	29.00	63.8%	36.2%	34.5%	19.5%	46.0%

The founder loses 2 percentage points after the second round under full ratchet compared with no protection at all, 35.3 down to 33.3, and the Series A investor gains 4.6 points, 17.6 up to 22.2. Note also that the Series B investor is diluted too, from 47.1 to 44.4 percent, which is why a new investor cares very much about what anti-dilution the previous round carries.

Pre-emption rights and the right of first refusal

Pre-emption rights give an investor the right to participate in future rounds by purchasing new shares up to their pro rata amount, so their percentage need not fall unless they choose to let it.

Right of first refusal allows the company to purchase shares that an investor or a founder wants to sell, on the same terms offered by a third party. It aims at preserving insiders’ ownership, and if the company does not exercise the right, the investors can.

Both clauses protect an investor’s percentage ownership, for two stated motivations: they allow investors to maintain their share in the upside, and a certain percentage ownership may be a necessary condition for board rights or information rights, so letting the percentage slip can quietly cost an investor their seat and their data.

Pay-to-play, the clause that protects the entrepreneur

The deck is explicit that entrepreneurs also need term sheet protection, and pay-to-play is the example. It imposes a duty on existing investors to participate pro rata in future rounds.

Duty to participate pro rataold investors must put in their share of the new round

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Keeps old investors contributingboth the money itself and the signal that insiders still believe

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Contractual penalty if they do notforfeiting rights such as anti-dilution and information rights

The signal is as valuable as the cash. An existing investor who refuses to follow their money tells the market something, so pay-to-play makes silence expensive.

13 · Investor liquidity: getting the money out

Investors need to sell their shares at some point, and a private company offers no market to sell them in. Four clauses address that.

Clause	What it grants	Who it favours
Redemption rights	The investor may redeem their shares after a reasonably long period, at the preferred terms	Investor, and it can drain company cash at an awkward moment
Tag-along rights	Investors can sell their shares along with the founders, on the same terms, if the founders sell	Investor, and it stops founders cashing out alone
Drag-along rights	Investors can force other shareholders to sell their stock	Investor, and it prevents a minority blocking an exit the investor wants
Registration rights and piggy-back	The right to force a public listing and to sell shares into it	Investor, and piggy-back lets them join a listing someone else triggered

Tag-along and drag-along are worth memorising as a pair because they are opposites. Tag-along is a right to join a sale; drag-along is a right to compel one.

14 · The remaining clauses

Clause	What it does
Information rights	Let the investor obtain hard data about the company, especially useful at early stages when nothing else is observable
Key man insurance	Insurance on the founders, because at this stage the company is the founders
Legal resolutions	Which law applies and how disputes are handled
Representations and warranties	Legally binding statements about the state of the company; any failure to be truthful can lead to financial liability and can possibly void the deal

And a set of clauses that govern the negotiation itself rather than the company:

• No shop clause - the entrepreneur agrees not to seek or negotiate other offers for a defined period, so the investor can run diligence without being auctioned against. Entrepreneur-unfriendly if the period is long, because it removes competitive tension exactly when it is most valuable.
• Exploding offer - the offer expires quickly, compressing the time available to shop it or to think.
• Due diligence conditionality - the offer holds only if diligence confirms what was claimed.
• Co-investors - the deal depends on other investors joining the round.
• Milestones - the contingent triggers from section 4, used here as a negotiation device.

15 · Valuation versus terms

You cannot have your cake and eat it, and you cannot negotiate every term at once. Valuation is the most visible term, and the easiest one for entrepreneurs to grasp - which is exactly the trap, because everything in sections 6 and 7 shows that cash flow rights can undo a generous valuation.

The deck then makes a more constructive point: the trade-offs prove that this negotiation is not a zero-sum game. Three axes to trade along:

Valuation versus control rights, meaning how much protection you give yourselfValuation versus compensation and future payoffsValuation in the upside versus valuation in the downside

The third one is illustrated with three versions of the same $20 investment, all with an exit of $400 in the good outcome and $80 in the bad outcome, each 50 percent likely.

Deal	Investor stake	Post-money	Investor, good	Investor, bad	Investor, expected	Founder, good	Founder, bad	Founder, expected
Common shares, $20 for 25%	25%	$80	$100	$20	$60	$300	$60	$180
2x preferred, $20 for 20%	20%	$100	$80	$40	$60	$320	$40	$180
3x preferred, $20 for 15%	15%	$133	$60	$60	$60	$340	$20	$180

Every row gives the investor the same expected $60 and the founder the same expected $180. The founder is being offered a higher valuation in exchange for a bigger preference, which is the trade in its purest form. What changes is not the average but the shape of the outcome.

Deal	Expected founder return if optimistic, 60% success	Expected founder return if pessimistic, 40% success
Common share deal	$204	$156
2x preferred share deal	$208	$152
3x preferred share deal	$212	$148

Deal	Spread between good and bad outcome, founders	Spread between good and bad outcome, investors
Common share deal	$240	$80
2x preferred share deal	$280	$40
3x preferred share deal	$320	$0

This is the cleanest lesson in the deck. If you genuinely believe your venture will succeed, accepting a bigger preference for a higher valuation makes you better off, $212 against $204 under the optimistic view. If you are privately less sure, the same trade makes you worse off, $148 against $156. And the spread table shows what you have actually bought: under the 3x deal the investor’s outcome is completely flat at $60 whether the exit is $400 or $80, while the founder now carries a $320 swing. You did not get a better deal, you took over the risk.

16 · Seed stage: convertible notes and SAFEs

Term sheets look different at the seed or pre-venture stage, which the deck characterises by three features: funding amounts under $100K, unsophisticated investors, and a most likely outcome in which the company simply fades away. Negotiating a full preferred round under those conditions costs more in legal fees than the round is worth.

Convertible notes are debt-like claims built for exactly this.

Money in as debtno valuation is agreed and no share price is set

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Automatic conversion at the first qualified roundtypically Series A

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Converts into the same security then issuedthat is, into the convertible preferred of that round

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At a pre-determined discount of 10 to 20 percentmaturity typically 12 to 24 months

The note buys time. Valuation, the hardest term to agree when there is nothing to value, is postponed until a real investor sets a price.

Conversion price with a discountPcn = (1 - DIS) * Pinv

Shares the note converts intoScn = Icn / Pcn = Icn / ((1 - DIS) * Pinv)

Valuation cap, which avoids paying for successPcn = Vcap / Spre ≤ (1 - DIS) * Pinv

Ownership relations under a capScn / Spre = Icn / Vcap and Scn / (Spre + Scn) = Icn / (Vcap + Icn)

New investors’ pricePinv = Vpre / (Spre + Scn)

The phrase paying for success names the problem the cap solves. With only a discount, the better the company does before the next round, the higher the price at which the seed investor’s money converts, so the person who backed the company first ends up with the smallest stake. A cap fixes a maximum valuation at which their note may convert.

WorkHorse convertible note, with and without a cap

Inputs: 950,000 pre-existing shares, a convertible note of $80,000 with a 20 percent discount, a seed investment of $500,000 at a $2,000,000 pre-money and $2,500,000 post-money valuation, giving a seed round share price of $2.

	Without cap	With a $1,000,000 cap
Price per share for the note	$1.60	$1.05
Number of shares to the note	50,000	76,000
Pre-existing shares including the note	1,000,000	1,026,000
Price per share for the new investors	$2.00	$1.95
Number of shares to the new investors	250,000	256,500
Total shares after the round	1,250,000	1,282,500
Note ownership before the seed round	5.00%	7.41%
Note ownership after the seed round	4.00%	5.93%

The cap alone lifts the seed investor from 4.00 to 5.93 percent of the company, roughly half as much again, for exactly the same $80,000.

PunchTab convertible note, the full sensitivity grid

The second example varies the Series A investor’s ownership from 70 percent down to 20 percent and traces what the note is worth in each case. Inputs: 1,000,000 pre-existing shares, a seed note of $750,000 with a 20 percent discount and 6 percent compounded interest, maturity 1 year giving a total note value of $795,000, a valuation cap of $6,000,000, and a Series A investment of $4,000,000.

Series A ownership	Post-money	Pre-money	Share price next round	Shares to Series A	Discounted note price	Capped note price	Shares to the note	Note ownership before	Note ownership after
70%	5,714,286	964,286	$0.96	4,148,148	$0.8	$6.0	1,030,556	50.75%	16.68%
65%	6,153,846	1,403,846	$1.40	2,849,315	$1.1	$6.0	707,877	41.45%	15.53%
60%	6,666,667	1,916,667	$1.92	2,086,957	$1.5	$6.0	518,478	34.14%	14.38%
55%	7,272,727	2,522,727	$2.52	1,585,586	$2.0	$6.0	393,919	28.26%	13.22%
50%	8,000,000	3,250,000	$3.25	1,230,769	$2.6	$6.0	305,769	23.42%	12.05%
45%	8,888,889	4,138,889	$4.14	966,443	$3.3	$6.0	240,101	19.36%	10.88%
40%	10,000,000	5,250,000	$5.25	761,905	$4.2	$6.0	189,286	15.92%	9.70%
35%	11,428,571	6,678,571	$6.68	598,930	$5.3	$6.0	148,797	12.95%	8.51%
30%	13,333,333	8,583,333	$8.58	466,019	$6.9	$6.0	132,500	11.70%	8.29%
25%	16,000,000	11,250,000	$11.25	355,556	$9.0	$6.0	132,500	11.70%	8.90%
20%	20,000,000	15,250,000	$15.25	262,295	$12.2	$6.0	132,500	11.70%	9.50%

Read the two price columns against each other. The note converts at whichever is lower, so down to a Series A ownership of 35 percent the discount is what binds; from 30 percent onwards the discounted price would exceed $6.0 and the cap takes over, freezing the note at 132,500 shares. That is precisely the “paying for success” effect being switched off, and it is why the final column stops falling and starts rising again, from 8.29 to 9.50 percent, once the cap is doing the work.

The appeal of convertible notes, and the reason they dominate at seed:

• A simple, standardised structure available as templates
• Which allows the parties to save on legal costs
• Virtually no control rights and no other protective rights attached
• It delegates and postpones both valuation and negotiation
• The SAFE, a Simple Agreement on Future Equity, is simpler still, because it has no maturity date and no dividend rate

Worked example

The liquidation preference is the clause that most changes who gets what, so it is worth walking one company through three exit sizes. Using the WorkHorse cap table from section 6.

The cap tableFounders: 1,250,000 common. Investor: 416,667 preferred at $4.80 = $2,000,000. Finv = 25%

The preferred terms, 8 percent dividend, 1 year to exitPT = I + IDT = 2,000,000 + 2,000,0000.081 = $2,160,000

Conversion thresholdCT = PT / Finv = 2,160,000 / 0.25 = $8,640,000

Now compare a non-participating 1x preference, where the investor must choose between the preference and converting, with a participating 1x preference, where the investor takes both.

Exit	Non-participating: investor	Non-participating: founders	Participating: investor	Participating: founders	Cost of participation to the founders
Low, $3.0M	$2.16M, takes PT	$0.84M	$2.37M	$0.63M	$0.21M
Medium, $8.0M	$2.16M, takes PT	$5.84M	$3.62M	$4.38M	$1.46M
High, $12.0M	$3.00M, converts	$9.00M	$4.62M	$7.38M	$1.62M

The arithmetic behind each participating figure is the same formula three times.

Low exitCFinv = 2.16 + 0.25*(3.00 - 2.16) = 2.16 + 0.21 = $2.37M

Medium exitCFinv = 2.16 + 0.25*(8.00 - 2.16) = 2.16 + 1.46 = $3.62M

High exitCFinv = 2.16 + 0.25*(12.00 - 2.16) = 2.16 + 2.46 = $4.62M

The conversion point. For the non-participating investor, converting is worth doing exactly when Finv*X overtakes PT.

Indifference0.25 * X = 2,160,000 which gives X = CT = $8,640,000

Below $8.64Mthe investor stays preferred and collects a flat $2.16M

Above $8.64Mthe investor converts and collects 25 percent of whatever the exit is

Two extensions worth checking that you can do. With a 2x multiple, PT = 2*2,000,000 + 160,000 = $4,160,000, so the conversion threshold moves out to 4,160,000 / 0.25 = $16,640,000 and the founders’ dead zone nearly doubles. And with a cap on participation at $20M, the participating investor stops accruing at 2.16 + 0.25*(20 - 2.16) = $6.62M, and only gives up the preference entirely above Xcom = 20 + 2.16*0.75/0.25 = $26.48M.

The lesson to carry out of the table: at the low exit the difference between participating and non-participating is small in absolute terms, $0.21M, but it is 25 percent of everything the founders were going to receive. Participation hurts most exactly where the founders can least afford it.

Apply it to your project

1. Do not read the valuation first. Cover it with your hand. Everything below is about what happens to money and decisions in states of the world you have not thought about yet, and the deck’s own warning is that cash flow rights can undo a generous valuation.

2. Sort every clause into the four areas - cash flow rights, control rights, compensation and employment, and other rights covering anti-dilution, future fundraising and liquidity. A clause you cannot classify is a clause you have not understood.

3. Find the security type and the preference. Is it common or convertible preferred? What is the multiple M? Is the dividend simple or compounding, and at what rate? Compute PT = M*I + I*D*T and then CT = PT / Finv yourself. Those two numbers define the shape of your entire payoff.

4. Ask the one-word question: participating or non-participating. Then build the low, medium and high exit table from the worked example above with your own numbers. If it is participating, ask for a cap and compute Xcom.

5. Check the anti-dilution wording. Full ratchet or weighted average, and if weighted average, narrow based or broad based. Run the re-pricing formula on a hypothetical down round at, say, 60 percent of your current price, and see what percentage you actually end up with.

6. List every decision right you are giving away. Board seats, whether any seat is contingent on a milestone, and every contractual right that supersedes voting and board control. For each veto or affirmative right, ask what happens in the scenario where you and the investor disagree, because that is the only scenario in which the clause is ever used.

7. Read your own employment agreement as an employee, not as a founder. Vesting schedule, cliff length, acceleration on an IPO or acquisition, what counts as dismissal with cause, the non-compete, and the IP assignment. Ask yourself concretely: if I am fired 11 months from now, what do I own?

8. Locate the option pool and its consumption rate. Is it 10 or 20 percent of the fully diluted base, and at 2 to 5 percent per year, how many years of hiring does it fund before you have to replenish it?

9. Walk the liquidity clauses. Redemption timing and amount, tag-along, drag-along, registration and piggy-back. Ask specifically what a drag-along lets the investor make you do, and check whether pay-to-play is present to keep existing investors honest in the next round.

10. Check the negotiation clauses before you sign anything. How long is the no-shop, is the offer exploding, is it conditional on due diligence or on co-investors joining, and are the milestones ones you can actually hit without under-pivoting or going short-termist.

11. Decide what you are trading. Use the section 15 logic: if you genuinely believe in the upside, a bigger preference for a higher valuation is a good trade for you. If you are privately unsure, it is a bad one. Be honest about which you are.

12. Then hand it to an experienced lawyer, which is the deck’s own instruction, and make them explain the interactions between clauses rather than the clauses one at a time.

Key terms

Term	What it means in plain words
Term sheet	The set of contractual clauses governing the rights and obligations of entrepreneur and investor, and the negotiation basis for the charter, the investor rights and purchase agreement, and the founder employment agreements
Incomplete contract	A contract that cannot list every possible future event, which is unavoidable and especially severe for uncertain ventures
Contingent contracting	Writing clauses that apply only in specified situations, instead of trying to describe the future
Milestone	A salient event that reveals whether progress matches expectations, used as the trigger for a contingent clause
Convertible preferred stock	The investor’s security: a debt-like fixed claim if the venture fails, convertible into common equity if it succeeds
Preferred terms, PT	What the investor is owed before common shareholders get anything, equal to the investment plus accrued dividend, times any multiple
Conversion threshold, CT	The exit value PT / Finv above which the investor prefers converting to common over taking the preference
Liquidation preference	The right to be paid first out of the exit proceeds; a multiple M returns the capital several times over
Non-participating preferred	The investor chooses either the preference or converting to common, but not both
Participating preferred	The double dip: the investor takes the preference and then also shares in the remaining common equity
Participation cap	A ceiling above which participation stops, added to preserve founder incentives; above Xcom the investor converts fully to common
Anti-dilution	Retroactive re-pricing of an earlier round after a down round, compensating an investor who paid too high a share price
Full ratchet	The harshest anti-dilution: the entire earlier round is re-priced at the new low price
Weighted average	Softer anti-dilution that re-prices only partway, narrow based on the earlier round’s shares or broad based including the founders’ shares
Down round, flat round	A round priced below the previous one, and a round whose price does not increase
Vesting and cliff	Founder stock earned back over time; the cliff is the minimum service period before any of it vests at all
Option pool	Shares reserved for employee options, 10 to 20 percent of the fully diluted base, consumed at 2 to 5 percent per year
Protective provisions	Contractual rights that can override voting and board control, as vetoes or as affirmative consents, often over the sale of the company or the CEO appointment
Pre-emption rights	The right to buy pro rata in future rounds so as to hold a percentage steady
Right of first refusal	The company’s right to buy shares an investor or founder is selling, on the same terms a third party offered
Pay-to-play	A duty on existing investors to keep investing pro rata, with forfeiture of rights such as anti-dilution or information rights as the penalty
Redemption rights	The investor’s right to have shares bought back after a long period, at the preferred terms
Tag-along and drag-along	The right to join a sale the founders are making, and the right to force other shareholders to sell
No shop clause	An agreement not to seek or negotiate competing offers for a defined period during diligence
Convertible note and SAFE	Seed instruments that postpone valuation, converting at the next qualified round at a discount and often a valuation cap; the SAFE drops the maturity date and dividend rate

Test yourself

1. Give the three legal documents a term sheet is the negotiation basis for, and list the five roles the deck says a term sheet plays.
2. Explain what contract incompleteness is and how contingent contracting responds to it. Then state the difference between a clause on a verifiable action and a clause allocating a decision right, and say which one suits ventures better and why.
3. A company has founders holding 1,250,000 common shares and an investor who paid $2,000,000 for 416,667 preferred shares, 25 percent of the company, with an 8 percent dividend and one year to exit. Compute the preferred terms and the conversion threshold, then say what the investor and the founders each receive at exits of $3M and $12M, first under a non-participating preference and then under a participating one.
4. What is a down round, and what does anti-dilution do about it? Contrast full ratchet with weighted average, and explain why broad based is friendlier to the founder than narrow based.
5. A founder is allotted 60 percent of the company, vesting at 6 percent per quarter with a one-year cliff. How much is vested after 9 months, after 12 months, and after how long is vesting complete?
6. Using the section 15 comparison, explain why an optimistic founder should prefer a 3x preferred deal at a higher valuation while a pessimistic founder should prefer the common share deal, even though both deals give the founder the same expected $180.

Answers

1. The corporate charter, the investor rights agreement and purchase agreement, and the founder employment agreements. The five roles: it governs the rights, obligations and rewards of the parties; it shapes the incentives of all parties including employees; it brings the parties to clarify their expectations; it allocates risk across the two parties; and it specifies the rights and duties of the parties towards external parties, namely employees and future investors.
2. Incompleteness means it is naturally impossible to cover all possible future events, a problem that uncertain ventures make far worse. Contingent contracting responds by writing clauses that apply only in certain specified situations, triggered by milestones. A clause on a verifiable action needs a milestone and relies on precise circumstances that disclose information; a clause allocating decision rights only needs to identify who has the right to decide. The second type suits ventures because venture information is opaque and difficult to interpret, so verification often is not possible.
3. PT = 2,000,000 + 2,000,000*0.08*1 = $2,160,000 and CT = 2,160,000 / 0.25 = $8,640,000. Non-participating at $3M: Finv*X = $0.75M is below PT, so the investor takes $2.16M and the founders get $0.84M. Non-participating at $12M: Finv*X = $3.0M beats PT, so the investor converts and takes $3.0M, founders $9.0M. Participating at $3M: 2.16 + 0.25*0.84 = $2.37M to the investor, $0.63M to the founders. Participating at $12M: 2.16 + 0.25*9.84 = $4.62M to the investor, $7.38M to the founders.
4. A down round is a round where the share price falls below the previous round’s price; a flat round is one where the price does not increase. Anti-dilution compensates an investor for having paid a price that turned out to be too high, by specifying a rule that retroactively adjusts the earlier round’s price and issues extra shares. Full ratchet re-prices the whole earlier round at the new low price, here $1.00 down to $0.75, regardless of how small the new round was. Weighted average re-prices only partway, weighted by how much new money came in cheaply. Broad based includes the entrepreneur’s shares in the base, making the base bigger, which pulls the adjusted price closer to the original, $0.88 rather than the narrow-based $0.82, so fewer extra shares are issued and the founder keeps 34.5 percent instead of 34.0 percent after the second round.
5. After 9 months, nothing, because the one-year cliff has not been reached. After 12 months the vested amount jumps straight to 4 * 6% = 24%. Vesting completes after 60 / 6 = 10 quarters, that is two and a half years.
6. All three deals give the investor the same expected $60 and the founder the same expected $180 at 50 percent success odds, so what is being traded is the shape rather than the average: a higher post-money valuation, $133 instead of $80, in exchange for a heavier preference. An optimist who believes success is 60 percent likely leans on the good outcome, where the 3x deal pays the founder $340 against the common deal’s $300, giving expected returns of $212 against $204. A pessimist at 40 percent leans on the bad outcome, where the 3x deal pays the founder only $20 against the common deal’s $60, giving $148 against $156. The spread table makes the same point structurally: under the 3x deal the investor’s payoff is completely flat at $60 in both outcomes while the founder’s swing widens to $320, so the founder has bought a higher valuation by taking over the risk.

Revision summary

Tip

The one-minute recap

• A term sheet is the set of contractual clauses governing the rights and obligations of both entrepreneur and investor, and the negotiation basis for the corporate charter, the investor rights and purchase agreement, and the founder employment agreements. Use experienced lawyers to read one.
• Its five roles: govern rights, obligations and rewards; shape incentives for all parties including employees; bring the parties to clarify expectations; allocate risk across the two parties; specify rights and duties towards external parties, meaning employees and future investors.
• Contracts are incomplete because no one can list every future event, and ventures make this worse. The fix is contingent contracting, with milestones as triggers, measured on financial, operational, managerial, technical and commercial dimensions. Milestones define targets, align expectations, give a focal point for renegotiation and help negotiate valuation - but performance can be elusive to define, and chasing them causes under-pivoting and short-termism. Where verification is impossible, clauses allocate decision rights instead.
• Four governed areas: cash flow rights, control rights, compensation and employment, and other rights covering anti-dilution, future fundraising and liquidity.
• Investors take convertible preferred, not common: a debt-like payoff if the venture fails, conversion to common if it succeeds. PT = M*I + I*D*T and CT = PT / Finv. Below PT the investor takes everything and founders take zero; between PT and CT the investor takes PT; above CT the investor converts and takes Finv*X.
• Participating preferred is the double dip: CFinv = PT + (X - PT)*Finv. A cap stops participation at Xcap to preserve founder incentives, with full conversion above Xcom = Xcap + PT*(1 - Finv)/Finv, and the drop at the cap is smoothed to avoid perverse exit incentives.
• Preferred stock exists to balance founder incentives, to screen out weak projects by self-selection, and to align expectations. In the deck’s numbers, self-selection lifts the investor from a naive 45 to an actual 51, while the common sheet attracts only the fakes and earns 36.
• Founders become employees: they can be fired, they face non-compete law, and they assign their IP. Pay is below-market salary plus bonus plus later options, deferred to save cash. Stock vests by time, with or without a cliff, and by performance, and is lost on dismissal with cause. In the example, 6 percent per quarter of a 60 percent allotment vests fully in 10 quarters, and the one-year cliff means zero at 9 months and 24 percent at 12 months.
• Option pool: 10 to 20 percent of the fully diluted base, set at Series A, replenished, consumed at 2 to 5 percent per year, with a small or last-round strike price, sometimes needing a company loan to exercise.
• Control rights come in three layers: shareholder voting, the board, and contractual rights that can supersede both, as vetoes or affirmative consents, typically over the sale of the company and the CEO appointment.
• Clauses reaching into future rounds: protective provisions, anti-dilution, pre-emption, right of first refusal, pay-to-play. Anti-dilution protects value after a down round, pre-emption protects percentage, and convertible preferred protects against a disappointing exit rather than a disappointing round. Full ratchet re-prices to $0.75; weighted average gives $0.82 narrow based or $0.88 broad based, leaving the founder with 33.3, 34.0 and 34.5 percent respectively against 35.3 percent with no protection.
• Liquidity clauses: redemption, tag-along to join a sale, drag-along to force one, and registration plus piggy-back to force and join a listing. Plus information rights, key man insurance, legal resolutions, representations and warranties, and the negotiation clauses: no shop, exploding offer, due diligence conditionality, co-investors and milestones.
• Valuation versus terms: valuation is the most visible and easiest term to grasp, but cash flow rights can undo it. Trade valuation against control, against compensation, and against upside versus downside. In the deck’s example all three deals give $60 expected to the investor and $180 to the founder, but a 3x preference flattens the investor’s payoff to $60 in every outcome and widens the founder’s swing to $320. An optimist gains from that trade, $212 against $204; a pessimist loses, $148 against $156.
• At seed, with amounts under $100K, unsophisticated investors and a likely fade-out, convertible notes convert automatically at the first qualified round into the same security then issued, at a 10 to 20 percent discount, maturity 12 to 24 months. A valuation cap stops the seed investor paying for success. Notes are cheap, standardised, carry virtually no control rights and postpone valuation; the SAFE goes further by dropping the maturity date and dividend rate.

Next: Staged Financing & Down Rounds → - why the money arrives in instalments.