When founders and their venture capital (VC) partners finally sit down to formalize their first funding agreements, the key details are usually negotiated in what’s known as a Term Sheet.
This document takes a long-term perspective on the company, looking beyond current market valuations to establish the rights and controls that will apply even after the deal closes.
Reaching this stage as a founder is both exciting and a bit overwhelming. On one hand, you’re likely thrilled to have found a private equity partner ready to back your vision. On the other, seeing your innovation translated into legal jargon can be jarring—and sometimes tough to decipher.
We've compiled some of the trickiest and most important terms you'll encounter when negotiating with investors, to clarify what they really mean and what you should keep in mind when bringing your priorities to the table.
Board Seats
You probably already know the general role of a Board. In many initial Term Sheets, board seats are allocated in proportion to share ownership. So, if investors hold about a quarter of your company's shares at the outset, they'll typically get 25 percent of the board seats as well.
However, as you move through future funding rounds, investors may end up owning a larger share of the company—or even a majority stake—to help extend your runway. Without clear language in your term sheet about board structure at key milestones, investors could eventually take majority control of your Board by default.
Here are a few alternative Board seat arrangements often included in post-Series A term sheets to avoid that scenario:
- 3-person Board; 2 members chosen by founders, 1 by the VC
- 3-person Board; 1 member chosen by founders, 1 by the VC, and 1 Independent Director
- 5-person Board; 2 members selected by founders, 2 by the VC, and 1 Independent Director
- No VC Board seats; investors receive “board observer rights” instead of seats
Liquidation Preference of Preferred Stock
If things don’t go as planned for investors, they’ll want the term sheet to include provisions that let them at least recover their initial investment. The Liquidation Preference is one such provision—it determines how much your main VC receives (before any other payouts) if the company is sold or liquidated.
The Liquidation Preference usually comes with a multiplier (for example, “2x Liquidation Preference”) that reflects the risk level of your venture. A “1x Liquidation Preference” means your VC gets back exactly what they invested, while a 2x preference means they receive double their original investment if there’s a liquidation event.
This can get complicated as your company goes through multiple VC rounds. What starts as a small investment can snowball into a much larger payout for investors as the business moves toward an exit.
In short, if the Liquidation Preference multiplier is set too high—and especially if there are several rounds of investment—there might be nothing left for common shareholders when the company is sold.
Participating Preferred Stock
This term builds on the protections offered by the liquidation preference. It’s a common request for VCs to not only get their liquidation preference in a sale, but also to receive a share of the remaining proceeds based on their ownership percentage.
In other words, VCs can recover at least their initial investment, and if they eventually own half your startup’s shares, they’ll also walk away with half of what’s left after the sale.
Unfortunately, many inventors are reluctant to remove this clause from their agreements. However, founders can argue that it could end up hurting the original preferred participants if future investors also add participating preferred terms to their deals. You can also negotiate for the participation rights to end once VCs have recovered their initial investment (or a multiple of it).
The key takeaway: don’t overlook or underestimate this part of your term sheet. While VCs often ask for it, founders should think carefully before agreeing—and make sure to discuss all the options.
Warrants
Warrants give investors the option to buy a set number of shares at a fixed price in the future. For founders, this can be a way to compensate investors instead of—or in addition to—cash. Warrants are often used in early-stage deals, but they can also appear in later rounds to offer extra upside to cautious investors.
The main thing founders should watch out for with warrants is that they usually give the right to buy shares from the latest stock class (not common shares or stock options). Warrants can also be used to compensate third parties, while regular stock is reserved for employees or stakeholders inside the company.
Veto Rights
While this term might sound intimidating (or confusing), it doesn’t necessarily mean investors get outsized control over decisions (for that, see Board Seats above).
Instead, these provisions are designed to protect a VC’s investment and maximize their potential return—which can benefit everyone if they’re clearly defined and used appropriately.
Some common veto rights include:
- The ability to change the rights—or increase or decrease the number of authorized shares—for preferred or common stockholders.
- Redeeming or acquiring any common shares on Board-approved terms
- Final approval over a sale or liquidation
- Setting limits on new debt
- Approving changes to the size or composition of the Board.
These are just a few of the VC terms founders will encounter as they seek funding. But remember: private equity isn’t the only path to growth.
If research and development is at the core of your business—whether you’re an early-stage company in a new market or a fast-growing startup constantly evolving your product—you have access to a range of non-dilutive funding options that can extend your runway without giving up equity.
Stay tuned for Part 2 of our series next week for more insights on what to expect when negotiating VC Term Sheets.
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